Which business model for tomorrow?

Originally published in the February 2010 issue


• The introduction of a full Management Company Passport (MCP)
• A new legal framework to facilitate cross-border UCITS mergers
• The introduction of UCITS Master/Feeder structures
• Replacement of the Simplified Prospectus with a Key Investor Information (KII) document
• A new and more efficient regulator-to-regulator notification procedure for registration of UCITS in EU countries
• Improved cooperation mechanisms between national supervisors to supervise cross-border business models

Aims and background of this report
Since the adoption of the original UCITS Directive in 1985, UCITS products have evolved into a dynamic and highly successful global brand, attracting interest from investors in Europe, Asia, Latin America and beyond. This success has driven a steady evolution of the market, underpinned by the release of a series of further European Directives, including the so-called UCITS Product and Management Directives in 2001, designed to enhance and expand the scope and range of the UCITS framework.

Markets are now set to embrace the latest phase of UCITS development with the implementation of UCITS IV in July 2011. While this process is still at an early stage, preparations for its introduction have created a raft of detailed new regulations and involved considerable industry consultation and participation. This report is based on a major RBC Dexia Investor Services/KPMG study assessing the likely impact of UCITS IV on the asset management industry. The purpose of the study was to gather opinions from a broad range of asset managers six months after the final text of the new UCITS IV Directive was approved by the European Parliament.

The study was designed to gain a better understanding of the intentions of the industry in capitalising on this evolving regulatory framework and also sought to explore the extent to which asset managers will use its key components, such as the new Management Company Passport (MCP) and Master/Feeder structures and are more likely to become more widely involved in cross-border fund merger activity. An important additional aim of the study was to identify any early indicators of how UCITS IV might contribute to change in the wider investment industry – and to broaden debate and discussion on this topic. As our research indicates, UCITS IV has already started to generate a wide level of interest and activity among the asset management community. Our study reveals important insights on the likely development of new competition between asset managers and the ways in which cross-border asset management and fund servicing models are likely to evolve under UCITS IV.

The report’s findings are based on a two-step approach with study data drawn from an online questionnaire of 52 asset managers conducted during June and July 2009, followed by structured interviews with senior executives from a number of major asset management companies.

Key messages
The main findings of our research are as follows:
• The vast majority of UCITS managers are taking a proactive approach to UCITS IV. Asset managers are already analysing the potential and implications of UCITS IV and intend to plan early how to leverage this new regulatory change to gain competitive advantage. Most have already gained a solid understanding of UCITS IV and are starting to look at the new strategic options it presents.
• Immediate cost savings are expected. The key high point of UCITS IV is the cost savings it is expected to deliver. The Management Company Passport will remove the duplicate costs of running several Management Companies in multiple jurisdictions and there are also potential cost savings from consolidation/rationalisation of fund administration. The new notification process to register UCITS in other EU markets presents significant and immediate cost savings for market players.
• The number of Management Companies will decrease under UCITS IV and many crossborder organisations intend to make use of the Management Company Passport to consolidate the number of Management Company legal entities that they operate in the EU. Current economic pressures and the arrival of UCITS IV will drive fresh fund consolidation in Europe as managers seek to limit costs and maximise efficiency.
• A favourable tax regime and regulatory framework will be crucial. The choice of location of the Management Company will be heavily influenced by the tax regime and regulatory framework of that domicile. VAT aspects are important and there is a preference for domiciles with a strong regulatory framework given potential issues with split supervision under the Management Company Passport.
• A new wave of fund mergers lies ahead. The investment funds market will see a new trend to merge local funds in advance of UCITS IV. In certain jurisdictions the new UCITS IV fund merger rules will add complexity to the regime for merging local funds, prompting some market players to accelerate local fund mergers in advance of UCITS IV implementation in 2011.
• Luxembourg and Ireland will gain. UCITS IV will drive an increase in assets under management in Luxembourg and Ireland as these jurisdictions are ideally placed to centralise and service assets from Master/Feeder structures and cross-border mergers. However, asset managers having their funds already domiciled in key markets such as the UK, France or Germany may decide to consolidate operations in their own markets.
• Master/Feeder structures will be a key for new markets or client segments. Asset managers intend to use the new UCITS IV Master/Feeder structure proactively for the distribution of products into new target markets and client segments. The harmonised framework will permit easier access to the full range of EU markets.
• Existing fund administration models may be challenged. UCITS IV may trigger a rethink of the fund administration model and spark new competition among administrators as asset managers reconsider their support options.
• The absence of a tax framework is the only significant drawback. The existence of a favourable tax regime is a key influence on funds domicile. There are some key concerns relating to VAT, tax residency, withholding tax and the implications of cross-border mergers. Clarification of the tax impact is still required.
• No ‘big bang’ but significant change to be expected. UCITS IV will bring significant benefits through cost savings and potential consolidation. Although it will not drive ‘big bang’ style reform in the investment industry, it is likely to drive significant change, increasing choice and flexibility and maximising cost effectiveness and efficiency for asset managers operating in the UCITS fund market.

