By Shane Brett
Now that the European AIFM Directive is moving towards its final form, one of the main issues affecting the hedge fund industry is what to do about domiciliation. With the existing “Private Placement” regime finishing in 2018, what will happen to non-EU based managers who want to market and sell their funds inside the EU?
To date the legislation has taken an inside or outside of Europe view, i.e. that the Hedge Fund either operated fully within the EU or fully outside it. This view also applies to Hedge Fund investors, service providers and Managers. In reality there is no such clear division. Funds (and their service providers) operate across multiple jurisdictions, just like organizations in any other global industry.
As a way around this one of the options raised in the last couple of years has been the possibility of Hedge Fund Managers running both an existing off-shore fund (largely Cayman domiciled), as well as a second mirror fund, on-shore in Europe.
While co-domiciliation would overcome the regulatory restrictions imposed by AIFMD, it does throw up a number of challenges.
Operationally it could be tricky to run an on-shore clone fund in parallel with an existing offshore structure. The EU vehicle will have stricter regulatory rules in areas like leverage and reporting. Maintaining an identical investment strategy in both will be a challenge and it may have an impact or divergence on performance.
Costs will be another factor. The on-shore fund will have additional regulatory requirements (relating to reporting, depositaries and the use of an administrator) that may not be application to the offshore entity.
It also means hedge funds may be trying to implement a co-domiciliation strategy while the outcome of the on-going Euro Zone crisis is being played out in the background. It will make for a challenging environment to implement substantial organizational change.
A recent report by RBC Dexia Investor Services and KPMG found that more than half (55%) of managers had opted for co-domiciliation over bringing an off-shore fund fully on-shore (24%). Though some large fund of funds (like Amundi Alternative Investments) have already changed their existing structure and moved their funds fully onshore, re-domiciling within the EU regulated framework.
Indeed hedge fund-friendly EU locations like Ireland & Luxembourg are pushing hard to promote themselves as an alternative domiciliation location. Ireland (which already has nearly half the global hedge fund administration market) is promoting its existing AIFM compliant QIF structure. Legal firms such as Ogiers are in the process of setting up offices in Luxembourg, specifically to meet the potential demand for co-domiciliation services.
The KPMG report also noted that even though many managers are considering co-domiciliation, very few were planning on moving fully away from the off-shore structure. Cayman is not about to be replaced. The existing Cayman driven model seems to service most investor’s needs. Co-domiciliation is likely to a complimentary (rather than replacement) option.
Many of the existing non-EU domiciles (including Cayman & the Channel Islands) are currently negotiating co-operation agreements with the EU, in order to ease the ability of Managers to run a co-domiciled fund.
While running an EU-based clone fund will not appeal to every manager, it may be attractive to those with a sizable European investor base, especially if those investors have an appetite for deeper regulation and transparency.
As the European industry moves toward a more UCITS-like regulatory model, co-domiciliation could be a future option for many global Hedge Fund Managers.
Shane Brett is Managing Director of Global Perspectives, an alternative investment & asset management consultancy based in London & Dublin.