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Off offshore

Date: Monday, June 22, 2009
Author: The Deal.com

The year 2009 may well be regarded as the high-water mark of the offshore "unregulated" alternative investment management industry for managers seeking to tap the vast quantity of capital in Europe and beyond.

For many, the offshore fund, typically established in the Cayman Islands, had become the path of least resistance. The structure was easily understood and relatively cheap, it was underpinned by centuries of common-law precedent and, most important, it could often be marketed in Europe to professional investors by using well-established private placement rules.

And yet this traditional model has faced unprecedented levels of scrutiny from regulators, politicians, tax authorities and investors. At times, much of this scrutiny has been unwarranted and -- despite more than one politician and regulator saying the financial crisis was not caused by alternative funds -- the future of so-called unregulated offshore centers has been called into question, particularly relating to funds that concentrate on the European market.

Much of this criticism has been raised by the European Commission itself. Hot on the heels of the London meeting of the G-20 group of governments, the commission has recently published a proposed Directive on Alternative Investment Fund Managers, or the AIFM Directive.

The severity of this proposed directive has caught many in the industry by surprise, as it extends direct regulation in the European Union to fund managers of all alternative funds, be they hedge, private equity or real estate funds. In fact, the AIFM Directive, as drafted, defines an alternative fund as any fund, open or closed, that is not a UCITS fund (the EU equivalent to a U.S. retail mutual fund).

In addition, much of the AIFM Directive has been indirectly extended to the funds themselves, the quid pro quo for this additional level of regulation being that a pan-EU marketing passport has been introduced for the first time.

In theory, this makes the widespread marketing of alternative funds easier in Europe, save for the crucial fact that this passport is not available to non-EU-domiciled funds for the first three years following the directive's enactment and thereafter only in certain circumstances. In the future, therefore, promoters may be biased -- at the expense of the established Cayman model -- toward EU-domiciled products that can easily be availed of a marketing passport.

There has also been a move among advisers to attract investments by sustainable, long-term institutional investors, which, combined with an investor-led "flight to quality," has led to many more queries from promoters as to their options when it comes to establishing onshore regulated products.

Much of the interest has surrounded the establishment of UCITS funds. Since the implementation of UCITS III, it has been possible to create a form of absolute-return fund under the directive, and there is an increasing trend toward doing so. For a number of years, promoters have also been able to establish true hedge funds within the EU. For example, Luxembourg and Ireland have had professional investor products on the market for about 10 years. There are also hedge fund-like products in France, Germany and Italy.

Unlike the UCITS fund, there is no pan-European model for private equity or real estate funds. However, many countries have well-established national regimes within the EU, including English limited partnerships, Luxembourg-authorized sociétés d'invest-issement en capital à risque, or Sicars, and specialized investment funds. And, for closed-end companies, there are listed permanent capital vehicles, which have been both hedge fund-like and private equity-like in the past.

The establishment of a fund-of-funds under one of the European regulated fund-of-funds regimes may greatly increase its investor base. Although establishing a UCITS-compliant fund-of-hedge-funds is, in practice, unlikely, there are credible alternatives in Ireland, Luxembourg, Malta and the U.K.

In 2009, the European alternative has come to the forefront of consideration among promoters worldwide. In light of the proposed AIFM Directive, many predict the onshore industry will also go from strength to strength. In this rapidly evolving environment, sponsors and others should monitor political and investor attitudes, position themselves to respond quickly and expect innovation to be the order of the day.

Simon Thomas is a London-based partner in Akin Gump Strauss Hauer & Feld LLP's investment fund practice.