The challenge of UCITS IV for service providers - Ernst & Young - Luxembourg

The challenge of UCITS IV for service providers

By Laurent Denayer et Yann Power*, Ernst & Young, Luxembourg  
Luxembourg Fund Review
April 2010  

UCITS IV is expected to drive consolidation of a fragmented European investment fund industry, both at fund and service provider level. It is hoped that this consolidation will boost the industry’s competitiveness by increasing economies of scale and lowering service provider costs.

Each of the main elements of UCITS IV creates new challenges, and opportunities, for service providers. In this article, we examine each key element in turn before turning to the strategic considerations for asset management groups, which provides the key to understanding the new environment for service providers.

The challenges of implementing UCITS IV

1. The notification procedure

The notification procedure is the procedure to be followed before the shares or units of a UCITS domiciled in one European Union (EU) Member State can be distributed to investors in another EU Member State. The new notification procedure under UCITS IV is simplified and accelerated. This will reduce time to market and the administrative burden for funds distributed cross-border, boosting cross-border distribution.

The new notification procedure is not expected to present significant new challenges for the industry. Service providers must nevertheless be ready to meet the challenge of increased cross-border distribution of UCITS, and in particular increases in the number of countries of distribution.

2. UCITS mergers

A procedure for UCITS mergers is established. This facilitates mergers of funds, particularly cross-border, to enable the creation of larger funds, which should be more competitive in terms of costs. This may accelerate the existing trend of merging smaller UCITS into “mega” UCITS in a single domicile, distributed cross-border.

A merger takes place between one or more UCITS, or sub-funds (compartments) thereof , and a receiving UCITS, or sub-fund thereof.

It may be difficult to benefit fully from the merger provisions unless specific measures are implemented to ensure that fund mergers are tax neutral events.

The challenges of UCITS mergers include:

• Evaluating the tax implications of the merger on the funds, on investors and on the management company of the merging fund(s)
• Drawing up common draft terms of the potential merger
• Drawing up the information to be provided to investors on the possible impact of the proposed merger
• Valuing the assets and establishing a methodology for calculation of the exchange ratio

3. Master-feeder UCITS structures

In master-feeder UCITS structures, the feeder UCITS invests most of its assets in a master UCITS. Therefore, the management of a significant portion of the portfolio of the feeder fund is effectively delegated to the manager of the master fund. The master, or one or more of the feeders, can be located in different Member States.

To be deemed a master-feeder under the UCITS Directive, the feeder should invest at least 85% of its assets into a single master.

Master-feeder UCITS structures will facilitate the channeling of investments into a single master fund. Mega UCITS in one domicile will likely be the “master”; feeders in other countries may facilitate tax efficiency and better serve certain local distribution channels (e.g., for cultural reasons).

An existing UCITS may become a feeder; a feeder UCITS may also change its master.

The challenges of implementing master-feeder structures will include:

• Drawing up the agreement between the master and feeder UCITS, or the internal conduct of business rules where both are managed by the same management company
• Implementing appropriate measures to avoid market timing
• Valuing the contribution in kind where the feeder transfers all or part of its assets to the master in exchange for shares or units (e.g., in the case of the conversion of an existing UCITS into a feeder)
• Establishing the flow of information and documents between the custodians to ensure the fulfillment of their duties, in particular where the master and feeder are in different Member States
• When converting an ordinary UCITS into a feeder UCITS, a feeder into an ordinary UCITS, or on change of master UCITS:
  • Evaluating the tax implications of the change on the funds, on investors and on the management companies: the pre-restructuring and post-restructuring tax impact
  • Providing information to investors

4. Key Investor Information (KII)

UCITS IV foresees a new document, replacing the simplified prospectus, entitled Key Investor Information (KII) for every UCITS.

KII must contain fair, clear and understandable information about the UCITS. It must be brief and nontechnical. It should be comparable and presented in an understandable way.

In the case of umbrella UCITS, a separate KII must be produced each sub-fund. In the case of multiple share classes, a separate KII must be produced for each share class, except where a share class can be selected to represent other share classes and certain conditions are met. In the case of master-feeder structures, a separate KII must be produced for each feeder UCITS.

For existing UCITS, simplified prospectuses must be replaced with KII within 12 months of the implementation of the related implementing measures.

The challenges of the KII will include:

• Implementing the risk and reward indicator
• Disclosing charges: presentation of charges and information on performance fees, new funds and funds changing their charging structure
• Illustrating past performance: issues include calculation method, treatment of charges, use of a benchmark and simulated data (in the cases of new share classes and master-feeders)

5. The management company passport

In the future, the management company of a UCITS domiciled in one EU Member State, such as Luxembourg, may be situated in another Member State, such as France; it may also provide its services through a branch. Furthermore, the management company will not be required to appoint service providers in the domicile of the UCITS, apart from the custodian which must always be in the domicile of the UCITS.

The UCITS must comply with its home Member State rules the constitution and functioning of the UCITS,
The management company must implement procedures and arrangements to enable the UCITS home Member State authority to monitor the UCITS’ compliance with the rules under its responsibility.

Where a UCITS is managed cross-border, the UCITS management company and custodian must enter into a written agreement on the flow of information between them to enable the custodian to carry out its duties.

There will be a number of key considerations when deciding where to domicile a management company, such as the domicile(s) of the fund(s) to be managed by the management company, the impact on distribution channels, direct and indirect tax, operational costs and the regulatory environment.

