K-Zine

Regulated Hedge Funds - Further Progress in Ireland¹Note: This article was first published in the AIMA Journal (September 2004).

The last four year period has been one in which the regulator, government and industry have been very active in formulating and implementing change and developing the framework for investment funds establishing in Ireland.

While the UCITS III Directives and legislation have dominated the landscape for some time this has not been to the detriment of development of the framework for regulated hedge funds.

The year 2000 saw the introduction by the Irish Financial Services Regulatory Authority (IFSRA) of an environment facilitating the establishment of professional investor hedge funds with the publication of draft Guidance Note 2/00.

Within two years IFSRA had moved further forward in providing for regulated funds of hedge funds saleable to retail investors. The rules facilitating professional investor hedge funds, which focus principally on the role of the prime broker and its relationship with the fund and the fund's custodian, have been under the microscope for some time now and have been the subject matter of intensive industry lobbying and consultation between IFSRA and industry.

The continued responsiveness of IFSRA to industry developments and requirements, while maintaining the high levels prudential regulation, have led to very welcome recent developments in the rules relating to retail funds of hedge funds and professional investor prime broker hedge funds.

Retail Funds of Hedge Funds
In June this year, and following industry consultation, IFSRA issued a revised NU25 which contains the rules governing funds of unregulated funds. NU 25 as originally introduced contained a limitation of 5% of net assets in any one unregulated fund and no more than 10% in units of funds managed by the same group. These limits were raised to 10% and 20% respectively if the underlying manager was authorised in an OECD jurisdiction.

The revised rules now contain a single diversification requirement and a fund is permitted to invest up to 20% of its net assets in the units of any one other fund. While there are additional disclosure requirements, there is no overall limit on the amount which can be invested in funds managed by the same group. The minimum subscription requirement of €12,500 has also now been removed.

Retail funds of funds are now permitted to invest up to 100% of their assets in unregulated funds subject to the stated diversification requirement of 20%. Such funds are also subject to the following a prohibition on investment in other funds of funds and feeder funds. This restriction is obviously designed to prevent a layering of investment and to provide for greater transparency.

NU 25 also imposes qualitative criteria on the underlying funds in which the regulated fund may invest. The underlying funds must be independently audited in accordance with generally accepted international accounting principles and must have their assets held by a party independent of the manager.

IFSRA also requires disclosure prospectus disclosures in relation to the risk profile of the underlying funds, specifically with regard to the risks associated with investment policies, leverage, liquidity issues and the effect of cumulative performance fees on returns. It is worth noting that the rules do not impose restrictions on the underlying funds and the issue is one of disclosure only.

The manager will also be required to demonstrate appropriate expertise and experience in managing alternative investment products and to also demonstrate that it has appropriate controls and systems in place to monitor the underlying funds.

The management of the fund must be able to provide to IFSRA on request, a detailed report on the risk profile and recent performance of the fund's investments.

Furthermore, where the fund invests more than 40% of net assets in schemes managed by the same group, the manager of the fund must make a quarterly report to IFSRA on the extent to which the underlying schemes diversified between trading strategies.

With respect to fees, initial and redemption charges must be waived by funds managed within the manager's group. Any commission received by the manager by virtue of investment in another fund cannot be retained by the manager must instead be paid into the property of the fund.

Direct investing prime broker hedge funds
Discussions between industry and IFSRA regarding the regulatory conditions attaching to the appointment of prime brokers and other financing counterparties have been ongoing for some time.

To date, prime broker funds have been operating in Ireland on the basis of the draft Guidance Note 2/00. Following these lengthy discussions, IFSRA has now issued a revised draft Guidance Note-/04 for consultation which contains substantial changes to the current regime. Industry groups have been working with IFSRA since the publication of the draft Guidance Note 2/00 to provide a more flexible framework for hedge funds in Ireland.