Proactive approach
The vast majority of UCITS managers are taking a proactive approach to UCITS IV and intend to plan early how to leverage the new regulatory changes to gain competitive advantage. Respondents were asked about the timeframe for their UCITS IV preparations. It emerged that planning is well underway. Nearly three-quarters (72%) had already started work on understanding the possibilities of UCITS IV, and a further 16% expected to have this completed in the course of 2009. Meanwhile, 72% expected to have analysed their current structure and to understand the tax, legal and contractual barriers and constraints of UCITS IV in the current year, including 37% who had already started on this work. Over half (54%) expected to have defined strategic options for funds by the end of 2009, including 28% who had already started on this while most of the rest (42%) intended to do this in 2010. Defining strategic options for Management Companies was generally more likely to happen in 2010 (50%).

UCITS IV possibilities
As optimism slowly returns to a global securities market battered by the recent financial crisis, global asset managers are seeking a range of new business opportunities. Impressed by the success of UCITS products in Europe and beyond, many are now looking to the next phase of their development, UCITS IV, for fresh ideas to expand their product offerings and capitalise on new business opportunities in readiness for its launch in 2011. The research confirms that asset managers are already planning to capitalise on future regulatory change under UCITS IV with many keenly aware of the potential opportunities the new Directive presents. A large majority of companies approached in our study are clearly demonstrating a proactive approach to the management of new opportunities and risks, exploring ways they can leverage new regulatory change to capitalise on opportunities promised by UCITS IV. Indeed some respondents – particularly those that have been closely involved in the preparation of UCITS IV legislation – already have a broad idea of how they will implement UCITS IV.

Impact analysis & strategic planning
While full UCITS IV implementation is still some way ahead, many asset managers are busy evaluating the likely impact of UCITS IV on the business and operating model for their Management Companies and their funds. Over a third of respondents said they were already examining their current structure and a similar proportion intended to do so this year. Many are also reviewing their product range and assessing share classes, charging structures, distribution channels and client segments and their expected requirements going forward. While many of our study respondents have already started to analyse scenarios to identify the benefits and constraints UCITS IV presents, the full picture surrounding implementation remains partially incomplete as one key element is currently missing. A full understanding of the final implementing measures for UCITS Management Companies, due to be released in July 2010, is necessary before any detailed analysis can be finalised and decisions made. Asset managers will also need to factor into their analysis any developments or changes to the taxation framework for UCITS across the EU.

Importantly, UCITS IV will introduce a passport for the UCITS Management Company (the Management Company Passport or MCP), which means that fund promoters will no longer be required to operate separate Management Companies in each EU Member State where UCITS are domiciled. UCITS IV also introduces the facility to create Master/Feeder structures which allow a UCITS Feeder fund to be invested in a Master UCITS, enabling the UCITS manager to achieve increased economies of scale and lower operational costs. Again, asset managers are awaiting the final implementing measures for UCITS Management Companies and Master/Feeder arrangements before they can make an informed decision as to whether to centralise their own Management Companies, create Master/Feeder structures or merge funds cross-border.

Detailed implementation measures
New provisions on the MCP will be accompanied by an extensive set of implementing rules that the Commission is required to adopt by 1 July 2010. These rules are part of a compromise to help build mutual confidence between regulators, which is necessary for the MCP to work effectively. The European Authorities are currently working to define the detailed rules, and aim to achieve a high level of consistency between the new rules and relevant Market in Financial Instruments Directive (MiFID) rules in this area.

The implementing rules related to the MCP will cover the following areas:

• organisational requirements
• risk management
• rules of conduct
• conflicts of interest
• measures to be taken by the depository
• exchange of information between competent authorities
• on-the-spot verification and investigation

In autumn 2009 the European Authorities consulted with market participants on a second wave of implementing rules relating to mergers of UCITS, Master/Feeder structures and the cross-border notification process that should also be implemented before July 2011. Certain respondents to our study indicated that they were actively engaged in the consultation process, providing their opinions and working to help shape the new implementing measures.


