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Legal changes boost appeal of hedge funds

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With markets worldwide suffering from the impact of the credit crunch over the past year and amid a drop in overall fund investment in Spain, stemming from market conditions but also tax changes, h

With markets worldwide suffering from the impact of the credit crunch over the past year and amid a drop in overall fund investment in Spain, stemming from market conditions but also tax changes, hedge funds and funds of funds were the only sector of the asset management industry to enjoy growth last year, albeit from a low base, given that the country’s first domestic hedge funds were approved only in December 2006.

EUR1bn was raised by funds of hedge funds last year and EUR445.8m by single-manager hedge funds. These are early days for the alternative investment industry, given that the country’s overall asset management market amounts to more than EUR260bn.

The fledgling industry has been buffeted by the turbulent economic conditions, and Spain’s alternative funds experienced slight negative performance during the second half of the year, albeit significantly less than the equity market downturn. The next few quarters will be important as hedge fund managers seek to build assets and, together with their distribution channels, educate investors about the diversification benefits of alternative investments and their ability to generate positive returns in all market conditions.

The outlook for the sector has been boosted by a number of legislative and regulatory developments over the past year that cumulatively are helping to make investment in Spanish domiciled hedge funds and funds of funds more attractive.

A royal decree in March 2007 clarified a number of issues regarding alternative funds and relaxed some of the original rules put in place in November 2005 and May 2006. In addition, investment restrictions have been relaxed for several categories of institutional investor, for instance allowing pension schemes to invest in OECD-domiciled hedge funds even if they are not registered for marketing in Spain. However, pension funds remains constrained by a 2 per cent limit on aggregate management fees, which affects their ability to invest in hedge funds that levy performance fees.

Insurance companies may invest in domestic hedge funds or foreign funds that are registered for marketing in Spain. In addition, Spanish Ucits are permitted to invest up to 10 per cent of their assets in so-called free assets, which may include hedge funds, private equity or other alternative investments.

An issue that appeared to restrict the ability of Spanish funds to invest through master-feeder structures has been resolved by the regulator, and last March a ministerial order implemented into Spanish law the provisions of the EU’s Eligible Asset Directive regarding the use of derivatives by Ucits funds, which in other jurisdictions have been used to mimic hedge fund strategies. The order also created marketing opportunities for exchange-traded closed-ended hedge funds and structured products based on underlying alternative investments.

The authorities have also issued new regulations regarding the role of custodians for both traditional and hedge funds, increasing their supervisory role, creating the ability to delegate functions to sub-custodians, including institutions abroad, and regulating the use of global or omnibus accounts.

More changes are in the pipeline, including a circular from the CMNV setting out hedge funds’ disclosure requirements, and rules that will create new short-selling opportunities for Spanish Ucits, a move that would do much to expand the market for securities lending. Perhaps most importantly, the European Union initiative to harmonise private placement requirements would open up the market for EU-domiciled hedge funds to be marketed to qualified investors without having to undergo local registration.

Juan Sosa Pons-Sorolla is a managing associate with Simmons & Simmons Mochales & Palacios in Madrid

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