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Sunday, 21st April 2024
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Pressure to open up retail hedge fund markets will persist says new report Back  
Europe is slowly coming around to the idea of retail hedge funds. In Luxembourg, retail investors now have access to hedge funds, provided the funds are approved by the local regulator, and last year, the Irish regulator abolished its minimum investment limits for Irish retail investors in fund of hedge funds. France is also easing access to retail investors with a minimum investment threshold of �10,000 for fund-of-hedge-funds. Ken Owens provides an overview of these and other regulatory and fiscal developments around Europe, drawing on PwC's new white paper, 'The Regulation and Distribution of Hedge Funds in Europe'.
In formulating policies and rules around the regulation and distribution of hedge funds, both regulatory and fiscal authorities need to find a delicate balance. They must protect the retail investor, ensure the contingency operation of orderly markets and develop an efficient and non-discriminatory tax approach. Yet they should also avoid unnecessarily hindering the expansion of a vibrant industry that genuinely offers a valuable alternative investment choice to investors of all sorts. Excessive regulation or tax barriers could stifle a growth industry which offers significant benefits for the financial services industry and investors alike.

Increasing influence necessitates regulation
As assets have expanded, hedge funds have become increasingly influential players in capital markets. The increasing high turnover of assets has made it the most valuable client group for the world�s leading investment banks and, in particular, their prime brokerage operations. Such influence has caused regulators to consider how best to supervise hedge funds more closely � both to guard against possible future losses at hedge fund managers spreading to the wider financial markets, and to police against market abuse.

Ken Owens

As rules are formulated to oversee the burgeoning hedge fund industry, there are several broad trends emerging. The first of these, which is best illustrated in the United States, is the move to increase the oversight of the hedge fund managers themselves. The Securities and Exchange Commission (SEC) has recently amended its rules to ensure that from 1 February 2006 many more hedge fund managers, will have to register with the SEC. For the first time, this will allow the SEC to supervise closely the activities of all hedge fund managers with more than a small number of US investors.

When it comes to hedge funds themselves, regulators are beginning to allow the establishment of onshore hedge funds that can be sold to retail investors (for more details, see below), or the sale of certain offshore hedge funds to retail investors. In doing so, they have tended to establish funds of hedge funds as the retail route into the industry. These are considered to be relatively low risk, with the advantages of diversification of individual hedge fund risk, as well as professional selection of hedge funds.

From a tax perspective, the fiscal authorities in those jurisdictions that want to encourage the hedge fund industry have removed some barriers to growth. In Germany, for example, there has been a large scale overhaul of taxation with the intention of promoting hedge fund growth.
But while the regulatory and fiscal authorities overseeing many of the world�s largest hedge fund marketplaces are seeking to establish a sensible balance between opening retail markets and appropriate policing, there is a real danger that they may fail. There is no universally accepted model on exactly what to regulate: the fund, the manager or the nature of distribution or a combination of all three. Furthermore, there is an increasing risk of dual or multiple registration requirements. Were other jurisdictions to adopt a similar approach to the SEC in the US, hedge fund managers would shoulder huge compliance burdens as they struggled to meet the requirements of multiple national regulators.

For the hedge fund industry to achieve its true potential growth, hedge fund managers need to be supervised in just one jurisdiction, and hedge fund distribution should be governed by sets of rules that apply across large geographical areas.

The regulatory and fiscal status of hedge funds in Europe
While high net worth private investors have been buying offshore hedge funds by way of private banks or through the establishment of family offices for many years, regulators across Europe have recently been introducing legislation to establish frameworks for onshore hedge fund markets. Of the major markets, France, Germany, Ireland and Switzerland have allowed onshore hedge funds. Generally speaking, they have permitted retail investors to acquire carefully regulated funds of hedge funds, while public distribution of single manager hedge funds is effectively limited to a more elite group of wealthy investors. No jurisdiction has established a specific tax regime for hedge funds, so typically they are subject to the same tax rates as other funds.

Germany, for example, has introduced a new regime covering both single manager hedge funds and funds of hedge funds. Following registration both domestic and foreign funds of hedge funds may be distributed to the public. In the case of foreign funds, the German regulator will only grant registration where it considers that home state regulation is effective. A new tax law governing fund investors came into effect at the end of 2003, and abolished prior discrimination against foreign funds. Single manager funds can only be actively sold to expert investors such as pension funds, insurance companies, wealthy investors and the funds of funds. Despite this general prohibition on retail distribution of single manager funds, indirect access is available to retail investors through instruments such as a structured note linked to the underlying fund.

In Luxembourg, retail investors have access to hedge funds, provided the funds are approved by the local regulator. Last year, the Irish regulator abolished its minimum investment limits for Irish retail investors in fund of hedge funds. France is also easing access to retail investors with a minimum investment threshold of �10,000 for fund-of-hedge-funds.

The UK is, has yet to establish a domestic retail hedge fund market. Hedge fund-like products can, however, be marketed to retail investors under recently revised rules for authorised funds. These funds can use derivatives for investment purposes and short selling, provided the �short� is liquid and can be cash settled or is covered by long positions with return profiles highly correlated to the short. There are also restrictions on gearing, which do impose practical limitations on hedge fund management techniques. Recent clarification of the tax situation for these funds � existing tax rules for authorised funds will apply � may lead to an increasing number of these funds being launched. However the tax treatment of such a fund in the UK would continue to be a disadvantage in comparison to most offshore vehicles. The Financial Services Authority, the UK regulator, has recently issued a Discussion Paper considering whether to establish a specific marketing regime allowing retail access to �proper� hedge funds.

In an ideal world, Europe would have a single regulatory regime and harmonised tax treatment, but there is little sign of this occurring. There are few signs, however, that the European Commission is keen to introduce new legislation. Instead, it may make small but significant alterations to the UCITS and MiFID Directives to embrace hedge funds. From a tax perspective, there is broad pressure from industry bodies for removal of tax barriers in UCITS funds, which may have implications for hedge funds.

Conclusion � opportunities and challenges
While hedge fund industry regulation has evolved considerably in recent years, with fiscal barriers also being removed in some jurisdictions, there is clearly some way to go as regulators seek to develop rules and practices that reflect the size and influence of hedge funds. Regulators are even now debating how to oversee the activities of managers who have become hugely influential and major capital market participants. What is more, pressure to open up retail markets will persist.
The perfect conditions for hedge fund growth everywhere require three factors: regulation focussed more on risk levels than how a fund is managed, no tax discrimination against hedge funds and stronger corporate governance frameworks.

In seeking to bring about these conditions regulators must be careful not to stifle growth. Over-regulation � through perhaps requiring managers to register in more than one jurisdiction � could hold back what is one of the healthiest innovations in financial markets over recent years.

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