In addition to outstanding questions on the MCP, various tax issues surrounding UCITS IV need to be clarified before asset managers can truly assess their strategic options under the new Directive. While most asset managers agree that UCITS IV will bring significant change and broadly welcome the new initiative, individual asset managers have different views on how soon they will commit to the market in terms of product development and organisational change. A number of respondents said that they would adopt a ‘wait-and-see’ approach to UCITS IV. These companies do not want to be early adopters of newly available facilities under the Directive and instead intend to study how the competition adapts to UCITS IV, note the options that work successfully and then replicate them.

Introducing the MCP
The introduction of the MCP facility under UCITS IV is arguably one of the most exciting and potentially landscape altering changes permitted under the new Directive. The MCP will allow a Management Company authorised in one Member State to manage, administer and market corporate or contractual funds in another Member State. It also creates rich potential for the consolidation of UCITS Management Companies throughout the EU. The respondents in our study were asked the following: indicate the top three factors in determining the choice of domicile for the UCITS IV Management Company and whether they would consider the MCP as an opportunity to centralise their UCITS Management Companies and, if so, which would be their chosen jurisdiction.

The most important factor overall, mentioned by almost half of respondents (49%) was the existence of a favourable tax regime. Also important, however, was the regulatory framework including the extent of permitted outsourcing of core activities (44%), the existence of a UCITS III Management Company in the jurisdiction (42%) and a preference for staying with the Group’s principal location in the EU (38%). One in three (33%) would be influenced by the availability of qualified and experienced personnel, 29% would choose the same domicile as their existing UCITS while one in four (24%) cited operational costs.

The tax challenge
As noted, tax was the most frequently mentioned factor in determining Management Company domicile (49%). Asset managers are understandably keen to secure the most tax efficient arrangements possible for their Management Companies. Several respondents considered the VAT aspects to be particularly important as the actual scope of the VAT exemption on management fees may vary from country to country, particularly in relation to outsourced activities. Transfer pricing issues also need to be considered. Controlled Foreign Corporation (CFC) tax rules raise some issues and tax authorities may pay more attention to transfer pricing policy in future. Among the most important questions is how the tax authorities will determine the tax residency of contractual funds, and trusts in particular, as well as corporate funds.

A sound regulatory framework
The presence of a modern regulatory framework was considered important by 44% of respondents, particularly in a post UCITS IV environment which will widen the scope of cross-border options. The need to locate in domiciles with strong regulatory reputations and the expected approach to be taken by the various regulators were important themes raised. The MCP relies heavily on the concept of split supervision and creates a degree of mutual dependency among regulators. Some respondents were apprehensive as to how regulators would react to cross-border supervision in the future. UCITS funds have become more complex than in the past and require sound supervisory oversight and control. These factors are of paramount importance to maintaining the integrity of the UCITS brand. Some asset managers perceive a real risk of effective ‘double supervision’ and the attitudes of regulators in key markets will be important here.

It has been clear in the consultation phase of UCITS IV that not all regulators within CESR are equally comfortable with the MCP and that it opens up regulatory cooperation challenges. The passport therefore needs a working model whereby full and timely cooperation, trust and harmonised practices can exist between regulators. If this is not the case then a Management Company making use of the MCP may well find itself subject to a second unofficial level of supervisory control by host regulators. To enhance confidence between authorities, UCITS IV implementing measures will address rules in relation to cross-border cooperation between supervisors that should ensure the smooth operation of the MCP. The question remains as to whether this will be sufficient.

UCITS III Management Company
The existence of a UCITS III Management Company in the domicile chosen by asset managers to locate in was a key consideration for 42% of respondents. The presence of a Management Company with significant know-how and expertise was perceived as a major advantage. Keeping a local entity also serves to maintain a high level of investor protection. Respondents to our study were asked whether they would consider the MCP as an opportunity to centralise their UCITS Management Companies. A majority (60%) said that they would; however a significant minority (40%) would not. Their reasons, and the preferred domicile for any centralisation, are considered in more depth below.

