Alain Guérard, CAIA, Executive Director, J.P.Morgan Luxembourg (text); Julien Becker (photo)The re-domiciliation of offshore hedge funds and funds of hedge funds into domiciles such as Luxembourg or Ireland started in the late 90s and early 2000s with the implementation of new sets of regulations allowing alternative investment strategies to be launched into regulated vehicles in Ireland and Luxembourg. This proved quite popular with institutions that were entering the hedge fund space at the time, following a great out-performance of the hedge fund segment in the “bear” years of 2000-2003. In the past few years, Luxembourg kept making ground in the alternative space with new regulations such as the Specialised Investment Funds law in 2007.

Even with this initial on-shoring trend and recent developments, hedge funds remain to a large extent domiciled in offshore centres such as the Cayman Islands. So what event could re-ignite the re-domiciliation debate within the hedge fund community? We can identify two main catalysts: investor appetite and new regulation: Investor Appetite – Following the recent credit crisis, institutional investors, which represent 72% of hedge fund industry assets according to a recent HFR survey, have maintained their commitment to hedge funds as a critical asset class, placing even greater emphasis on transparency, diversification and on the non-correlated risk return profile they can offer. One way for institutions to resolve the paradigm between getting alpha and maintaining the flexibility of investment strategies – while also improving transparency, increasing oversight and protecting investors – is to shift their focus to more regulated fund structures domiciled within the EU. Not surprisingly, there are now more than 200 hedge fund offerings complying with Ucits III guidelines, according to HFR. Those so called “Newcits” have experienced a rapid growth over the last 2 years and now exceed $50bn of assets. Let us look at the benefits of Ucits for hedge funds investors.

Liquidity – The better liquidity terms offered by “Newcits” compared to offshore hedge funds vehicles is one of the key benefits of the Ucits structures. The rationale for this liquidity appetite is that liquidity risk became brutally apparent to many hedge funds investors in late 2008 when they were exposed to some of the defence mechanisms, such as NAV suspensions, gates and side pockets used by hedge funds managers to prevent fire-sale of their less liquid assets.

Distribution – Ucits funds can be freely marketed to institutions and retail investors across the EU, Asia and South America. This is a clear benefit compared to the private placement regime applied to offshore hedge funds. It opens new types of investors to hedge fund managers such as retail investors, accessed through retail aggregators like retail banks or IFA networks and private banks. It also opens the door to Insurance companies or Pensions Funds. So above and beyond the distribution potential, Ucits offer a good level of investor protection and transparency, a fund oversight by a depositary bank and a liquidity profile not offered in the offshore world.

The actual trade-off for the hedge fund managers is less flexibility in their investment strategies, as they are facing some restrictions on leverage, physical shorting and the requirement to offer investors bi-monthly liquidity. “Newcits” opponents believe that many hedge fund strategies may have to be profoundly altered to be structured as Ucits and may not achieve the historical performance achieved by those same strategies in an offshore format. Clearly a heated debate will continue for the foreseeable future with tracking error between offshore and onshore funds being heavily scrutinised.

Regulation – In early 2009, the EU published a Draft project of Directive on Alternative Investments Funds Managers (“AIFMD”). This Directive is aimed at increasing the level of regulation on alternative fund managers in Europe but also on non-EU managers distributing products into the EU.One aspect of the directive that could potentially trigger a significant re-domiciliation trend into the EU in general and Luxembourg in particular, is the possible restriction on hedge funds distributing their offshore vehicles to professional investors within the EU. It is not clear yet if this would happen after a three year grace period or right after the directive is signed into law. If the most restrictive route is chosen, hedge fund managers may have no other option but to re-domicile their offshore funds into the EU. That said, it is obvious that Luxembourg has a great card to play and should be a jurisdiction of choice in this re-domiciliation exercise.

Finally, in the context of discussions about potential re-domiciliation of hedge fund managers outside London, the AIFMD could potentially create a management company passport very similar to Ucits IV. This could create a new opportunity for the Grand Duchy to attract hedge fund managers. Only time will tell if Luxembourg can become more than a fund domicile and service centre for hedge fund managers.