20 October 2003
Since the inception of its International Financial Services Centre (IFSC) only 16 years ago, Dublin has grown to be a significant location for a wide range of global financial services activities. There are now almost 450 international institutions operating directly from Dublin, with a further 700 managed entities carrying on business there. The IFSC now accounts for around 15 per cent of overall corporate tax contributions to the Irish exchequer and employs nearly 12,000 people directly.
An integral part of its development has been the growth of the funds industry, which employs around 5,500 people directly in Ireland, with an estimated further 1,500 people employed in professional advisory firms servicing the industry. More recently, legal and regulatory developments have facilitated fund promoters in domiciling a wider range of fund products in Dublin. One of the consequences of particular note has been the increase in the number of hedge funds being domiciled in Dublin.
As Dublin's reputation as a domicile for hedge funds grows, however, lawyers, regulators and other service providers in the area need to continue to be agile in their response to regulatory and industry demands. On the regulatory side, Dublin is constantly being challenged to formulate, implement and modify regulation that will facilitate the development of the hedge fund industry while also providing a framework for prudential control. On the industry side, the increasing complexity of investment strategies and instruments continues to challenge all professional advisers and service providers to develop their specialist knowledge in this area.
The welcome introduction by the Irish Financial Services Regulatory Authority (IFSRA) in December 2002 of regulations permitting retail funds of hedge funds is an example of the Irish regulator's ability and willingness to work with the industry in an effort to meet investors' demands. Ireland has, as a result, become the first European jurisdiction to allow the authorisation of retail funds of hedge funds. This confirms the positive message that Ireland is a pioneering jurisdiction for regulated hedge funds.
The challenge for the IFSRA now is to consider submissions made by the Dublin Funds Industry Association (DFIA) on the treatment of prime brokers and the collateralisation of fund assets.
Principal among the suggestions put forward by the DFIA on behalf of the industry are the following:
That the exposure of a fund to the prime broker be increased to an excess exposure limit of 40 per cent. This would bring the level into line with the equivalent level in the US and could considerably ease the operational burden on US-based prime brokers without materially increasing the fund's exposure.
That this limit should be calculated on the basis of indebtedness as opposed to net or gross asset value. This, again, would correspond more closely with the US model and would avoid creating an additional layer of reporting that would otherwise arise, as the prime broker would not necessarily have automatic access to the fund's net or gross asset value.
That authorisation procedures, similar to those applying to traditional funds, be implemented to speed up the authorisation of hedge funds by removing the requirement for each prime broker agreement to be reviewed, once the custodian and the fund's lawyers confirm that it complies with the regulatory requirements.
That collateral assets transferred to facilitate exchange-traded transactions be excluded from any limitations imposed on the transfer of assets by way of collateral.
That the limit imposed on the level of collateral assets that may be provided to a prime broker should not be aggregated with other limits that may apply to certain other transactions.
To date, the IFSRA has displayed a commendable openness and flexibility by responding to industry requests to assist the growth of the hedge fund industry in Ireland, and it is hoped that this flexibility will extend to its consideration of the current submission.
In many ways the principal challenge for the industry in Dublin is to manage the growth of hedge funds. In the intervening five years since the rescue of long-term capital, hedge funds have reclaimed their credibility and, indeed, have become the investment of choice for many investors.
Driving this shift has been the uncertainty in the global economy and the subsequent volatility in world equity markets, resulting in an appetite among investors to diversify against poor performance in traditional asset classes, particularly equities. In short, investors saw hedge funds as the principal method of generating returns in times of falling markets.
The global growth of hedge fund assets has been estimated to be in the region of 20 per cent per annum over the last 10 years. It is now estimated that hedge funds globally have assets under management of almost $1 trillion (£600.65bn), and this figure is expected to reach $2 trillion (£1.2 trillion) by 2010. In Ireland, in the year ended June 2003, the net asset value of Irish domiciled alternative investment funds grew by almost 60 per cent. As a centre for hedge fund administration, it is estimated that more than $100bn (£60.07bn) worth of hedge fund assets are under administration in Dublin.
This growth brings its own challenges, not least of which is the necessity for all stakeholders to develop their understanding and familiarity with the increasingly complex and sophisticated strategies being deployed by investment managers. These stakeholders include lawyers, auditors, administrators, custodians and regulators.
The challenges facing administrators are particularly relevant as the degree of sophistication, specialist knowledge and technology being demanded of them intensifies. The complexity of convertible/ statistical/volatility arbitrage strategies, global macro strategies or market-neutral strategies being used by hedge fund managers requires sophisticated levels of valuation. The investments involved in these strategies are, in turn, often unlisted and illiquid, and the volatility of the fund can be compounded by the use of leverage. Another layer of complexity is added as fee structures tend to be performance-based.
Obviously, these increased levels of sophistication also bring with them particular challenges for the lawyers. Articulating these issues in the fund documentation and understanding and managing the fund's exposure arising from more complex investment strategies mean that the fund lawyer's role in the development of the industry remains pivotal.
The factors that helped Dublin consolidate its position as a leading centre for hedge fund administration still apply, however. The level of expertise and knowledge of its highly educated workforce in this area is still of the highest calibre and Ireland still boasts favourable taxation rates and a good communications infrastructure. One of its biggest advantages in this area is its timezone. As hedge funds move towards daily dealing, valuations done in Dublin today as of close of business yesterday can be delivered to fund managers in the US by start of business today in the US.
Ireland currently faces the challenge of finalising regulation that will facilitate the development of the hedge fund industry while providing the framework for prudential control. The challenges extend, however, beyond regulation, as this highly dynamic industry continues to evolve and challenge practitioners to keep pace with the continuing complexity and sophistication of the strategies being developed. Now more than ever, the industry and the regulator continue to work towards the common goal of ensuring that Dublin retains its competitive edge as a location for hedge fund administration, while also providing a practical regulatory framework to make it the domicile of choice in Europe for hedge fund products.
Fionán Breathnach is head of the investment funds unit at Mason Hayes & Curran