The case for centralisation
The advantages of the MCP have not been lost on an asset management community facing growing costs, complexity and the aftermath of the recent financial crisis. In our study, 60% of respondents said they viewed the MCP as an opportunity to centralise their UCITS Management Companies and create efficiencies via consolidation of their existing Management Company entities. The MCP may prove particularly interesting for those asset managers that have expanded in Europe through merger and acquisition (M&A) activity. In the past, certain groups expanded in the EU through mergers and/or acquisitions of asset management groups established in different EU countries, as opposed to organic growth of their business, and thus inherited or acquired a web of duplicate Management Companies and similar fund ranges. These groups would particularly welcome the UCITS IV MCP and the new fund merger regulatory framework as a potential means of rationalising this duplication. Looking forward, more M&A activity in the sector is predicted in the future as:

• some banks are expected to spin off their asset management units;
• UCITS funds have suffered significant withdrawals since the credit crunch;
• some asset managers are expected to exit the business due to low assets under management and underperforming funds.

The new MCP facility itself is flexible enough to allow investment managers a range of options in determining their Management Company location and requirements. Several respondents to our study said they would use the MCP without making any changes to their current fund structures. These companies aim to consolidate the Management Company in their Group’s principal location in the EU and leave any funds they manage in their relevant ‘exporting’ countries. A majority of 60% of respondents would consider the MCP as an opportunity to centralise their UCITS Management Companies.

In turn, a number of study respondents said they considered the MCP an interesting option for new entrants to the UCITS market whose development would help them put in place an optimal crossborder structure. A third group of respondents said they intended to use the MCP combined with the new UCITS IV Master/Feeder structure to sell products into new EU markets or to new market segments. Certain respondents already operate substantial cross-border business models supported by service providers in several EU jurisdictions, or with investment management based in different international locations. Oversight and compliance of these operations is already working well and could be extended to the Management Company. In turn, this could lead to the establishment of centres of excellence, reduced operational errors and real economies of scale. Whichever approach companies decide to take to the MCP, if any, its creation does offer added flexibility and potential to build new efficiencies and lower costs in the burgeoning UCITS market.

Under UCITS IV a wide range of options exists to centralise UCITS Management Companies. Traditional UCITS distribution or exporting centres such as Luxembourg and Ireland are just one choice and asset managers now have the possibility of basing Management Companies in the same location as their Group headquarters, in an EU country with a strong domestic fund market such as France, Germany, Italy or the UK or in an emerging low cost EU Member State to minimise costs. Respondents were asked what the most probable scenarios for centralising their UCITS Management Companies were (i.e., in which jurisdictions were they likely to be based). By far the most popular option was Luxembourg, mentioned by 43%. The only other significant individual jurisdiction was Ireland (18%). One in four (23%) were likely to choose the jurisdiction of their Group headquarters while 13% favoured another EU domicile.

Fund administration
The UCITS IV Directive will pose a number of administrative challenges and opportunities. This could trigger a rethink of current administration models if asset managers choose to centralise their UCITS Management Companies or establish a Master/Feeder structure allowing cost efficiencies to be gained by having the same service provider in different jurisdictions.

The likely impact of UCITS IV implementation on the fund administration market is not yet fully clear, but our study found that this area is already an important focus of attention for asset managers. Over half (52%) of respondents did not plan to concentrate their administration further as they had already carried out this centralisation exercise. However, a similar proportion (48%) indicated that they did plan to concentrate the administration of their UCITS products going forward. In parallel, there is a growing trend towards creating more efficient models of administration with institutions streamlining and consolidating operational processes. Other factors driving this trend include cost pressures, increased competition, increased product complexity and growing regulatory and disclosure requirements. Asset managers are increasingly seeking to outsource non-core activities (such as back-office services) and sharpen their focus oninvestment management.

Preferred operating model
Asset managers face a wide range of administrative options. While some may choose to handle this function completely in-house, others will use a single external service provider or multiple providers. Respondents were asked what would be the most likely operating model for their fund administration under UCITS IV. The most popular choice (37%) was to have a limited number of preferred external service providers. This is seen in part as allowing for services and fees to be easily compared. However, one in four (25%) preferred a full internal/insourced operating model, while the option of an internal/insourced model with partial outsourcing and that of a single external service provider were both preferred by one in five (19%).

Fund rationalisation grows

The proliferation of funds within the EU has been widely noted and the market represents a highly fragmented sector made up of over 37,000 UCITS funds. Several factors have driven the exponential growth of European funds in recent years, notably national preferences for local retail funds, the fragmentation of the investment management industry in the EU and the different tax and regulatory requirements of individual markets.

There are many new fund launches in an industry that is characterised by innovation, but the European funds market faces a number of key issues. In terms of efficiency, many funds are sub-optimal in size and over 50% of funds have less than €50m in assets under management (US funds are on average five times larger than European funds). Costs to investors are high in terms of Total Expense Ratios (TERs) and this impacts the competitiveness of UCITS products.

