Gearing up investment management systems for UCITS IV

The countdown to legal implementation of Undertakings for Collective Investment in Transferable Securities (UCITS) IV in July 2011 is compelling the investment management industry to shift into higher gear the tasks of aligning business models and making operational structures more efficient. In this context, it is worth examining the challenges and opportunities presented by the latest evolution of the UCITS framework and exploring the significance for the German asset management industry.

by Managing Director Alexander Poppe, HSBC INKA

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With UCITS IV set to be written into the national legislation of all 27 EU member states by 1 July 2011, an assessment of the likely impact of the directive and the strategies that fund companies should adopt has become more pressing. The potential capability for easing access across European borders engendered in the UCITS IV directive provides opportunities to achieve greater efficiencies across a wider horizon. But there are also challenges to be taken into consideration.

The aim of UCITS IV is clear: to increase economies of scale and reduce costs for UCITS investors by introducing an improved regulatory environment that will increase cross-border efficiencies while enhancing choice, transparency and investor protection. In addition, the range of UCITS funds will widen to include some alternative fund products. However, what is less clear is the way in which implementation will pan out in the operational and administrative spheres. In these areas it will be crucial to have the right investment management system.

ALIGNING BUSINESS MODELS IS KEY

According to a report published by Ernst & Young in January, business model alignment with UCITS IV will compel companies to improve their operating models. In a survey of 98 European investment funds, 49% indicated that business model alignment with UCITS IV was the biggest driver for improving their operating models. This compared with 37% that identified cost efficiency as the biggest driver.

However, the survey also revealed that UCITS IV is not bringing the operational cost reductions many European investment managers assumed. According to Ernst & Young UCITS IV leader Crispin Rolt, the focus has turned to using UCITS IV to optimise the operating model and fund ranges, to align better with the business strategy of the organisation.

The report indicated that operational efficiency was a key feature of UCITS IV and that it would bring benefits to managers through a more scalable fund range. Changes under the directive will improve distribution opportunities, bringing speedier entry into new markets and that should be the leading driver for managers distributing prod¬ucts across borders.

Although the implementation deadline for UCITS IV is July 2011, the survey showed that with less than 18 months to go, a fifth of funds had not started work in this area. Less than a third had already started work on implementation, either by appointing a steering committee or conducting high-level analysis.

THE KEY FEATURES OF UCITS IV

One of the main objectives of UCITS IV is to address what have been perceived as the structural inefficiencies of the UCITS framework. UCITS IV contains six provisions that are intended to increase the efficiency of the current legislative framework by allowing UCITS managers to more easily trade cross-border and drive down the costs of management, while improving investor protection. These key elements are:

• introduction of the management company passport (MCP), enabling funds to be managed by a company located in any EU member state;
• simplifying and speeding up the UCITS notification procedure;
• clarifying the rules for cross-border mergers between UCITS funds;
• introducing rules to create UCITS master-feeder (pooling) structures;
• replacing the simplified prospectus with a ‘Key Investor Information’ (KII) factsheet;
• reinforcing existing regulatory requirements, such as organisational requirements and rules of conduct for management companies.

THE MAIN IMPLICATIONS OF UCITS IV

Through UCITS IV, the European Commission aims to increase economies of scale and to reduce costs for Europe’s UCITS investors by improving cross-border efficiency. Improved efficiency should in turn result in improved investor returns. The main implications of the directive’s six provisions as outlined above are foreseen as the following:

• Implementing the management company passport will have to take into consideration the tax implications. The profits of the management company will be taxed in the tax domicile of the management company. Given the differing corporation tax rates across the EU, certain domiciles may be favoured over others. Also the regulatory framework may differ from one location to another.
• The new notification procedure is a definite improvement, but it does not apply to marketing material, which many fund groups choose to publish in order to define how they add value, nor to changes to an existing prospectus. The electronic transmission of documents will considerably reduce the administrative burden of the notification process, as would the establishment of a central electronic database to warehouse all fund documentation – a proposal that is currently under consideration.
• In clarifying the rules for UCITS mergers investment mergers have the greatest potential scope for delivering efficiencies. Full mergers eliminate more costs than entity pooling structures because the result is a single fund vehicle, with one prospectus and one interface with one primary regulator. However, given the differences in Europe’s national tax frameworks, including the tax treatment of mergers, it will prove difficult for UCITS managers to merge funds on the scale originally envisaged.
• Master-feeder (pooling) structures provide very important flexibility. There are a variety of ways in which UCITS managers could in practice use master-feeder structures, which can be introduced for either umbrella or sub-funds. Most obviously, a UCITS manager could decide to have a European hub in one particular centre and to run all of its EU feeder funds into that master.
• Like the simplified prospectus, the KII document requires updating annually, or more frequently in the event of a material change to the contents, with updates sent to home and host regulator. It will also have to be translated into the language of every country (or into English if approved) in which the fund is marketed and made available on the management company’s website, so incurring extra costs.
• Strengthening current regulatory requirements should make it easier for UCITS managers to consolidate their cross-border activities, thereby creating savings and significantly improving the ability of a fund pro-moter based in one country to distribute and market funds in other member states.