In the context of a UCITS managed by a management company cross-border, the challenges will include:

• For the custodian:
  • Entering into and implementing the agreement covering such flow of information between the management company and custodian to enable the custodian to carry out its duties
  • Implementing measures in order to enable it to fulfill its duties regarding a UCITS managed cross-border
  • As a point of contact for providing information to the UCITS home Member State authority, and, potentially dealing with investor complaints
• For service provider to which the management company has delegated an activity (such as administration) or function (such as compliance or risk management) outside the UCITS home Member State: complying, on an ongoing basis, with the management company’s home Member State rules relating to the delegated activity or function and, where applicable, the rules of the UCITS home Member State regarding the constitution and functioning of the UCITS

6. Reinforcement of existing regulatory requirements for management companies

UCITS IV will increase, at EU level, the minimum regulatory requirements to be complied with by management companies and their service providers. The same requirements should also be applied to self-managed UCITS. These relate to:

• Organizational requirements and conflicts of interest
• Rules of conduct
• Risk management

For management companies or self-managed UCITS, the challenges of the reinforced regulatory requirements will include:

• Complying with organizational and conflicts of interest requirements and rules of conduct: The application of MiFID-like requirements to management companies may represent a substantial additional burden for management companies in a number of Member States.
• Complying with risk management requirements: The impact of these measures will depend on the level of current Member State requirements.
• Applying similar standards to non-UCITS: the Committee of European Securities Regulators (CESR) recommends that the same regulatory requirements be applied to the management of non-UCITS by UCITS management companies.
• Performing due diligence when delegating activities or functions to a third party

Service providers will, therefore, have the opportunity to offer compliance and risk management support services to management companies.

Strategic considerations for asset management groups

UCITS IV creates the opportunity for asset management groups to streamline their UCITS product ranges and optimize their service provider set-up. Asset management group will try to develop a holistic strategy that optimizes tax, regulatory, operational efficiencies of their entire operations.

The key considerations for asset management groups will include:

A. Streamlining and enhancing of product ranges

Asset management groups will consider streamlining and optimizing their product ranges to create funds of sufficient size to benefit from economies of scale. They may also consider consolidating funds from other promoters into their own range.

B. Boosting cross-border distribution

Asset management groups may also take advantage of the simplification of the notification procedure to increase the number of countries, particularly EU countries, of distribution of their UCITS.

C. Optimization of service provider set-up

Asset management groups and promoters will reconsider their current service provider set-up, with a view to determining the optimal structure to service to their fund range. The options open relate to:

• Configuration: the optimal combination of own and third-party or joint venture management companies and service providers.
• Delegation: the activities which will remain in-house, and those which may be outsourced by management companies and service providers. Management companies and self-managed investment companies may delegate activities (portfolio management, administration or marketing) or functions (such as compliance, internal audit and risk management) where permitted by the regulations of the management company’s home Member State. Service providers may, in turn, be permitted to delegate certain activities.
• Domicile: the choice of domicile of the management companies and service providers. The management company passport enables a management company in one EU Member State to manage a UCITS in another directly or indirectly. If permitted by the regulations of the management company’s home Member State, the management company may also delegate activities or functions to service providers cross-border. In the case of self-managed investment companies, cross-border delegation will depend on the rules of the UCITS home Member State.

The new business environment for service providers

The streamlining of UCITS fund ranges and optimization of asset management groups’ service provider set up creates new opportunities and threats for service providers. These may include:

• Winning and losing business. For example:
  • Streamlining of UCITS ranges will tend to concentrate assets to be serviced in a few domiciles
  • Groups are likely to outsource more activities and functions to remain competitive, benefiting third party and joint venture service providers
• Mergers, acquisitions and liquidations. For example:
  • Groups deciding to sell service provider businesses or set up joint ventures will create targets for acquisitions and mergers respectively.
  • Underperforming service providers may be taken over or liquidated
• Outsourcing: service providers may themselves delegate certain activities or functions to other service providers, for example to reduce costs.

The key challenge for service providers will be meeting the quality of service requirements at a competitive price. Service providers will therefore need to attain critical size and implement robust and efficient processes and procedures. Competition in the service provider space is likely to be fierce, and a shake-out is to be expected.

This may also lead to concentration and consolidation in the most attractive jurisdictions. The choice of domicile for services providers will depend on factors such as:

• Quality and cost of service
• Reputational considerations relating to the appointment of the service provider and its domicile
• Ability to work with other service providers
• Direct and indirect tax considerations
• Regulatory environment, such as delegation/outsourcing rules
• Proximity considerations (e.g. clients for distribution, management company for administration)
• Qualifications and knowledge of the workforce

Conclusion

Service providers will differentiate themselves on quality of service and costs. The degree of complexity of the business process, as well as the technology required, combined with pressure on costs, is likely to drive natural selection amongst service providers.

Pan-European service providers may emerge with the technical and intellectual infrastructure, and flexibility, to service asset management groups across Europe – either as a single group or through alliances. Labor-intensive processes, such as NAV calculation and fund accounting will be seen from a cost-efficiency perspective, and may be outsourced, even off-shored.

New types of specialist services may appear such as multi-jurisdiction compliance and risk management services, investment fund documentation, operational due-diligence and fund range structuring consultancy services.

Luxembourg has consistently demonstrated its expertise in the cross-border context, and already has a multi-lingual workforce with expertise cross-border fund-servicing issues. This environment will take years to replicate.

Mastering the rules related to the domicile of UCITS and management company on a pan-European scale will represent a challenge which Luxembourg service providers, with their expertise in dealing with cross-border issues, are particularly well-placed to meet.

We therefore believe that Luxembourg will prove to be an attractive domicile for service providers for both Luxembourg domiciled UCITS and non-domiciled UCITS.

*By Laurent Denayer, Financial Services Risk Management Leader and Strategy and Risk Management Leader for UCITS IV services Ernst & Young, Luxembourg

and Yann Power, Manager, Financial Services R&D, Ernst & Young, Luxembourg

Posted on 10 May 2010