Over the last few years, a distinct trend has emerged in the types of investment funds that are being structured in Ireland and authorised by the Financial Regulator. These funds are mostly promoted by the international investment managers who use Ireland as the domicile for their funds which are then sold in the international market place. However, there is a growing demand for these products in the domestic market as Ireland's growing private wealth management sector looks to make greater use of these products.

The trend is for funds to be either structured as a UCITS (1), under the increasingly flexible rules which apply to these retail products, or for the funds to be structured as Qualifying Investor Funds or QIFs which can only be sold to professional or institutional investors. For a QIF, the Financial Regulator disapplies most of the usual investment and borrowing restrictions which apply to other types of fund structures, so making this the vehicle of choice where the investment manager wishes to employ leverage or retain maximum flexibility with regard to the fund's investment policies.

The natural drift towards these two types of structure has been caused by a number of regulatory developments at European and domestic level.

In 2003, Ireland implemented the UCITS III Directive which was the first major step in expanding the range of assets that a UCITS can invest in. The changes included the ability for a UCITS to invest in derivatives, money market instruments and other investment funds so allowing for the creation of fund of funds structures. In a fund of funds, the investment manager uses their skill to select the best performing managers in a specific sector on a global basis and then invests in their funds, so in effect delegating the individual stock selection to proven performers.

However, the market always moves faster than the regulators and as the financial markets have created ever more complex financial instruments, there was some doubt and differing views expressed on whether certain types of instruments, particularly those which have embedded derivatives, were 'eligible assets' for a UCITS and if so, how they should be treated for compliance monitoring purposes. Accordingly, the next step in this process has been for the EU Commission to clarify whether these complex financial instruments could be considered "eligible assets" for a UCITS. The culmination of this process was the adoption of the Eligible Assets Directive in March 2007 which was transposed into Irish law in December 2007 by S.I. 832 of 2007.

What does this mean?

• Structured financial instruments, which satisfy certain conditions, may now be classified as transferable securities and so become eligible assets.
  
  
• A new definition of the types of closed ended fund which a UCITS may invest in has been created, leading to greater clarity.
  
  
• A new definition of money market instruments has been introduced. In addition, the Financial Regulator is now permitting certain floating rate commercial bank loans to be eligible assets if they are of the type that are normally dealt with on the money market.
  
  
• Further clarification on the use of derivatives has been included, building on the UCITS III changes, so permitting access to broader asset classes and new investment strategies. For example:
  
  
  • Although a UCITS may not invest directly in hedge funds, it can gain a similar exposure by investing in an index comprised of a number of hedge funds through a derivative instrument.
    
    
  • A UCITS may create a synthetic short position on a particular stock by the use of derivative. This development has allowed UCITS to be structured as so-called 130/30 funds (2), making it theoretically possible for the once conservative UCITS structure to undertake strategies which were previously the preserve of hedge fund managers only. In addition, the European Commission is currently considering a proposal from the Financial Regulator to permit UCITS to engage in physical short selling in conjunction with a stock borrowing transaction. If this is permitted, a 130/30 fund may be created either through the use of derivatives or through physical short selling or a combination of the two.

Enough about UCITS, the structure of choice of the institutional investor, where the cross border marketing advantages of a UCITS are not required, is usually the QIF. Since February 2007, the Financial Regulator has stopped carrying out its pre-authorisation reviews of QIF structures and it is now possible to have a new QIF structure authorised on a filing only basis within one business day.

Since this ground breaking change in approach, dialogue has continued with the Financial Regulator and the funds industry to further improve the QIF product from the perspective of fund managers and investors. The objective is to remove certain requirements that are deemed not to add any real value for investors, such as the requirement for the QIF to produce interim accounts. We await publication of any agreed changes to further enhance this structure which has proved to be ideal for the creation of investment products such as hedge funds, private equity funds, real estate funds and fund of funds (including funds of hedge funds).

As the financial market place becomes ever more complex, the regulatory regime which exists in Ireland for the creation of investment fund structures is responding accordingly.

May 2008.

For further information please contact David Williams.

Notes:

(1) A UCITS is an Undertaking for Collective Investment in Transferable Securities, an investment fund which may be freely marketed to any type of investor within the EU.

(2) A 130/30 fund allows the fund manager to short positions (up to 30%) and then use the cash proceeds to invest in additional long positions (up to 30%), which means that the market exposure of the total portfolio remains at a net 100%.