By Hamlin Lovell
Costs are the chief criticism of UCITS hedge funds: extra costs for the levels and layers of supervision and monitoring, from daily reconciliation and reporting, to depositaries and risk management, local regulators and the over-arching Luxembourg regulator that approves and monitors UCITS. The European Commission in Brussels has explicitly identified high Total Expense Ratios (TERs) as a concern, although it has not yet imposed any ceilings on costs. The regulator pragmatically recognizes that some of these costs historically stemmed from operating multiple feeder funds of small size for different European Union states. Just as each US state has its own insurance regulator, so too each EU member state has its own miniature SEC type regulator holding up hoops for funds to jump through.
The chart below shows only 13% of UCITS funds have only one domicile. Some 87% of them have between 2 and 7 domiciles, which must add costs from duplication of fund formation and service provider spending.
Moreover, some 23% of UCITS have less than EUR 10mm of assets. That means fixed costs have a far bigger impact on the percentage expense ratio (where these are not absorbed by the manager, more of which later).
As of July 1st 2011, the advent of the fourth incarnation of UCITS rules allows not only for fund mergers, within and across countries, but also, and more importantly, pan-European distribution. After all it was local distribution rules that lay behind the multiplicity of vehicles.
Whilst many in southern Europe especially would no doubt like to move towards a federal system of taxation (and borrowing), this remains very far away: indeed, certain countries such as Ireland only consented to the Lisbon Treaty on the condition that they retained national sovereignty over their low 12.5% tax rates. So, tax in Europe is still a patchwork quilt of disparate regimes, and this 120-page paper addresses a whole raft of tax implications of UCITS 4, including those pertaining to mergers.
“90 percent of respondents claimed that tax is a significant factor when deciding which funds to merge”
They further argue that fund mergers should be “tax neutral” since investors are not realizing investments – the usual trigger for a capital gains tax liability. Unfortunately however, under some countries’ tax codes a merger can crystallize tax liabilities, and it gets worse. Some tax systems will penalise one type of merger but not another type, thus “discriminating” against particular forms of merger, according to the report. The table below shows only 4 out of 23 EU members: Cyprus, Estonia, and the U.K. are “tax neutral” for all types of fund mergers considered !
Tax ramifications go beyond implications for investors in feeder funds: they also bite at the management company, and master fund levels.
Types of taxes can include capital gains, income, withholding taxes, corporation taxes and there may even be complications of wealth taxes and inheritance taxes. Europe’s tax inspectors can attack UCITS from every angle.
With the new regime only starting over the quiet summer months, when many Europeans take advantage of their generous holiday entitlements, it is far too early to tell how many mergers we will see. But it seems likely that, absent reforms to facilitate tax neutrality, its absence may prevent many otherwise sensible deals; googling Ucits mergers brings up plenty of papers championing or caveating the benefits of mergers, but so far no news of actual or imminent mergers.
Even if merger mania doesn’t materialise, there are simpler ways to bring the costs of a UCITS closer to those of an offshore hedge fund. Those many hundreds of hedge funds launching UCITS afresh clearly need not fret about legacy issues such as mergers: they can proceed straight to one master fund in one domicile. The simplest way to keep costs controlled is for managers to forego some of their own fees to offset or absorb the extra UCITS costs, and quite a few hedge funds are doing just that.
And costs are only part of the story. Transparency – through full portfolio snapshots twice a year, or as frequently as real time via some platforms – is another attraction of UCITS, as AAA has been pointing out for some time in these postings: