Hedge fund redomiciliation trends in evolving markets KPMG RBC Dexia Investor Services 3

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3 Hedge fund redomiciliation trends in evolving markets KPMG RBC Dexia Investor Services 3 KPMG 2011 KPMG S.à r.l., a Luxembourg private limited company, is a subsidiary of KPMG Europe LLP and a member of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International. [Printed in Luxembourg.] The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. RBC Investor Services RBC Investor Services Limited RBC Investor Services Limited is a holding company that provides strategic direction and management oversight to its affiliates, including RBC Investor Services Trust, which operates in the UK through a branch authorised and regulated by the Financial Services Authority. All are licensed users of the RBC trademark (a registered trademark of Royal Bank of Canada) and conduct their global custody and investment administration business under the RBC Investor Services brand name. These materials are provided by RBC Investor Services for general information purposes only. RBC Investor Services makes no representation or warranties and accepts no responsibility or liability of any kind for their accuracy, reliability or completeness or for any action taken, or results obtained, from the use of the materials. Readers should be aware that the content of these materials should not be regarded as legal, accounting, investment, financial, or other professional advice, nor is it intended for such use. / Trademarks of Royal Bank of Canada. Used under licence. * Trademark of RBC Investor Services Limited.

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5 Hedge fund redomiciliation trends in evolving markets KPMG RBC Dexia Investor Services 5 Table of contents Foreword 7 Executive summary, aims, context and key messages 8 Profile of participants Key drivers for redomiciling hedge funds to an EU jurisdiction Timeline for set-up of EU regulated hedge funds Preferred EU structures, techniques, strategies and solutions Choice of jurisdiction Redomiciliation: satisfaction and challenges Reasons for not moving hedge funds onshore 37 About us 41

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7 Hedge fund redomiciliation trends in evolving markets KPMG RBC Investor Services 7 Foreword We are pleased to introduce the joint RBC Investor Services and KPMG survey report entitled: Alternative options: hedge fund redomiciliation trends in evolving markets. This report explores some of the key trends surrounding hedge fund redomiciliation and is set against a backdrop of major regulatory change and growing competition within the global hedge fund industry. While the industry was heavily impacted by the financial crisis of 2008/9 and initially saw widespread fund redemptions, it has since shown remarkable resilience in rebuilding assets under management. Consequently, the market continues to recover, adapt and grow in terms of product development and jurisdictional reach. The impact of the financial crisis and various associated events forced a major rethink on regulation. In Europe, debate on the issue prompted plans to introduce the new Alternative Investment Fund Managers Directive (AIFMD). This important new Directive will, over time, introduce a new wave of mandatory registration and regulatory disclosure with significant implications for the domiciliation of funds. In addition, other measures, such as new Solvency II requirements and German insurance regulation could have a significant market impact in future. However, regulation is not the only factor likely to influence the choice of domiciles and strategies selected by global hedge fund managers. While hedge funds have traditionally been viewed as offshore unregulated products, the development of more regulated onshore alternatives in centres such as Luxembourg and Ireland has also widened the choice of domiciles and regulatory options. In turn, a number of managers have redomiciled their existing hedge funds or launched new funds onshore. The growing popularity and increased investment flexibility of UCITS funds has also spurred interest in their use for alternative investment asset classes. This study explores these themes in more detail in advance of the launch of the AIFMD to assess the appetite for the redomiciliation of hedge funds in onshore locations. It also assesses the popularity of the various centres which offer onshore hedge fund solutions and the levels of satisfaction amongst those managers which have set up onshore funds. As financial organisations operating within the alternative investment sector, both RBC Investor Services and KPMG understand that market knowledge is a powerful tool that can help shape and refine business decisions and we are committed to providing dedicated research in this key area. We therefore hope that you will find this report informative and useful in shaping your future strategies and initiatives in this important sector. Sincerely, Jean-Michel Loehr, Chief Industry & Government Relations, RBC Investor Services Tom Brown, Head of KPMG s Investment Management practice for the Europe, Middle East and African region

8 8 Executive Summary Aims, background and context of this report While the hedge fund industry has traditionally been associated with offshore jurisdictions, recent years have seen a significant uptake in the launch of hedge funds within the EU. Some EU domiciles have developed regulated structures to compete for hedge fund business and a number of managers have fully redomiciled their funds onshore, while others have launched funds onshore to complement their offshore funds offering. There has also been a surge of interest in the use of the EU UCITS framework to run certain alternative strategies. Historically, hedge funds were not covered by any specific regulation at a European level. But, following the financial crisis of 2008/9, the sector faced major uncertainty as politicians, regulators and the wider funds industry debated its future regulation. Protracted EU negotiations on the regulation of hedge fund managers culminated in a parliamentary vote in November 2010 and the final adoption of the new Alternative Investment Fund Managers Directive (AIFMD). The AIFMD imposes mandatory registration and disclosure to regulators and is expected to be transposed into national law by Member States in A new passport regime giving managers access to professional investors across the EU with a single registration will be available to EU-domiciled funds from 2013 and non-eu domiciled funds from National Private Placement regimes for the marketing of funds, which allow hedge funds to apply to sell into EU markets on a country-bycountry basis, will continue to exist up until 2018, although their future beyond this point will depend on further industry and regulatory debate involving the European Securities and Markets Authority (ESMA). In this context, RBC Investor Services and KPMG decided to work together to conduct a study of hedge fund managers to explore the trends regarding the redomiciliation of their hedge funds, three months after the final AIFMD rules were approved. The purpose of the study was to gain a better understanding of the main factors contributing to the redomiciliation of hedge funds into the EU. Our research gathered the views of a broad range of hedge fund managers on the reasons for domiciling hedge funds in both the EU and offshore. The study was designed to build a better understanding of how and why hedge fund managers establish EU hedge funds. Surveying both managers that had set up EU hedge funds and those who intend to establish EU hedge funds in the future, we explored their reasons for redomiciliation, preferred EU fund structures, the methods they used to move hedge funds to an EU domicile, the strategies they manage in EU hedge funds and their choice of EU fund domicile. We also asked hedge fund managers who currently had no plans to redomicile what they saw as the advantages of remaining offshore. Of the hedge funds managers who participated in our survey: 24% had already redomiciled offshore hedge funds to an EU domicile; 27% were considering doing so in the future; 49% had not redomiciled any funds and currently had no future plans to do so. Have you redomiciled any offshore hedge funds to an EU domicile? 49% not redomiciling considering redomiciliation had redomiciled 24% 27% Chapters 1-5 of this report consider the responses of hedge fund managers who had either already redomiciled or who were considering doing so. Chapter 6 considers the reasons why redomiciliation is currently not an option. It concludes by exploring possible future trends and the potential for co-domiciliation - retaining offshore funds for investors who prefer and benefit from them, whilst setting up EU-domiciled funds to address needs from investors who prefer a greater degree of regulation and security.

9 Hedge fund redomiciliation trends in evolving markets KPMG RBC Investor Services 9 Methodology The report s findings are based on a two-step approach, with the study data drawn from an online questionnaire of 49 hedge fund managers conducted during January and February 2011, followed by structured in-depth interviews with senior executives from a number of hedge fund firms. For the purposes of this research the term onshore was defined as encompassing EU Member States only. Our foremost thanks go to the organisations who participated in this research and we would like to offer special thanks to those senior executives who took part in our interviews. The list of participants in our research remains strictly confidential, at the request of the participating firms. Headline messages The main findings of our research are as follows: Half of our survey respondents have redomiciled offshore hedge funds (24%) or are considering doing so in the future (27%). The remaining 49% had no immediate plans to do so. However most were still intending to keep some hedge funds offshore. The top drivers to redomicile funds in the EU are restrictions on the ability of European institutional investors to invest in offshore hedge funds, the possibility of replicating hedge funds strategies in a UCITS and the ability to offer more liquid, transparent and diversified hedge funds to investors. Investment managers are keen to address changing client needs and maximize product choice and solutions. A key driver for potential redomiciles is uncertainty about the impact of the Alternative Investment Fund Managers Directive (AIFMD). Doubts over the final AIFMD framework have encouraged some to consider EU options. There is likely to be increased interest in redomiciliation in 2012 in advance of implementation of AIFMD. Uncertainty surrounding various aspects of the impact of the AIFMD is a key driver for potential redomiciliation. Hedge fund managers who have already redomiciled hedge funds to the EU used either UCITS funds or non-ucits regulated hedge funds. UCITS funds however give security to investors on regulation and transparency. Hedge fund managers considering setting up EU hedge funds in the future express a strong preference for regulated non-ucits structures. In established fund centres these products are becoming recognised as well regulated and flexible alternatives to offshore funds. A majority of hedge fund managers who had already redomiciled to an EU jurisdiction created clone funds to complement existing fund ranges. However, for those considering redomiciliation, the transfer of the domicile

10 10 of the fund to the EU was the most favoured option. Long/short strategies have been the most popular hedge fund strategies run in a UCITS. However hedge fund managers still considering the set up of a UCITS are looking at a wide range of alternative strategies. The established EU investment centres of Luxembourg and Ireland are the preferred locations for setting up EU hedge funds. Specialist expertise and track record in these centres is widely recognised. Availability of global service providers, economic and tax regime stability and a flexible and robust legal and regulatory framework are the most important factors in selecting a future onshore jurisdiction. Investment managers require complex specialist support and stability in a changing regulatory environment as they develop their fund ranges. Hedge fund managers who have redomiciled funds to an EU jurisdiction are highly satisfied with their experience. They are especially satisfied with the impact of set-up and running costs on fund performance, which are manageable and predictable. Half of the survey respondents had not redomiciled any funds and currently had no plans to do so. Indeed, only a small minority of hedge fund managers have fully redomiciled their funds away from offshore jurisdictions or intend to do so. Those who have set up an onshore hedge fund range did so to complement their offshore fund ranges and attract different client segments. The principal reason for not redomiciling is the lack of investor demand for EU domiciled funds. Many investment clients did not see significant benefits in more regulated hedge funds. There is an increased focus on due diligence, but current regulatory arrangements and transparency of offshore funds are considered sufficient. Some investors post-madoff are seeking enhanced transparency and liquidity and many managers are concentrating on satisfying investors due diligence requirements rather than redomiciling funds in more regulated structures. Traditional offshore fund centres such as Cayman are still considered the best choice for many hedge fund managers. They offer much greater investment flexibility and established expertise. Co-domiciliation, with hedge funds offering both offshore and onshore options, is the most likely way forward. Market interest in alternative UCITS funds is growing, but these structures are likely to evolve as complementary to offshore hedge funds in the longer term rather than replacing them.

11 Hedge fund redomiciliation trends in evolving markets KPMG RBC Investor Services 11 Profile of participants Country of origin In which country is the hedge fund manager based? The survey population for our study comprised 49 hedge fund managers based in 18 different countries. 34 of the hedge fund managers were EU licensed managers and 9 of these managers were also licensed managers in non-eu jurisdictions. 15 of the hedge fund managers in our survey were not licensed in the EU. 13% 15% 7% 5% 14% 27% 19% UK France USA Other Europe Offshore Other Americas Asia Assets under Management The hedge fund managers in our survey handled assets of some US$159bn as at the end of November The respondents were drawn from a mix of large groups and niche players, with 26 of the hedge fund managers managing in excess of US$1bn. US$71 billion of the hedge fund assets were run by managers based in London. Domicile of hedge funds 27 managers ran hedge funds in more than one jurisdiction, with the most popular jurisdictions being Cayman, Luxembourg, France and Ireland. 16 managers did not manage any funds set-up in the EU and 8 of the EU Managers handled offshore funds only. In addition, 9 of the managers who responded to our survey were EU and non-eu licensed. In which jurisdictions are your hedge funds domiciled? 2% Cayman 6% Luxembourg 13% France 32% Ireland 10% Other offshore 14% 23% Other Europe Other Americas

12 12 1. Key drivers for redomiciling offshore hedge funds to an EU jurisdiction Key Messages Half of our survey respondents have redomiciled their offshore hedge fund (24%) or are considering doing so in the future (27%). The top drivers to redomicile funds in the EU are restrictions on the ability of European institutional investors to invest in offshore hedge funds, the possibility of replicating hedge funds strategies in a UCITS and the ability to offer more liquid, transparent and diversified hedge funds to investors. A key driver for potential redomiciles is uncertainty about the impact of the Alternative Investment Fund Managers Directive. Top three drivers for redomiciliation The 24% of fund managers who had already redomiciled hedge funds to the EU were asked what were their top three reasons for doing so. The most important reasons, all mentioned by over 40%, were: restrictions on the ability of European institutional investors to invest in offshore hedge funds; the possibility to replicate hedge fund strategies in a UCITS; and the ability to offer more liquid, transparent and diversified hedge funds to investors. The full results are given in the chart below. Similarly, the 27% of fund managers who were considering redomiciling hedge funds to the EU were asked what were the top three reasons that would lead them to do so. The most important reasons for this group, all mentioned by over 50%, were: the possibility to replicate hedge fund strategies in a UCITS; restrictions on the ability of European institutional investors to invest in offshore hedge funds; and uncertainty surrounding marketing restrictions on the sale of non-eu hedge funds to EU investors in the final Alternative Investment Fund Managers Directive (AIFMD). What were the top 3 drivers behind your decision to redomicile hedge funds in the EU? Restrictions on ability of European institutional investors to invest in offshore hedge funds The possibility to replicate hedge fund strategies in a UCITS 50% 42% To offer more liquid, transparent and diversified hedge funds to investors 42% Increasing asset allocation to hedge fund / hedge fund of fund strategies by investors Availibility of an EU fund passport / the global cross-border distribution potential of a UCITS To extend the client base to wealthy retail investors by setting up a UCITS Uncertainty surrounding any marketing restrictions on the sale of non-eu hedge funds to EU investors in the final AIFMD 33% 33% 25% 17% 0% 10% 20% 30% 40% 50% 60%

13 Hedge fund redomiciliation trends in evolving markets KPMG RBC Investor Services 13 This latter issue of uncertainty about AIFMD was a relatively minor factor for fund managers who had already redomiciled. This reflects the impending arrival of AIFMD, which would have been less of an immediate concern to those redomiciling over the past few years. The full results are given in the chart below. All the various drivers identified are considered in greater detail next. Our commentary draws on our in-depth interview material and background knowledge of the market. Restrictions on ability of European institutional investors to invest in offshore hedge funds One of the most important drivers behind hedge fund managers decisions to redomicile offshore hedge funds to an EU jurisdiction was the restriction on the ability of European institutional investors to invest in offshore hedge funds. This was the top driver for those who had already redomiciled and the second most important for those who were considering it for the future. Europe hosts a diverse group of institutional investors, including pension funds and insurers, seeking to allocate investment to regulated hedge funds. These institutions have substantial amounts of money to invest and generally maintain a long-term investment What are the top 3 drivers that would lead you to redomicile hedge funds in the EU in the future? The possibility to replicate hedge fund strategies in a UCITS Restrictions on ability of European institutional investors to invest in offshore hedge funds Uncertainty surrounding any marketing restrictions on the sale of non-eu hedge funds to EU investors in the final AIFMD Increasing asset allocation to hedge fund / hedge fund of fund strategies by investors To offer more liquid, transparent and diversified hedge funds to investors Availibility of an EU fund passport / the global cross-border distribution potential of a UCITS 31% 31% 38% 62% 54% 54% To extend the client base to wealthy retail investors by setting up a UCITS 8% 0% 10% 20% 30% 40% 50% 60% 70%

14 14 focus. Consequently, this market is generating considerable interest among hedge fund managers, with many actively targeting these investors via their asset raising initiatives. Some of the hedge fund managers included in our survey mentioned that they were seeing a wave of new institutional investors allocating to hedge funds. This included a number of pension funds expanding their investment strategies to encompass hedge funds for the very first time. Although a substantial number of European institutional investors have already been allocating to hedge funds for some years, some of them are penalized by regulation if they invest in offshore hedge funds. Insurance companies are a good example of this. In some EU Member States insurers may have to deal with punitive capital charges or other restrictions on their investments in offshore funds when compared with investments made in EU regulated investment funds. Institutional investors generally have large sums of money to allocate to hedge funds. This gives them the power to dictate the terms of their investment strategies, including the creation of onshore hedge funds if specifically required. If a hedge fund manager wants to embrace institutional investors then, depending on investor requirements, it may have no real option but to offer an onshore fund. Some typical quotes from our interviews were: Another reason for setting up Irish hedge funds was to satisfy certain European institutional investors which are restricted from investing in offshore hedge funds. We set up regulated hedge funds to satisfy the requirements of certain institutional investors who have strict limits on their investments in hedge funds. Our UK investors do not require onshore funds but our continental European investors have a clear preference for European funds, which is why we offer a Luxembourg range of onshore regulated hedge funds and funds of hedge funds. Pension funds that are already experienced hedge fund investors appear comfortable with the way offshore hedge funds are run and tend to be less concerned about regulation. However views are divided amongst newer pension fund entrants to the hedge fund market. On the one hand, some of the newer entrants tend to favour regulated funds. In some cases, they expect the same standards from hedge funds as they enjoy in their traditional mutual fund investments, particularly with regard to transparency and regulation. On the other hand, some managers we surveyed believed that institutional investors new to the market would not necessarily require regulated hedge funds. For instance, one of our hedge fund manager respondents pointed out that, in his experience, novice pension funds he dealt with were generally advised by, and relied on,

15 Hedge fund redomiciliation trends in evolving markets KPMG RBC Investor Services 15 experienced professional advisers familiar with offshore hedge fund structures and willing to advise their clients to allocate investments to offshore hedge funds. This supported the sentiment expressed by a large number of our respondents who said that they believed investment decisions were still driven by investors/advisers identifying the best managers and the best strategies, which might well include an offshore hedge fund allocation. This approach included a proper and thorough due diligence of the target hedge fund s operating model and careful consideration of the actual vehicle needed for the client s investment. For example: Our investors are not asking for EU regulated hedge funds. Their due diligence focuses on risk disclosure and valuation. Institutional investors clearly have duties towards their own retail investors and (either their own team or through independent advisers) undertake extensive due diligence on the manager and their investment strategy. The possibility to replicate hedge fund strategies in a UCITS Another key driver behind the decision to redomicile to an EU jurisdiction was the possibility to replicate hedge fund strategies in a UCITS. This was the equal second driver for those who had already redomiciled and indeed the top driver for those who were considering it for the future. UCITS funds (for details see box on page 16) have existed in the European Union for over 25 years. Although they are perhaps best known as retail products, UCITS are also widely sold to institutional investors. Their aim is to provide a well regulated and transparent structure for cross-border EU based investment funds. Amendments brought in under UCITS III enabled certain hedge fund strategies to be run under a UCITS, creating new opportunities for onshore EU-based alternative investment funds. European Fund and Asset Management Association (EFAMA) statistics at the end of 2010 recorded investment fund assets in Europe of EUR 8,025 billion that were managed by around 53,000 investment funds. UCITS funds represent about 75% of the assets under management (AuM) in Europe, and some 35,000 fund structures. In recent years UCITS have received growing attention from hedge fund managers. This has stemmed from the introduction of UCITS III as mentioned above, which created the possibility of running certain hedge strategies in a UCITS structure. For example: Every serious hedge fund manager needs to have a UCITS in their product range to offer to their clients. We have looked at setting up a UCITS for our hedge funds we were interested in it purely as a marketing tool. In our case we are targeting institutional clients and have seen a real appetite among prospective investors for our UCITS hedge strategies.

16 16 UCITS in focus UCITS was born with the introduction of European Directive 85/611/EEC, entitled Undertakings for Collective Investments in Transferable Securities, that introduced a single regulatory regime across the European Union for open-ended funds investing in transferable securities such as shares and bonds. The Directive imposed rules concerning portfolio diversification, liquidity and borrowings and regulates the organisation, management and oversight of these We wanted to be innovative and to bring to market another set of strategies. There is a strong rationale for investing in alternative UCITS from a diversification perspective as the funds have low correlation with beta funds. The alternative UCITS are complementary to our traditional UCITS. We are targeting our existing sophisticated and institutional investors, mostly in the UK. The impressive amount of capital raised by some managers hedge fund UCITS has also generated significant interest across the entire hedge fund industry. According to a study released in October 2010 by Strategic Insight 1, alternative UCITS saw a 70% growth in net inflows from January to September 2010 compared with the same period in 2009 and were on track to finish 2010 with EUR 33 billion net new inflows, accounting funds. UCITS products are often structured as umbrella funds with different ring-fenced sub-funds offering diverse investment strategies under one legal structure. UCITS regulation focuses heavily on good risk management practices and a high level of investor protection. UCITS has EU-wide regulatory approval and a UCITS fund that is established in one EU country is authorized to be distributed, under a European passport, throughout all the 27 for some 15% of total net inflows into all long-term UCITS funds. The Strategic Insight study also reported that a growing number of these alternative UCITS were run by hedge fund managers, although a substantial proportion were managed by retail oriented, traditionally long-only investment firms building their alternative fund ranges. In our survey over half the hedge fund managers that had already set up onshore regulated hedge funds had set up hedge fund style alternative UCITS products and this was also an important potential option for those considering redomiciliation in the future. There are however other regulated hedge fund options offered by jurisdictions such as Luxembourg and Ireland, which may provide an acceptable alternative. These issues are considered further in Chapter 3. European Union Member States subject to local marketing rules. From an operational infrastructure perspective, each UCITS must appoint an independent depositary to provide custody services and a level of oversight of the operations of the fund. Amendments brought in under UCITS III enabled certain hedge fund strategies to be run under a UCITS. The next stage of development of UCITS products, under UCITS IV, is set for implementation in July Alternative and Hedge Fund UCITS in the next decade by Strategic Insight 2010, prepared for the ALFI (Association of the Luxembourg Fund Industry)

17 Hedge fund redomiciliation trends in evolving markets KPMG RBC Investor Services 17 To offer more liquid, transparent and diversified hedge funds to investors The third top driver for those respondents who had already moved hedge funds onshore was to offer more liquid, transparent and diversified hedge funds to investors. This appeared to be a little less important to investment managers seeking to redomicile their hedge funds in the future, but this may well be because liquidity and transparency has already increased post Madoff, also that in their selection of key drivers they were more focused on issues with AIFMD (see overleaf). The pain suffered after the demise of US investment bank Lehman Brothers and the losses incurred due to the Madoff Ponzi scheme collapse have clearly impacted a range of hedge fund investors. Private banks managing High Net Worth portfolios tend to seek more liquid hedge fund investments after the fund suspension and liquidity issues that developed in 2008 and institutional investors also have considerable concerns. Some typical quotes were: We have not redomiciled funds from Cayman but we did decide to launch Irish UCITS to provide our clients with a more liquid and regulated fund. Our investor base was also looking for enhanced transparency, liquidity and regulation in its fund investments post Madoff and the market events of The financial crisis in 2008 and the discovery of the Madoff Ponzi scheme frightened many investors away from offshore funds. There was clearly a flight by some investors to regulated products who wanted the assurance of better liquidity and enhanced transparency. Fund of Hedge Fund Managers also bore the brunt of fund suspensions and liquidity issues impacting their portfolios. One hedge fund manager we interviewed said it had seen a number of its biggest institutional clients exit hedge funds to invest with managed accounts which could satisfy their need for control, transparency and liquidity of their investments: The liquidity crisis coupled with the Madoff fraud pushed some of our very large institutional clients, which had invested in hedge funds for a number of years, to ask for a managed account for their investments in hedge fund strategies. This gave them greater transparency and liquidity of their investments. Managed accounts were also seen as a partial means of reducing the impact of similar problems in the future. A number of the managers in our survey also mentioned that hedge fund operating models were coming under increased scrutiny in the due diligence process, which is unsurprising given the heightened awareness post Madoff of potential risk.

18 18 Uncertainty surrounding any marketing restrictions on the sale of non-eu hedge funds to EU investors in the final Alternative Investment Fund Managers Directive (AIFMD) Uncertainty surrounding marketing restrictions on the sale of non-eu hedge funds to EU investors in the final Alternative Investment Fund Managers Directive (AIFMD) was bottom of our list of drivers among those managers who had already redomiciled to the EU. However it was amongst the top three drivers for managers who were considering redomiciliation in the future. This undoubtedly reflects the fact that AIFMD is a key top-of-head issue at the moment. For example: We would re-domicile depending on the final level 2 AIFMD provisions and on how the offshore domiciles respond to the AIFMD equivalence requirements. Political agreement on the final text of the AIFMD was reached in November However, at the time of publication of this report, the alternatives industry was still waiting for the European Commission to finalise its numerous implementing measures, which will ultimately determine how AIFMD works in practice. An industry consultation process on the array of implementing measures is currently in progress. Final details are expected by Q and the Directive is due to be implemented into local regulation/law in One area where our survey respondents felt that there was a lot of uncertainty related to the marketing rules and, in particular, the rules surrounding the use by hedge fund managers of the Private Placement Regime to market their non-eu funds in the EU. To comply with the Directive, the offshore domicile where any hedge fund is established would need a supervisory co-operation agreement in place with the regulatory authorities supervising the hedge fund manager and the regulatory authorities in the EU Member State where the hedge fund is marketed, in cases where the manager is non-eu. The precise framework for these supervisory agreements has not yet been clearly defined. Some of our respondents expressed concern that offshore domiciles might not have sufficient time to amend existing agreements and/ or put in place new agreements to be fully compliant with AIFMD. However there was also a general expectation among managers that principal offshore hedge fund domiciles would make every effort to ensure timely compliance with the new requirements to protect their business. Uncertainty also centred on how the new passport regime for non-eu funds would work from its proposed introduction in 2015 onwards. Under the regime the tax authorities in the offshore fund domiciles would also have to put in place tax information exchange agreements with the revenue authorities in the country where the fund was to be distributed. Some of our respondents said that they were carefully watching developments in this area and would adopt a wait-and-see approach to assess the impact of the final rules on how they operated in the EU market. However, for others, ongoing uncertainty was likely to encourage

19 Hedge fund redomiciliation trends in evolving markets KPMG RBC Investor Services 19 them to establish an EU fund before 2013 in order to ensure minimal disruption and uncertainty in regard to their business operations. Another aspect of regulatory reform generating interest among hedge fund managers and linked to the AIFMD related to the emergence of new rules in some EU countries encouraging hedge fund managers to adopt the Directive. There have been discussions in certain EU countries aimed at modifying the prudential regulation of insurers and other institutional investors to allow them to invest with funds that comply with the AIFMD. This potential change in the rules would put UCITS and alternative investment funds on a level playing field and might also encourage the creation of non-ucits hedge funds onshore. Some of the non-eu hedge fund managers we spoke to were considering the option of moving their hedge fund management onshore whilst leaving their hedge funds in an offshore jurisdiction. These managers felt that the Directive would provide an adequate level of regulation and investor protection through the direct regulation of the manager. They also expressed the view that bringing their hedge funds onshore would add very little additional investor protection. Clearly, the full impact of AIFMD is not yet known. However fund managers are watching developments with interest and the provisions of the new Directive, when clarified, are likely to have a major impact on future decisions as to whether or not to redomicile to the EU. Availability of an EU fund passport/the global crossborder distribution potential of a UCITS The availability of an EU fund passport and the global crossborder distribution potential of UCITS structures were specifically important for one in three of both those who had redomiciled already and those who were considering doing so. According to EFAMA, UCITS registered net inflows of EUR 166 billion in 2010, compared to EUR 150 billion in 2009 i.e. an increase of 10.7% in the course of one year. Although UCITS were initially intended only to be marketed across the European Union using an EU fund passport regime, they have since become a highly successful global brand distributed in over sixty-five countries worldwide. Over 40% of net new UCITS sales are outside the EU, notably in Switzerland, South America and Asia. In Hong Kong, Singapore and Taiwan over 70% of authorised investment funds are UCITS. As a result, an increasing number of asset managers are establishing UCITS funds with a clearly defined global marketing and distribution strategy. Many of the hedge fund managers we surveyed were looking to raise money from new markets. They viewed UCITS as a useful tool for this given its strong brand image in the EU and global marketing potential in regions such as Asia, the Middle East and Latin America. For example:

20 20 Our existing institutional clients have been quite indifferent as to the regulated status of the funds that we offer. But we have institutional client prospects in the US, Europe (including the UK) and in Asia and the UCITS label will clearly help us to push our fund products to investors and distributors in these markets. While there is considerable support for the UCITS concept, there is however some disagreement as to whether the passport will actually provide the best solution for highly complex markets such as Asia. Increasing asset allocation to hedge fund strategies by investors Increasing asset allocation to hedge fund strategies by investors was similarly important for around one in three of both those who had redomiciled already and those who were considering doing so. Our earlier findings showed how institutional investors were interested in hedge funds but concerned as to their regulation, and how the appeal of regulated funds such as UCITS might help to reassure investors not least as regards transparency. Redomiciliation to the EU may therefore be expected to increase asset allocation to hedge funds, as investors become more confident that EU regulated hedge funds may offer a viable alternative to traditional investment options whilst avoiding the perceived higher risk of previous hedge fund offerings. The increasing potential interest in allocation to hedge funds is further illustrated in the following interview quotations: Our professional investor base was looking to invest in more sophisticated, actively managed strategies than the passively managed beta regulated funds that were on offer. We are not seeking to extend our distribution to the retail market. There is enough new institutional money poised to enter the market that we will try and capture. We only work with investors who understand our long-term investment horizon and who accept the liquidity that we offer. To extend the client base to wealthy retail investors by setting up a UCITS Extending the client base to wealthy retail investors was not one of the most important key drivers for redomiciliation. One in four of those who had already redomiciled said that it had been a factor in their decision. However only one of the fund managers considering redomiciliation thought this might be important. Respondents cited a number of reasons for this. In the first instance, retail investors were not traditional hedge fund investors. Hedge fund managers tended to focus on High Net Worth investors and lacked the resources and expertise to provide a retail service. For example, many of the hedge fund managers that took part in our survey did not have access to distribution channels which would enable them to target this market. One manager considered the level of legal risk in selling to retail investors and the operational and distribution costs linked to servicing them to be too high. Most of the hedge fund managers we interviewed used UCITS to target institutional investors.

