Discussing Passports and UCITS Wrappers with John Adams

Regulatory, UCITs 22 May 2012

John Adams, counsel in the London office of the global law firm Shearman & Sterling, advises clients on the formation, operation and promotion of all sorts of retail investment funds as well as on their documentation.

He is very illuminating on the current state of the EU’s Alternative Investment Fund Management Directive.

Context

One of the goals of AIFMD, one of the motives that have long driven the process, is the desire to remove some of the political and regulatory constraints in the way of onshore and pan-Europe operations. Indeed, IPE recently quoted a Lyxor manager thus: “Many of these investors are fully supportive of the move from what they sometimes perceive as offshore, tax-haven investing, or non-transparent black-box investing, toward onshore and more regulated investment.”

But part of the lure that is supposed to draw fund managers “onshore,” within the EU jurisdictions, is the creation of a “passport” system. The success of UCITS funds – that is, funds working under Europe’s framework for “Undertakings for Collective Investment in Transferable Securities” in its latest incarnation, which have long had the benefit of passporting – has encouraged the idea. UCITS funds with authorization to market in their home Member State are marketed throughout the European Union. The new Directive will offer the same feature to AIFs – eventually. It will also allow an EU AIFM in compliance to market non-EU AI funds to qualified investors within the EU.

Unfortunately, the passporting aspect of AIFMD seems to have been indefinitely delayed. Further, there is speculation in some quarters that it isn’t the AIFMD but UCITS/Newcits that offers the “future of hedge funds” in Europe.

No Passports

Against this background, I asked Adams about how outside managers might go about marketing themselves in Europe. He said: “Right now there is no marketing passport. Whether you are in New York or in Europe, the marketing rules you’ll have to obey differ through Europe, country by country. In Italy, for example, it is incredibly hard to market alternatives at all. You have to let investors come to you.”

The member states of the EU are expected to enact the pertinent legislation in July 2013. Then a London-based fund will be able to market in Italy by virtue of an intra-EU “passport,” although a hedge fund firm in New York or Hong Kong won’t be able to get such a passport for some time to come. The outsiders will have to work country-by-country, and this may well put them at a serious competitive disadvantage.

The whole issue of non-EU (or, as they are called, “third party) managers is quite controversial. On the one hand, there is a good deal of sentiment both inside and outside of the EU that a “Fortress Europe” approach, seeking to lock out managers in New York or Hong Kong, would be a mistake.

On the other hand, says Adams, “The argument being made by those opposing a passport for third countries was basically: if you want to have access to European investors, you need to be regulated under our rules.” Poul Rasmussen, a former prime minister of Denmark, in particular has become identified with this position.

ESMA and UCITS

As regular readers of AllAboutAlpha already know, there are significant differences between the ESMA and the EC drafts of the Level 2 implementation. Adams’ take on this? “Unfortunately, the Commission staff came up with something that didn’t follow ESMA’s advice in some very important ways. Some aspects of the Commission’s draft could prove unworkable. The member states are in intense discussions now about the necessary improvements to this draft.”

Many managers, perhaps especially those from countries outside the EU, are no doubt already considering the pluses and minuses of AIFMD as it is shaping up on the one hand, and Newcits on the other.  Newcits of course are funds working under UCITS that employ hedge fund style strategies.

Asked about Newcits, Adams said, “For as long as non-EU managers can’t have a passport under the AIFMD, UCITS will continue to benefit from a marketing passport. And many hedge fund strategies can fit within the UCITS wrapper.”

He did caution, though, that UCITS are held to very strict requirements as to diversification, leverage, and redemption. These will make them a poor fit for some hedge fund. Also, he said, for “other alternatives like private equity, UCITS is not really an option at all.”

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