UCITS

New policy regarding short selling for Irish UCITS

MARK BROWNE, MAPLES AND CALDER, CAYMAN ISLANDS

The Irish Financial Regulator has recently announced details of a policy change that will permit collective investment schemes authorised as Undertakings for Collective Investment in Transferable Securities (UCITS) in Ireland to carry out short sales, subject to certain conditions. The change in policy is designed to facilitate the use of shorting strategies, including the so called ‘13030’ strategies, by UCITS. It is anticipated that this change will create greater interest among alternative investment managers in establishing products authorised as UCITS. This article seeks to explore the revised policy and provide a general overview of market developments in the UCITS space.

Background to the revised policy

The UCITS regulatory regime was substantially revised in recent years by the amendment of the initial UCITS directive and the adoption of the so-called UCITS III regulatory regime. Although it had been highly successful, aspects of the initial UCITS directive, which dated back to the mid 1980’s, were increasingly viewed as inappropriate given the innovation and general development which had taken place in the financial markets since the introduction of this legislation. In particular, the template restrictions imposed on UCITS and the prohibition on using derivative instruments for investment purposes were out of date in the context of current market practices. The adoption of the UCITS III regime, which comprised two Directives, respectively referred to as the ‘Management Directive’ and the ‘Product Directive’, greatly increased the scope of the range of permitted investments for UCITS. Key amendments included a revision of the investment restriction template and importantly the inclusion of financial derivative instruments as permitted investments in their own right.

Following the adoption of UCITS III, collective investment schemes authorised as UCITS have been progressively pursuing investment strategies involving derivatives as permitted under the revised regime. One of the key growth areas in this regard has been the creation of the so-called ‘13030’ funds. This strategy involves the use of a portfolio that combines long positions with a total value of 130% of the net asset value of the portfolio with short positions with a value of 30% of the portfolio. This can be achieved where the UCITS borrows a stock which it has sold short using its assets to support the borrowing transaction and then uses the proceeds from the short sale to achieve leverage which it invests in additional long positions. The portfolio therefore comprises a combination of long positions with a total value of 130% of the net asset value of the portfolio with short positions with a value of 30% of the portfolio. Similar strategies using alternative ratios are also possible.

Regulatory considerations

Although UCITS III extended the range of investment strategies that UCITS could pursue, such funds remain prohibited from carrying out uncovered short sales. Following submissions from the funds industry in Ireland, the Irish Financial Regulator reviewed its policy regarding the use of short sales in conjunction with the Guidelines Concerning Eligible Assets for Investment by UCITS as prepared by the Committee for the European Securities Regulators (CESR). Following this review, the Financial Regulator concluded that a distinction could be drawn between ‘covered’ and ‘uncovered’ short sales and that where a stock is borrowed prior to entry into a short sale, this would be viewed as being a ‘covered’ short sale.

UCITS are subject to strict limits on the amount of borrowings that they may incur. However, the Financial Regulator further concluded that stock borrowed under stock borrowing arrangements would not constitute ‘borrowings’ for the purposes of these restrictions provided certain conditions are complied with.

Accordingly the Financial Regulator recently issued an amended policy regarding the use of short sales by UCITS and has revised the relevant UCITS Notices applicable to this issue.

Amended policy

Under the amended policy, the Financial Regulator will now permit UCITS to engage in short selling, provided that:

  • the strategy only involves covered short sales, in accordance with the UCITS Regulations ;
  • leverage generated falls within the permitted limits, as measured by the global exposure of the UCITS;
  • the strategy is subject to a risk management process prepared in accordance with the Financial Regulator’s requirements; and
  • there is appropriate disclosure of the strategy in the prospectus.

The prospectus of a UCITS intending to engage in short selling will be required to include the following:

  • a clear description of the strategy, including details of relevant stock borrowing arrangements;
  • an indication of leverage levels to be incurred;
  • confirmation that leverage will be measured in accordance with the requirements of the Financial Regulator and will be added to any exposure created through the use of financial derivative instruments for risk management purposes; and
  • inclusion of appropriate warnings in the risk factors section of the prospectus.

The revised policy has been warmly welcomed by the funds industry in Ireland as it clarifies the Financial Regulator’s position and further enhances the attractiveness of Ireland as a domicile for UCITS.

Implications for the alternative investment industry

This latest policy amendment facilitates the adoption by UCITS, which has historically been a traditional investment product, of strategies that have hitherto been the remit of alternative investment managers. As such it represents a further example of the increased convergence between the traditional and alternative branches of the investment industry.

The defining attraction of authorisation as a UCITS is the ‘passport’ it grants the relevant fund to be sold on a retail basis throughout the European Union without receiving any additional authorisations from local regulators. Authorisation as a UCITS is also increasingly seen as an international badge of approval and the products are recognised to varying degrees by regulatory authorities in jurisdictions outside the European Union such as Chile, Hong Kong and Singapore.

Traditional investment managers with products authorised as UCITS may now take advantage of this amended policy to offer a wider range of strategies, while availing of the UCITS passport. Accordingly this policy change increases the potential for additional competition for alternative investment managers from the traditional sector.

On the other hand, alternative investment managers may now also seek to take advantage of this policy change to launch products authorised as UCITS, which invest derivative instruments and engage in short selling but can still take advantage of the UCITS passport. There is already significant interest being shown in these new opportunities by the alternative market sector.

In summary, the recent policy changes relating to Irish UCITS have amplified the level of convergence with the alternative investment industry that is now possible for such products and mean that UCITS now represent an increasingly attractive vehicle for alternative investment managers and promoters.


Biology

MARK BROWNE

Mark Browne is an associate in the Cayman Islands office of Maples and Calder and advises on the establishment of both Cayman and Irish domiciled investment funds, including hedge funds and UCITS.