21 Hedge fund redomiciliation trends in evolving markets KPMG RBC Investor Services Timeline for set-up of EU regulated hedge funds Respondents who had already redomiciled or set up onshore EU hedge funds were asked when they had done so. Those who were considering redomiciliation were asked what was their expected time frame. The chart below plots the timeframe of both previous and future EU redomiciliation. It can be seen that: for hedge funds that had already been redomiciled (24% of respondents), there was a peak in 2009; most hedge fund managers who were considering redomiciliation (27% of respondents) were thinking of doing so in A proportion of the hedge fund managers included in our survey had been moving their funds onshore for a number of years. Prior to 2008 the set-up of onshore funds was mainly driven by internal reorganization of each hedge fund manager s business. In some cases the move onshore was triggered by the integration of newly acquired asset management entities. Some managers also took the independent decision to create onshore hedge funds in their product range. There was an increase in the set-up of EU regulated hedge funds in The factors contributing to this phenomenon were described in detail in the previous chapter. The hedge fund industry has faced increasing regulation and scrutiny since the financial crisis in The liquidity crisis alarmed a number of hedge fund investors and has contributed to an increasing focus on fund governance and more regulated jurisdictions. The broad success of alternative UCITS since 2007 has encouraged a number of investment managers to establish new alternative funds under the UCITS framework. The uncertainty caused by the draft AIFMD has also played a role and the continued uncertainty surrounding the implementing measures remains a key factor. This in particular is an important driver for fund managers who are considering redomiciliation and it is perhaps not surprising that most of these expected to do so in 2012, the year before the new Directive is implemented. Key Message There is likely to be increased interest in redomiciliation in 2012 in advance of implementation of AIFMD. In what year did you redomicile or set up onshore hedge funds in the EU/ what is your expected timeframe for doing so? 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% Post 2015

22 22 3. Preferred EU structures, techniques, strategies & solutions Key Messages Hedge fund managers who have already redomiciled hedge funds to the EU used either UCITS funds or non-ucits regulated hedge funds. Hedge fund managers considering setting up EU hedge funds in the future express a strong preference for regulated non-ucits structures. A majority of hedge fund managers who had already redomiciled to an EU jurisdiction created clone funds to complement existing fund ranges. Preferred fund structure Hedge fund managers who had already redomiciled hedge funds to the EU (24% of our respondents) were asked which type of regulated fund structure they had used. Over half (58%) had used UCITS, while an exactly similar proportion had used non-ucits regulated hedge funds. The overlap in the percentages indicates that a few had both types of funds. None had opted for an unregulated structure. Similarly, the 27% of our respondents who were considering redomiciling hedge funds to the EU in the future were asked which type of regulated fund structure they would use. For this group, there was a strong preference (77%) for non-ucits regulated funds. However, just under half (46%) favoured UCITS and a small minority were considering the possibility of an unregulated structure. Here there is a significant overlap in the percentages, indicating that this group were either looking at introducing different alternatives to suit varied investor requirements or that they had not yet made up their minds as to what the actual structure would be. Long/short strategies have been the most popular hedge fund strategies run in a UCITS. Which type of fund structure did you use when you redomiciled your hedge funds? Regulated non-ucits 58% UCITS 58% Unregulated structure 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% Which type of fund structure would you use to redomicile your hedge funds? Regulated non-ucits 77% UCITS 46% Unregulated structure 15% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90%

