Is there any truth to this, or is this simply noise generated by promoters of those jurisdictions, hoping to profit from uncertainty over the Alternative Investment Fund Managers Directive?
To answer this question, it is necessary to have a brief look first at the features of QIFs and SIFs to try to identify what, if any, advantages they offer over Cayman funds; and secondly to consider the expected treatment of QIFs, SIFs and Cayman funds under the AIFM Directive. This inevitably involves some crystal ball-gazing as, at the time of writing, the EU legislative sausage-making process in the trialogues has not concluded.
QIFs are Irish regulated, specialist investment funds targeted at sophisticated and institutional investors. According to the Irish Funds Industry Association, “the main advantage of the QIF is the removal of the financial regulator’s general conditions relating to investment policies and borrowing”; but in fact it is the oversight of a European regulator that remains touted as one of the principal selling points for QIFs.
The table below summarises some of the key features of QIFs, and identifies the corresponding position for Cayman funds. Clearly, the regulation of QIFs is more prescriptive than it is for Cayman funds. (See Table 1)
As you can see, the time between submission of a redemption request and payment of redemption proceeds must not exceed 90 days for stand-alone funds (95 days for feeder funds and funds of funds). There are also limitations on the application of gates. QIFs are required to submit monthly returns to the regulator detailing the fund’s latest gross asset value and net asset value.
These liquidity requirements are not the world’s most onerous restrictions, but it is difficult to see what benefit they bring for investors who are, by definition, sophisticated. The same commitments can be baked into the documents of a Cayman fund without it causing a regulatory issue if the fund wishes to offer a class of shares with a more restricted gate or a longer pay-out period.
Perhaps more significantly, the management company, fund administrator and the trustee or custodian in respect of a QIF must be located in Ireland. Further, at least two of the directors of the management company must be Irish residents. There are no equivalent residency requirements for service providers or directors in Cayman other than the requirement for local auditors to be appointed to sign off on the annual accounts.
The minimum initial subscription per investor in a QIF is €250,000. The Cayman equivalent is US$100,000, but this requirement does not apply if the fund appoints a licensed Cayman administrator. The higher minimum subscription for a QIF may be unduly restrictive for managers who wish to allow their employees to invest in the fund.
On timing, QIFs can be authorised by the Irish Financial Regulator within 24 hours of submission of the requisite documentation, which is on par with Cayman funds.
However, unlike with Cayman funds, the service providers to a QIF (including the manager and directors) must be pre-approved by the regulator before the authorisation documents can be submitted. This may take six to eight weeks. For many managers, launching a Cayman fund is therefore likely to continue to be quicker than an Irish fund.
Turning to SIFs, these are the Luxembourg equivalent of QIFs. The table below lists certain key elements. Managers who are used to dealing with the flexibility of Cayman and Delaware funds may be surprised by some of these features. (See Table 2)
Although SIFs may invest in any type of asset, they must do so in compliance with risk-spreading principles. Subject to specific exceptions, a SIF may not invest more than 30 per cent of its assets or commitments to subscribe in securities of the same nature issued by the same issuer. A corresponding restriction applies to the size of open positions in respect of any issuer that a QIF may hold when short selling. Comparable risk-spreading restrictions apply to the use of derivatives.
Again, as with QIFs, the impact of these restrictions on most funds will be limited but, without evidence of any compelling benefits of SIFs, managers may nonetheless be hesitant about leaving themselves open to regulatory sanction should a technical breach arise.
SIFs are also liable for an annual subscription tax up to a maximum tax rate of 0.01 per cent of the average net assets of the fund, and under certain circumstances non-resident investors in corporate SIFs may themselves be subject to Luxembourg income tax. In contrast, there are no taxes in Cayman that apply to a Cayman fund or its investors.
Another similarity with their Irish counterparts is the requirement for SIFs to have certain services performed locally. SIFs must have their central administration undertaken in Luxembourg. The custody of the assets of the fund must be entrusted to a depositary which must be a credit institution with its registered office in Luxembourg or be established in Luxembourg as the branch office of a credit institution registered in another EU member state. The depositary has a supervisory role as well as a safe-keeping role, and is liable to the investors for any loss suffered by them as a result of its wrongful failure to perform its obligations. The depositary requirements will inevitably lead to reduced choice and increased costs for the fund.
