What does UCITS IV mean from a practical point of view?

On June 19, 2009, the Council of the European Union adopted the UCITS IV Directive that recasts the existing UCITS Directive 85/611/EEC. Although the related implementing measures are still under discussion at CESR[1] level, UCITS IV is an important step forward likely to have implications on the business model of promoters of UCITS. 

The faster registration process and Key Investor Document will increase competition between UCITS and favor restructuring needs 

The faster notification procedure will significantly reduce the time-to-market of cross-border UCITS: a regulator-to-regulator process will indeed be put in place based on the principle of approval of the home country regulator and will not last more than ten working days! Thanks to UCITS IV, one may hope that existing European distribution barriers will be removed and promoters of UCITS would be able to market their products on a cross-border basis more easily. 

The “Key Investor Document” (“KID”) will replace the existing and often over-long simplified prospectus in order to provide investors with shorter and more understandable investment decision-making information. In addition, the fact that no civil liability will be attached to the KID should significantly reduce risks inherent to the issue and publication of such a pre-contractual document. However, in the current context of transparency improvement, sales and advice for retail investment products[2], the KID would ease comparisons between UCITS and potentially between UCITS and other retail investment products (unit-linked life insurance products, structured notes, etc). 

Performances and cost efficiencies based competition would consequently be increased between domestic and cross-border promoters and issuers of financial products. Likely UCITS IV business implications must then be considered, in particular in terms of restructuring needs to achieve economies of scale. 

The current UCITS environment and UCITS IV amalgamation solutions 

At the end of 2008, 30% of UCITS had less than EUR 10 M[3] assets under management and the size of 65% of UCITS didn’t exceed EUR 50 M²! The European investment industry is characterised by a high number of small or medium-size funds and European funds are on average approximately six times smaller than US ones. Unfortunately, the current financial turmoil will not improve the situation. 

One of the reasons that could explain the relative small size of the European UCITS is inherent to the fact that many promoters offer domestic rather than cross-border UCITS to their European investors. 66% of the top 30 promoters in terms of number of countries of distribution have launched UCITS in at least four different countries of domicile and 7% of them have domiciled their funds range in more than eight European countries! 

It does not come as a surprise that UCITS IV will favor restructurings for the purpose of rationalising UCITS by allowing "Master-Feeder" structures and by developing a new set of European rules related to mergers of UCITS. 

The Master-Feeder solution of UCITS IV consists in adopting an investment strategy by which one UCITS (the “Feeder fund”) invests at least 85% of its net asset value in another UCITS (the “Master fund”). Promoters will then be entitled to pool the assets of their UCITS in one so-called Master fund. The advantages of such a restructuring solution are at least twofold:

• The management and the administration of the Master fund (i.e. the pool of assets) will be centralised in one country of expertise and promoters should be able to rationalise their platforms and consequently reduce inherent costs charged to the UCITS and indirectly paid by the investors.
• The impacts on the existing investors in domestic UCITS are limited: with the exception of the modification of the Feeder’s investment policy (from a diversified investment policy to a Master-Feeder investment policy), the investors will remain in the same “local” vehicle. From a tax point of view, investors should not be subject to any tax resulting from this restructuring. Tax impacts will be somewhat different when promoters decide not to amalgamate the assets of domestic UCITS with another UCITS but to interpose a Feeder fund between one existing fund (that will become the Master fund) and the final investors. In that case, the latter will be transferred from one UCITS to another one and potentially taxed on their capital gains. 

The merger solution of UCITS IV consists in merging, on a domestic and/or cross-border basis, the funds range of one promoter in order to merge the assets of several disappearing UCITS as well as their investors with only one receiving vehicle. 

By merging their UCITS, promoters will then benefit from the opportunity to significantly rationalize their European funds in order to manage, administer and market only one range of products from a single European platform. The merger of UCITS is probably the restructuring process generating the most economies of scale and cost reductions. However, impacts on investors are potentially more important than the Master-Feeder solution: investors will indeed be transferred not only from one structure to another one but also, in case of a cross-border merger, from one country of investment to another. Such a transfer may potentially be considered as a taxable event at the level of the investors (except where tax reliefs could apply). In addition, a one-month prior notice will have to be observed, during which investors of both the merging and receiving UCITS will have the possibility to redeem their investments free of charge. Risks of asset flight are then not negligible. 

Obviously, the location of the Master fund (in case of Master-Feeder structure) or of the receiving fund (in case of merger of UCITS) is key and subject to various and complex criteria. Since all administrative tasks (multiple classes of shares, valuation of investments, cross-border distribution and registration, tax reporting (including German tax, etc) will be centralised within one UCITS (the Master fund or the receiving fund), the latter must be administered in a country having the experience of such international and complex products. 

Current management company environment and UCITS IV management company passport solution 

As a consequence of the current obligation to have local presence in the country of the UCITS, more than 65% of the top 30 cross-border fund promoters have management companies domiciled in more than three EU countries³ and 20% of the same have UCITS management companies in more than five European Member States³! 

In that context, UCITS IV will finally introduce a full management company passport. There is no doubt that promoters will benefit from this new regulatory flexibility to review and rationalize their value chain on a cross-border basis in order to reduce existing and costly duplication of resources and capital requirements across the EU, potentially combining it with the above described UCITS restructuring solutions. 

Since UCITS IV is not, however a tax Directive, the success of the management company passport is strictly linked to potential tax impacts/reliefs in connection to the provision of cross-border collective portfolio management services and the related substance impairment of the managed UCITS. The management company passport should indeed not be at the origin of tax challenges around the location of the UCITS management and its tax residency or raise transfer pricing issues. Consequently and in the absence of harmonisation between the related European regulatory and tax rules, the management company passport is still subject to tax controversies that must be closely considered before making restructuring decision. 

UCITS IV will be effective as from July 1, 2011. The implementation measures should be proposed by CESR as of October this year. Yet we recommend the market start doing its homework now.