The number of onshore funds being launched by hedge fund managers has risen sharply over the past two years, as investors demand more regulated products with better liquidity and transparency.
This has led to a shift in the way prime brokers service their hedge fund clients – they have needed to adapt to keep up.
Most managers are launching onshore funds in Ucits III vehicles. These are funds which follow the rules set out in the Ucits directive (undertakings for collective investment in transferable securities).
Managers running a Ucits III hedge fund, dubbed Newcits, must adhere to much stricter investment guidelines than when operating offshore.
This has changed the relationship between prime broker and hedge fund manager, as managers are no longer looking to prime brokers for leverage and shorting, but for help with structuring and distributing products to a wider client base.
In the last 24 months, the Ucits III hedge fund universe has experienced fairly rapid growth, according to Andra Ofosu, member of the capital services team at Credit Suisse. “The universe of strictly defined Ucits III hedge funds is currently estimated by us to be $70-$80bn, across 400-450 funds,” she says.
Credit Suisse estimates the size of the Ucits III hedge fund industry represents approximately 4 per cent of the broader hedge fund industry, estimated at $1,920bn by Hedge Fund Research as of the end of 2010. “Consequently, the impact of the Ucits III hedge fund industry for the prime brokerage business is currently minimal but growing rapidly,” says Ms Ofosu.
This growth has been strongest in Europe, with managers running liquid strategies, such as equity long/short, and managers with recognisable and established brand names.
Credit Suisse’s 2010 Global Manager Survey, which represents $475bn in hedge fund assets, identified that 50 per cent of all managers, and 71 per cent of managers in Europe, either managed or were investigating Ucits III hedge funds.
“It is important, however, to point out that the growth in [Ucits III hedge funds], while healthy, has certainly not come anywhere near to some forecasts of $300bn,” adds Ms Ofosu.
“So far, inflows into [Ucits III hedge funds] have been largely from retail sources. Therefore, for managers that launch Ucits III hedge funds with the aim of solely targeting institutional investors, this presents a dichotomy in terms of expectations.”
Ucits III hedge funds do not require a prime broker in the same way offshore funds do. Mark Russell-Jones, managing director for alternative investment services at BNY Mellon, says the prime broker has two key roles within a traditional hedge fund strategy: lending securities, and providing financing.
“The Ucits regulations stipulate that managers cannot physically short a security. This has to be done synthetically, so the prime broker’s role is as the swap counterparty, which is the only role they fulfil within Ucits.”
As the distribution of a Ucits III hedge fund is very different to that of a conventional hedge fund, Mr Russell-Jones says this is where the prime brokers and investment banks “come into play” by offering distribution platforms for Ucits structures.
Morgan Stanley, Deutsche Bank and Bank of America Merrill Lynch are among the firms that offer Ucits platforms for hedge fund managers. The banks provide the infrastructure and distribution, while the assets are managed by the hedge funds.
Although there are many advantages for hedge fund managers using these platforms, such as avoiding regulatory red tape and access to a different distribution channel, it is not a solution that suits all managers.
Credit Suisse decided against launching a Ucits platform. Ms Ofosu says this was driven by two principal factors. Many of its largest clients which have, or are considering, launching a Ucits III hedge fund, have the ability and also prefer to build their own platforms.
Heidi Zatlukal, managing director of prime brokerage at Morgan Stanley, says it is a common misconception that the only interaction prime brokers have with their Ucits managers is via their Ucits platforms.
“The platform is just one way we interact with managers that run [Ucits III hedge funds]. Most managers that run Ucits III hedge funds in the equity long/short space still need help from a prime broker, only they interact differently than the traditional set up.
“If a manager is running a long/short fund they still need access to leverage and shorting, but both of those have to be in a derivative format, [whereas] the rest remains the same. We can become a synthetic prime broker.”
Industry commentators expect the trend of hedge funds launching onshore versions to continue. Currently, European long/short equities strategies are by far the largest segment, with macro strategies being the second largest strategy segment.