CHALLENGES AND OPPORTUNITIES

By now it is clear that UCITS IV will pose a number of administrative challenges and opportunities, not least in the investment management systems area. This could trigger a rethink of current business and IT models if investment managers choose to centralise their UCITS management companies or establish a master-feeder structure, allowing cost efficiencies to be gained by having the same service provider in different jurisdictions. Overall, the real challenge facing the investment management industry will be to identify the optimal operating model afforded to it by the new possibilities under UCITS IV, while at the same time refocusing on meeting the needs of investors.

While the full impact of UCITS IV implementation on the fund administration market remains unclear, this area is already an important focus of attention for investment managers. In parallel, there is a growing trend towards creating more efficient administrative models with institutions streamlining and consolidating operational processes and IT platforms. Other factors driving this trend include cost pressures, increased competition, increased product complexity and growing regulatory and disclosure requirements. Investment management companies are increasingly seeking to outsource non-core activities (such as back-office services) and sharpen their focus on investment management.

Investment managers face a wide range of administrative options. While some may choose to handle this function completely in-house, others will use a single external service provider or multiple providers. There is also an appetite for partially outsourcing transfer agency activities to experienced transfer agents that could help asset managers distribute products in new markets and extend their fund distribution channels. An increase in cross-border markets targeted by UCITS managers is likely to accelerate the trend to transfer agency outsourcing given the complexity of cross-border distribution.
Ongoing consolidation of the fund administration business should lead to greater levels of standardisation and automation in the industry. As UCITS IV approaches there is some evidence that asset managers are considering their administration options. Beside the clients, the winners of the new UCITS IV regulations will be those custodians and fund administrators that have sufficient size and either act on a European scale or are leading specialists for their home market.

CAPITALISING ON A UNIQUE SYSTEM

The asset management value chain in Germany is modular, with most funds contracting a number of services externally. A minority of special funds, mutual funds and free assets use the same provider for asset management and administration services. This modularisation of the value chain is facilitated by German investment law, which allows investment companies (known as Kapitalanlagegesellschaft or KAG) to outsource almost all of their non-core services, provided supervision by the country’s financial supervisory authority – the Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin) – remains unaffected.

Core services, which must not be outsourced, include the supervision of the investment process and the preparation of annual reports. A unique element common to the German market is the Master Investment Company, known as ‘Master-KAG’. This form of investment management company was established to consolidate reporting across various portfolios under different asset managers, standardising the reports that investors receive.

This vehicle is increasingly popular. Today, half of all investment funds registered with the German investment fund industry association – the Bundesverand Investment und Asset Management eV (BVI) – are administered through a Master-KAG, and the proportion of such funds has increased steadily in recent years.

It remains to be seen precisely how Master-KAGs will fare under UCITS IV. It has been suggested that these companies, which are unique to the German market, will find themselves exposed to the new regulations, as Master-KAGs have been specifically created to cater for the German market. However, their degree of specialisation suggests that no direct repercussions are to be expected. It is even predicted in some circles that the idea of the Master-KAG will spread across Europe, as this is the ideal format for assets pooled internationally that require consolidated reporting.

As far as the administration of special funds from national institutional investors are concerned, no direct changes are expected through UCITS IV. Special funds are a typical German product. By contrast, UCITS IV regulates the mutual funds embodied in undertakings for collective investment in transferable securities (UCITS), particularly their related cross-border activities.

Indirectly UCITS IV could drive the trend towards large specialised Master-KAGs even further to encompass a cross-border component for institutional clients: Master-KAGs, which due to their involvement in a European group have the appropriate expertise and reflect a system supporting the various international legal norms, might in future also offer institutional investors with subsidiaries abroad a holistic – not just national – form of administration.

