The funds industry is under the media spotlight, particularly in light of a number of high-profile fund failures and a worrying trend of fund redemptions. According to the annual report released by EFAMA (European Funds and Asset Management Association) last month, €3 trillion assets have been withdrawn from professionally managed assets in Europe during 2008. Sarah Lane takes a look at the Irish funds industry and the challenges it faces in the turbulent economic environment.
Irish Funds Industry Overview
Since the establishment of the International Financial Services Centre in Ireland in 1987, the government has implemented substantial legislation to facilitate the international funds industry in Ireland. Irish funds vehicles can take the form of UCITS or non-UCITS, the main difference being the rules governing investment objectives. At the end of February 2009, UCITS funds represented 80% of the total NAV of the Irish funds industry at €523,910m (source data).
Funds can be domiciled in one country, administered in a second and sold in a third. Ireland is ranked fourth in Europe in terms of fund domiciliation with €806b assets domiciled here at the end of 2007(source data). Funds domiciled in Ireland are generally exempt from Irish tax on their income and gains, provided IFSRA's conditions are met.
In addition to funds being domiciled here, Ireland is also seen as one of the European leaders in the administration of funds domiciled in other countries, for example Cayman, Bermuda and the Channel Islands. According to IFIA (Irish Funds Industry Association), there are 5,830 non-Irish registered funds administered in Ireland. The Irish Stock Exchange has developed a substantial business of listing both Irish and foreign domiciled funds.
Challenges facing the Irish Funds Industry
1. Regulation
The crisis has highlighted the gaps and other flaws in our system of financial regulation. In March, the ICI (Investment Company Institute) in the US published Financial Services Regulatory Reform: Discussion and Recommendations detailing proposed reforms, with particular focus on the functioning of the capital markets and the regulation of investment companies in the US. The Turner Review published in mid-March set out a series of changes for banking regulation which will affect the funds industry, including fundamental changes in the regulatory approach to capital, liquidity and accounting.
Regulation will undoubtedly continue to be the subject of thoughtful deliberation following the G20 meeting in early April. The financial services regulatory landscape is continually changing, including updates to IFRS, Solvency II, MiFID, UCITS III/IV and derivative regulation. All Irish domiciled funds are regulated by the Financial Regulator, their classification as UCITS or Non-UCITS determining the specific supervisory and reporting requirements.
The crisis has fundamentally changed the nature of the relationship between the financial regulator, the government and the central bank. Investors are calling for increased regulation with respect to financial reporting, accounting and tax laws, corporate governance and risk management. The funds industry should ensure it stays abreast of any changes such as the proposed UCITS IV proposal.
UCITS funds are regulated by a series of Directives which have been implemented in Ireland by regulations made under the European Communities Acts. The UCITS IV proposal was put forward in July 2008 and is expected to be implemented in 2011 which will update these rules.
More recently the European Commission proposed a directive for AIFM(Alternative Investment Fund Managers) which will increase standards of risk and liquidity management for the industry. Under the new rules, EU based hedge fund managers with more than €100 million in assets will be required to register with national regulators. As regards private equity, managers will need to produce disclosures for key stakeholders, including employees. This will help to improve the transparency and accountability of the buy-out activity.
A number of other European developments are in the pipeline which may affect the Irish funds industry; the review of the market abuse directive, guidance on structure and determination of directors' remuneration and better investor protection measures for packaged retail investment products.
2. Liquidity Crisis
Governments across the world have taken action to ensure the stability of the financial system, including capital injections and government guarantee schemes. Despite this, the dramatic slide in market prices, the pressure to deleverage, short selling bans and the increased cost of borrowing have negatively affected the funds industry.
The result for many has been poor performance and this has led to an increase in the level of redemption requests and a need for liquidity to fund such redemptions. The remaining invested shareholders therefore hold a more volatile portfolio which may not reach its value when liquidated.
The creation of side pockets, permitted by the financial regulator in December 2008 for QIFs, PIFs and Non-UCITS retail funds, has served to alleviate this problem. Banks and other debt providers are demanding quality cash and working capital reporting, in order to continue to provide capital. The challenge for the Irish funds industry is to ensure it continues to respond to these fundamental changes in a timely manner.
3. Competition
Within the European space, Luxembourg has often been seen by many as Ireland's traditional rival in the funds industry. The vast majority of service providers in Ireland often have operations in Luxembourg, operating off identical accounting and transfer agency platforms and facing similar challenges. It is essential the Irish funds industry continues to evolve to maintain its existing competitive advantage.
4. Tax
National taxation regimes restrict the funds industry offering products globally. For example the need to comply with UK distributor status requirements imposes an additional cost and administrative burden on funds located in Ireland. Irish UCITS have an EU passport and are able to roll up income and gains with no tax, instead of having to distribute to avoid tax, which provides an additional competitive advantage versus our international rivals.
5. Governance and Risk Management
Although risk is endemic in the funds industry, supervision and risk management systems are being reconfigured to reduce it and ensure future stability. The Madoff investor fraud scandal focused media attention on corporate governance both internationally and within Ireland. Under Irish law directors of funds are bound by the concepts of law applicable to all corporate entities.
It is the responsibility of the board of directors, in conjunction with the fund's trustee, to ensure the fund is managed in the interest of all investors and in accordance with the fund rules. The challenge for the industry is to ensure it provides greater investor assurance regarding governance issues to help restore confidence.
6. Transparency in product offering
Previously funds were continually extending the range of instruments they used within their portfolios and adopting more complex investment strategies, in an effort to make a certain return. More recently, risk appetite amongst investors has diminished and product transparency is required. The challenge for the funds industry is to respond to the renewed focus on educating stakeholders on financial literacy by providing clear and concise information about their financial products.
7. Transparency in valuation
Investors are concerned about lack of transparency in asset and fund valuation. The funds industry needs to find a more consistent approach to the valuation and disclosure of illiquid instruments and, more importantly, ensure that their techniques are transparent. IFRS now require preparers of financial statements to include extensive disclosures where valuation techniques such as models are used (IFRS 7 Financial Instruments: Disclosures).
Conclusion
Turmoil in the world's financial markets has put a strain on both the domestic and the foreign sides of the funds industry. Challenges remain on the horizon and the funds industry needs to focus on what's necessary to overcome these and maintain the long-term health of the industry. There are many reasons to support an optimistic view for the future of the Irish fund industry, but it is also no time to be complacent.