These factors are driving demand for measures which will enable rationalisation of the European funds market. The desire for this exists, especially among asset managers that have acquired crossborder businesses. Against this backdrop, considerable merger and acquisition activity is taking place within the funds industry, with more anticipated in future. A number of banks look likely to sell off their asset management units and some of the smaller asset managers may exit the UCITS business altogether. Our study revealed that 49% of respondents plan to restructure their fund ranges, and that:

• Many groups have not waited for the advent of UCITS IV to rationalise their fund ranges. The trend to rationalise funds is already established and is set to continue.
• Rationalisation is being driven by big drops in assets under management due to a number of factors, not least falling markets and high levels of redemptions in the wake of the economic crisis. As a result, asset manager revenues have decreased with fund managers increasingly keen to streamline fund ranges.
• Going forward, fund managers are likely to retain only those funds that are in strong demand or have achieved critical mass.

UCITS IV may well accelerate this trend. That said, the industry will continue to launch new funds to meet client demands. While the rationalisation trend is well in train, it was noted by study respondents that it is easier to launch new products than to rationalise or close existing fund ranges. Rationalisation requires a high degree of discipline. While UCITS IV merger provisions will facilitate cross-border fund mergers, the market may also see a large number of new Feeder funds emerge. It will be important to identify Feeder funds separately and to assess any real rationalisation in Europe resulting directly from UCITS IV.

High Points of UCITS IV
Respondents were asked what, overall, was the single high point of UCITS IV for their company. By far the most important advantage noted was cost savings, mentioned by 43%. However 24% also cited easier access to EU markets and 21% the increased competitiveness of UCITS products. Most importantly, only 2% saw no advantages at all in the new UCITS structure.

Drawbacks of UCITS IV
Respondentswere asked what, overall, was the main drawback of UCITS IV for their company. By far the most important drawback was the absence of a tax framework, mentioned by almost half (45%). Other drawbacks included: the perception that UCITS IV would not deliver on its promises; that there would be an increase in compliance costs; and that there would be an increase in red tape/bureaucracy – each cited by 10% of respondents. However, one in five (18%) saw no drawbacks at all.

While the advent of UCITS IV is a major new development, a range of separate external developments may also influence its future impact and success and shape the debate over continued evolution of UCITS funds. Important factors include the following:

• The market will need to assess the impact that the proposed Alternative Investment Fund Managers (AIFM) Directive will have on the European asset management industry as a whole. Developments surrounding the AIFM may well remove much of the demand for a potential UCITS V, specifically in relation to the proposed passport for real estate funds. The content of any future UCITS V Directive is likely to depend to a great extent on the scope of the final AIFM Directive.
• There will also be a need to monitor the impact of the financial crisis and greater controls on liquidity and counterparty risk.
• Current consultation by the European Commission on the UCITS depository function in the wake of the Madoff fraud could lead to new legislative proposals on the status, role and liability regime for the UCITS depository and could have a major impact on costs in the industry. This will need to be closely monitored.
• Corporate governance is expected to be more prominent. This may drive the need for a Code of Conduct for the UCITS industry as it increasingly manages the retirement money of many retail investors. Similarly, the market may face calls for Independent Directors of UCITS funds.
• Going forward the industry will need to monitor closely the impact of other changes, such as potential International Financial Reporting Standards (IFRS) adapted for funds and risk management practices.

It should also be noted, however, that a number of respondents commented that the impact of UCITS III had yet to be fully realised and that adjustment to UCITS IV could take some time. There are also some remaining issues regarding the delineation of UCITS and non-UCITS funds.

Towards UCITS V
One current topic of debate in the market is: if a UCITS V Directive were to be created should it amend or extend existing UCITS investment powers? As yet, the depth and breadth of investment strategies possible under UCITS III are still emerging and the full investment scope of UCITS products has not yet been fully exploited. There is still demand for new product development and innovation. There is also a growing interest among hedge fund managers in using the UCITS passport to sell products across Europe, Asia and South America.

In terms of expanding the UCITS fund range, there may be a case for allowing small investments in precious metals and microfinance to enter the UCITS framework to provide better protection to investors in uncertain markets. But any future extension of UCITS investment powers should carefully assess any likely increase in risk within the context of protecting the hard won strength and reputation of the UCITS brand.

Jean-Michel Loehr is Chief, Industry & Government Relations with RBC Dexia Investor Services. Vincent Heymans is Partner with KPMG Luxembourg.