Under the current regime, a professional investor fund (minimum subscription of €125,000) and a qualifying investor fund (minimum subscription of €250,000 plus minimum net worth/assets test) may pass fund assets outside of the trustee network with such assets being held by one or more prime brokers as collateral.

The prime broker may then pledge, lend, re-hypothecate or otherwise utilise for its own purposes, these assets of the fund subject to certain conditions. One of the principle conditions which applies and which are now subject to amendment is a requirement that the assets so passed should not exceed the level of the funds indebtedness to the prime broker.

Draft Guidance Note-/04 would permit the assets so passed to have a value of up to 140% of the level of the funds indebtedness to the prime broker. This revised limitation would apply to professional investor funds only with the limitation being waived in its entirety for qualifying investor funds.

Set out below is a summary of the principle terms of the draft Guidance Note/04 on the appointment of prime brokers and related issues. While the principles of the changes have been approved by the Board of IFSRA, and IFSRA has confirmed that funds may immediately avail of its provisions, draft Guidance Note-/04 is currently with the industry for consultation and is therefore subject to change prior to publication in final form.

A PIF or QIF may enter into relationships with prime brokers where the fund can meet the following requirements:-

A. A PIF and QIF may pass assets of the fund to a prime broker which assets the prime broker may pledge, lend, re-hypothecate or otherwise utilise for its own purposes under the following conditions:-

1. In the case of a PIF, the assets so passed (including cash on deposit) shall not exceed 140% of the level of the PIFs indebtedness to the prime broker. In the case of a QIF, there is no limit on the extent to which assets may be passed to the prime broker subject to full disclosure in the prospectus of the extent of the potential exposure.

2. The arrangement provides for positions to be marked to market daily.

3. The prime broker agrees to return the same or equivalent securities to the fund.

4. The arrangements incorporate a legally enforceable right of set off for the fund.

B. Where the prime broker holds assets of a fund, other than as provided above, the prime broker must be appointed as a sub-custodian by the trustee. While the prime broker may take a charge over the assets so held, the assets must be held on a fiduciary basis.

C. The prime broker must be regulated as such by a recognised regulatory authority with the prime broker or its parent company having shareholders' funds in excess of €200million. The prime broker or its parent must also have a minimum credit rating of A1/P1.

Other financing counterparties
A PIF or QIF may enter into arrangements with counterparties, including counterparties to OTC derivatives provided that:

1. The counterparty has a minimum credit rating of A2/P2;

2. In the case of a PIF, risk exposure to the counterparty must not exceed 20% of net asset value rising to 30% in the case of a credit institution authorised in the EEA and other defined jurisdictions;

While these counterparty exposure limits are not applicable to QIFs, transactions which may give rise to counterparty exposure in excess of 40% of net asset value must be made in accordance with the conditions applicable to the appointment of prime brokers discussed above;

3. Counterparty risk exposure is measured on an aggregate basis to include for example exposures arising from investments in securities issued by the counterparty, amounts held on deposit and OTC derivative positions.

The draft Guidance Note-/04 also imposes stringent minimum monitoring and reconciliation obligations on the trustee of the fund.

While the substance of the changes to the prime broker rules are broadly welcome, a comprehensive industry submission has been made to IFSRA seeking certain clarifications, outlining potential issues and requesting further consideration by IFSRA of provisions viewed as problematic.

Industry will continue to work with IFSRA to ensure that the final Guidance Note-/04 is implemented in a way that respects both the need for sound regulation and the desirability of a healthy and efficient fund industry.

Future developments
Coming down the tracks, hopefully by the end of this year is a mini investment funds bill. The new legislation will enable ring fencing of liabilities at sub-fund level, cross investment between sub funds in an umbrella structure and contain provisions for establishing non-UCITs Common Contractual Fund structures.

IFSRA has also undertaken to review its requirements in relation to the provision by funds of collateral security to counterparties. The partnership of industry regulator and government clearly never rests in its work to preserve and enhance Ireland's position as the dominant regulated hedge fund jurisdiction.