Notionally, SIFs require no prior approval by the Luxembourg regulator before creation. However, an authorisation file must be submitted within one month of creation of the SIF and authorisation remains subject to approval of the SIF’s constitutional documents and approval of the choice of depositary and auditor. For this reason, it is recommended that the regulator be involved before launch to identify any issues. Clearly then, establishing a SIF is not likely to be any quicker than launching a Cayman fund.
Apples and apples
So where does this leave Cayman funds when compared in a fair fight against QIFs and SIFs based purely on their current regulatory features?
It is difficult to see what competitive advantage Luxembourg or Ireland have in the sophisticated fund market. They are each more expensive than Cayman, less experienced and make a virtue out of regulating funds for the protection of sophisticated investors who, in any event, insist on due diligence, transparency and independent oversight from third party administrators, auditors and directors: all prudent measures which are inculcated in the Cayman model.
Regulation is not inherently evil: Cayman funds have operated in a regulated environment for many years now and most industry participants recognise that a degree of regulation is as appropriate as it is inevitable for the hedge fund industry. But regulation only makes sense if it is targeted and proportionate for the purpose of protecting someone, or something, that needs protection. Even in the highly distressed environment following Lehman’s collapse in September 2008, Cayman’s disclosure-based regulatory approach has proven to be effective and appropriate for the sophisticated funds, which QIFs and SIFs are seeking to emulate. Indeed, it is difficult to see how any of the restrictive regulatory requirements for SIFs and QIFs listed above might have proved superior in protecting investors during the financial crisis: even the liquidity requirements for QIFs would have been unlikely to have helped in practice.
So, all things being equal, it would be an odd sophisticated investor who decided to invest in one fund rather than another based on the claimed expertise of the regulator (which is not insuring or guaranteeing their investment) in the jurisdiction in which the fund was domiciled.
What difference does the AIFM Directive make? Does this give QIFs and SIFs a tremendous new advantage over Cayman funds?
The answer to these questions will not be known until the separate AIFM Directive texts of the European Commission, European Council and European Parliament have been reconciled into a single final draft.
At this stage, it is clear that EU investors will be able to invest in Irish and Luxembourg funds through a passporting mechanism available to EU authorised funds.
It is equally clear that EU investors will be able to invest in Cayman funds; it is only the mechanism by which this will be possible, and the criteria that must be satisfied, that have yet to be determined. These are the so-called ‘Third Country’ provisions.
It is beyond the scope of this article to analyse the draft proposals, but in essence it is expected that Cayman funds will continue to be eligible to be marketed to professional investors in the EU either on the basis of the existing national private placement regimes (the Council proposal), or on the basis of the passporting regime under the Directive if certain criteria are met (the Parliament proposal). Industry professionals in Cayman consider that Cayman funds will have no difficulty in satisfying the criteria indicated in the latest drafts and comments emanating from the EU, especially given that implementation of the Directive is not likely before 2013.
Ultimately, for QIFs and SIFs to be genuinely considered as the Next Big Thing requires an affirmative answer to at least one of the following questions:
- Have QIFs and SIFs already established a position of sufficient industry recognition that managers should set up funds in Ireland and Luxembourg “because everybody else does”? Table 3 (as at the end of 2009 for the QIF/SIF figures) demonstrates that this is patently not the case. (See Table 3)
- Do QIFs and SIFs offer an evident commercial or regulatory advantage over Cayman funds regardless of the AIFM Directive?
As demonstrated, this is unlikely to be the case for anyone but the most timid and Eurocentric of investors.
- Will QIFs and SIFs offer an evident commercial or regulatory advantage over Cayman funds when the AIFM Directive is implemented?
The uncertainty surrounding the Directive means it is too early to answer this last question with anything more than a Gallic shrug, but as we have seen it seems clear that Cayman funds will generally be able to continue to be marketed to European sophisticated investors whatever the outcome is on the Third Party provisions.
The funds industry never stands still, and the foundation for its success over the last two decades has been the willingness of managers to explore new opportunities. The hype surrounding QIFs and SIFs is a trade that managers and advisers should carefully scrutinise before placing the buy order.