European Hedge Fund Industry Faces Increasing Polarisation

by Ulrika Lomas, for LawAndTax-News.com, Brussels

09 August 2006

Market polarisation within the European hedge fund industry is looking increasingly likely, as hedge fund managers choose whether to align with institutional or high-net-worth investors, according to a report by PricewaterhouseCoopers.

PwC's fourth annual report on the regulation, taxation and distribution of hedge funds in Europe finds that hedge fund managers are largely being driven by increased demand for absolute return strategies from institutional investors.

However, regardless of how the European hedge fund market polarises, the report finds that the industry in Europe will face significant regulatory scrutiny, with an ever-increasing focus on the underlying product by both regulatory and tax authorities.

“As large institutional investors allocate more assets to hedge funds, the ‘best of breed’ funds and their managers should find it easier to increase assets under management, compared to the smaller boutique specialist managers," observed Graham Phillips, European hedge fund practice leader at PwC.

“Of course, institutional investors will search for funds that are characterised by more than a track record of alpha generation – they will seek to ensure good governance practice and high standards over the management of non-investment or operational risk," he added.

While the report notes a current light touch regulatory approach, this is against a backdrop of increased regulatory activity, both at national and pan-European levels. The report concludes, therefore, that it seems unlikely European hedge funds and their managers will escape significant regulatory scrutiny.

"During the past year, there has been an unprecedented increase in the number of discussion papers, consultation papers and committees reviewing the hedge fund industry. Such activity has resulted in new rules and a number of territories have changed their regulatory or tax regimes. The introduction of the Markets in Financial Instruments Directive (MiFID) too will bring more formality and rigour to the organisation of hedge fund managers," Phillips continued.

“It is important for the hedge fund industry to maintain its collaborative approach and to continue to focus on shaping and influencing industry standards," he added.

The report also notes that taxation of hedge funds remains the domain of national tax authorities and while there is a willingness for national regulators to allow hedge funds to be marketed on a pan-European basis, national tax authorities seem reluctant to accommodate non-domestic hedge funds. This has led to market fragmentation with domestic hedge fund regimes having favourable tax treatment for domestic investors but little wider appeal.

Furthermore, the rapid expansion in the number and choice of investment strategies adopted by hedge funds not only presents new challenges in the area of taxation, it affects the tax treatment of funds and can create tax risks, the report finds.

“With the emergence of some of the new fund strategies, the risk of creating a taxable presence in an onshore EU jurisdiction is significantly increased," observed Robert Mellor, partner, PwC.

"While tax authorities are aware of these issues, it is not currently clear how they will react," he added.

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