In this regard those Master-KAGs that have both the technical and human resources to provide an infrastructure for a complete range of administrative services i.e. from Germany and Luxembourg, and in addition form part of an international network, are very well positioned for all developments encompassing UCITS IV.

FUTURE OF THE GERMAN DEPOTBANK

Similarly divided is the opinion concerning the future of the German-specific Depotbank. Under German law, investors must designate a Depotbank to do the settlement, monitor the investment limits, reconcile the net asset value and control the activities of the investment company. Rising costs, tighter margins and greater demand for additional services could see a sizeable chunk of the market volume opening up for competitors when smaller providers are squeezed out of the market.

UCITS IV throws up another challenge for Depotbanks: although UCITS IV requires a custodian in each country where a fund operates, custodians operating exclusively in Germany may find themselves less attractive than those which can offer services throughout the EU. Reporting obligations might require cross-border knowledge, and clients might prefer to centralise services providers rather than to deal with a bunch of different custodians.

One solution for local custodians could be to specialise in their home market and to become the leading provider within the national boundaries. These smaller niche players will be able to provide services in a form large companies are not able to do. These aspects include personal service, more flexibility and individual solutions.

Another solution might be to form cross-border alliances to provide the international service required under UCITS IV. Despite the increasing internationalisation of the European fund industry under UCITS IV, a deep understanding of the local markets will always be crucial. As the European investment management environment becomes increasingly complex, the need for specialists with a thorough understanding of local affairs will only grow. This will leave room for providers with a strong position in their national markets.

CHOOSING THE RIGHT PARTNER

One of the main aims of UCITS IV is to increase the efficiency of Europe’s fund industry by reducing the number of funds, as we have seen, either through fund mergers or master-feeder structures. As fund ranges are rationalised, so UCITS managers are likely to consolidate their service provider relationships.

Needless to say, UCITS investment managers will prefer those investment servicing providers offering the best quality of service at the lowest cost. They will want intelligence from all of the countries where they have funds to keep them up to date with local regulatory changes. They will also want access to the greatest available economies of scale. Importantly, scale will help investment servicing companies make the substantial IT investments needed to keep abreast of change, including forthcoming amendments to tax legislation in some countries.

For large pan-European UCITS managers, selecting the right provider will be essential if they are to realise the full potential cost efficiency. As these groups decide how best to structure their fund ranges and management companies, they will need providers that can offer them as much flexibility as possible.

In general, the large fund groups will gravitate toward providers with pan-European infrastructures. So investment servicing companies will need to be able to provide local services at the individual country level where the UCITS fund is domiciled, as well as the wider range of servicing solutions, wherever they make most sense to the fund company. Additionally, they may need to be able to provide labour-intensive processes, such as fund accounting, from cost-efficient centres.

A BLUEPRINT FOR ACTION

By making it easier for the investment management industry to launch and operate fund products across a range of product types and countries, including certain types of alternative investment strategies, the UCITS IV directive will further enrich investor choice. In addition, UCITS IV will enable investment management companies to streamline their operating models, with consequent benefits for profitability.

Asset managers should undertake holistic cost-benefit analyses, looking not only at how they can optimise their fund ranges but also at how they might rationalise the structures of their management companies. When making these assessments, they should take into account tax and regulatory implications, where their valuable intellectual talent is based and what the cost of making far-reaching changes is likely to be.

Investment managers should also consider the role of their service providers in ensuring that they obtain the full benefit from the opportunities on offer. What type of asset administrators and auditors do they need in practice? What investment management systems will prove best suited to tackle the demands of UCITS IV? As noted, pan-European investment managers will be likely to consolidate their service provider relationships, selecting companies that can provide flexible, cost-efficient and forward-thinking services and IT system infrastructures across Europe.

Given the complexity of the issues surrounding UCITS IV, and the strong desire of the Commission to make Europe’s investment management industry more efficient, UCITS IV marks only one step further down the road to consolidation and harmonisation. For now, implementing UCITS IV is the task at hand. In view of the many critical factors, whether fiscal, regulatory or operational, which have to taken into consideration when implementing the directive, and with the clock ticking inexorably towards July 2011, the time to act is sooner rather than later.



Managing Director Alexander Poppe has been with HSBC INKA since 2002, from 2007 as a management member. Mr. Poppe, who holds a Master in Finance and Accounting, is a German Certified Tax Advisor and has previously worked for five years in KPMG’s Financial Services department.