23 Hedge fund redomiciliation trends in evolving markets KPMG RBC Investor Services 23 There are two broad categories of regulated funds available in the EU: UCITS (as described in Chapter 1) and non-ucits structures, such as the Irish Qualified Investment Fund (QIF) and the Luxembourg Specialised Investment Fund (SIF). Non-UCITS fund structures are subject to national laws in the EU Member State where they are established. Several EU countries have developed fund structures suitable for hedge funds. The Irish QIF and the Luxembourg SIF were the most popular EU structures among the hedge fund managers in our survey. These structures are authorised and regulated respectively by the Central Bank of Ireland and the Commission de Surveillance du Secteur Financier in Luxembourg and share the characteristics and flexibility of typical hedge funds. There is a minimum permitted investment amount in a QIF of EUR 100,000 per investor and in a SIF of EUR 125,000 per investor. However, they are not subject to specific investment and borrowing restrictions. These structures are required to appoint an independent custodian to safeguard the assets of the fund and a fund administrator, whose duties include calculating a net asset value, fund accounting and reporting and the processing of subscriptions and redemptions. There is currently no EU passport available for these fund structures, though when the AIFMD comes into force in 2013 both the QIF and the SIF would be suitable for sale under the new passport regime. UCITS are the second broad category of regulated funds that hedge fund managers can adopt in the EU. UCITS are outside the scope of the AIFMD and are subject to their own EU legal and regulatory regime based on the 1985 UCITS Directive. The legal framework was modernised by the UCITS III package of amendments, introducing the flexibility to accommodate some hedge fund strategies in UCITS products. This new investment flexibility has opened up an exciting new spectrum of product possibilities and has become a major driver in product innovation within the UCITS sphere. The UCITS III toolbox has also contributed to a growing convergence of the traditional long-only funds industry with the alternatives industry in the EU. The majority of the hedge fund managers we spoke to have already analysed the possibility of replicating their hedge fund strategies in a UCITS wrapper. As one respondent commented: Hedge fund managers that offer certain strategies need to have a UCITS, the trend is established. Since UCITS was launched, the range of permissible investments in a UCITS portfolio has been enlarged to permit a UCITS III fund to invest broadly in financial derivative instruments as part of its general investment policies. Previously this was only available for hedging and efficient portfolio management purposes. Many types of derivatives can be used in a UCITS III fund, including exchange traded futures and options and OTC derivatives such as Contract for Difference (CFDs), Total Return Swaps, Credit Default Swaps (CDSs) and derivatives on commodity indices. As a result, the UCITS III package has allowed a number of hedge fund-type strategies, which could previously have been managed only by offshore hedge funds or regulated onshore funds such as the SIF and QIF to be managed under a UCITS framework. However, there is a set of regulatory constraints that a hedge fund manager needs to address under the UCITS framework. The offshore hedge strategy generally needs to be adapted to meet the specific risk, diversification, short-selling, borrowing and liquidity rules and requirements of a UCITS. For example, UCITS regulation does not permit the physical shorting of a security and therefore investment managers need to use derivatives to create synthetic short positions. UCITS are not allowed to borrow for investment purposes and therefore leverage needs to be generated via the use of derivatives. The UCITS risk management process that the Investment Manager is required to implement must be in line with UCITS IV requirements. The risk management rules require the use of a Value at Risk (VaR) and stress testing methodology for any funds that make a more sophisticated use of derivatives. There are also specific eligible assets rules, concentration limits and counterparty exposure limits to be respected by the Investment Managers of a UCITS.

24 24 UCITS funds mainly provide daily liquidity to their investors, although weekly and fortnightly liquidity is legally feasible. Accordingly UCITS are restricted in the percentage of illiquid positions they can hold in the portfolio in order to be able to honour all redemption requests at the required frequency. One respondent commented: Our equity market neutral investment strategy is very liquid and can be easily run under the UCITS III framework. This liquidity requirement may not be an issue for hedge fund managers running liquid strategies, but would clearly create an issue for the more illiquid strategies. After UCITS III became effective the first new alternative UCITS were launched, mainly by traditional UCITS managers. These companies were among the first to widen their product range and offer absolute return style UCITS to their investors. In more recent years we have seen hedge fund managers with knowledge and experience in running offshore hedge funds bring their expertise to UCITS. According to the Strategic Insight report cited earlier in this document, assets in hedge fund-style alternative UCITS exceeded EUR 114 billion at the end of September Despite this, it should be noted that some foreign regulators are increasingly concerned by the use of complex instruments by alternative UCITS intending to distribute into their territories and ease of distribution is not guaranteed in future, regardless of the acknowledged establishment of the domicile. It should also be noted that several fund managers included in our survey said it was not possible to deliver their strategies within the UCITS framework. These managers reported particular issues in delivering less liquid credit strategies, distressed debt, private equity strategies, mezzanine and small cap strategies. For example: Some hedge fund strategies are UCITS friendly but certain strategies will never work within the constraints of UCITS and as such the UCITS product cannot replace offshore hedge funds. For some of the managers in our survey the only way to replicate hedge fund strategies they used in the Cayman Islands was via an Over the Counter (OTC) swap, whereby their UCITS would enter into a total return swap to swap the return of its portfolio for the return on a reference basket/index. For some complex strategies that require an index creation, the costs associated with the index creation and the swap counterparty fees were considered prohibitive for some of the smaller independent managers we surveyed and ultimately led them to abandon the idea of setting up a UCITS. None of their institutional investors would be willing to pay the extra basis points for replicating the strategy in a UCITS wrapper when they could access the same strategy in a Cayman fund. Fund of Funds can also be structured as alternative UCITS and are required to invest their assets in other UCITS with only a maximum of 30% of investment permissible in non-ucits funds. Although there is a large universe of target hedge fund style alternative UCITS, some of the Fund of Hedge Fund Managers we spoke to felt that they would be unable to offer the same product to their investors in a UCITS that they could in a non-ucits. For example: I view UCITS as light hedge funds. The offshore hedge strategy is clearly distorted when run in a UCITS. Some of the Fund of Hedge Fund managers we spoke to expressed fears that managers might be offering strategies that were not well suited to the liquidity requirements of UCITS. They warned that during times of stress these alternative UCITS might not provide sufficient liquidity. However, even if there are certain strategies that cannot be replicated within the UCITS format, RBC Investor Services estimated in a separate analysis published in the Hedge Fund Journal in July 2010 that 90% of hedge fund strategies can in fact be replicated within the UCITS. UCITS may well offer greater potential for hedge fund managers than has currently been recognised.