From 6 March 2010, the scope of the UK regime for retail collective investment schemes will be extended such that it will be possible to establish and operate a funds of funds (a fund of alternative investment funds (“FAIF”)) which may invest all of its assets in “unregulated” offshore funds. This will, for the first time, allow UK retail investors to gain significant exposure (albeit indirect) to hedge funds and other “unregulated” products. The key points to note are: the manager of an FAIF will have the discretion to invest all of its assets into offshore “unregulated” funds such as hedge funds;

  • up to 35% of a FAIF’s assets may be made up of units in any one underlying scheme (although a feeder FAIF in a master-feeder structure may invest substantially all of its assets in a single master fund);
  • the manager of an FAIF will be allowed up to 185 days to pay redemption proceeds;
  • the manager of an FAIF must perform not insignificant due diligence on its underlying investments; and
  • changes to the tax rules for authorised funds investing in offshore funds also taking effect on 6 March 2010 are such that UK tax will be charged at investor, rather than fund, level.

The new rules for funds of alternative investment funds (“FAIF”) are set out in the Financial Services Authority’s (“FSA”) Policy Statement 10/3 (“PS 10/3”). A FAIF is a type of non-UCITS retail scheme (“NURS”) but with investment and borrowing powers distinct from other NURS.

Investment and borrowing parameters

The key investment power for a FAIF will be the discretion to invest all of its assets into other collective investment schemes. Accordingly, the portfolio of a FAIF may be wholly comprised of hedge funds Client Alert March 2010 established in non-EU jurisdictions. However, the FSA authorised manager of the FAIF must perform initial ongoing due diligence on each of its underlying investments (see Due diligence below).

The spread requirements for FAIF in relation to underlying collective investment schemes should not be problematic for managers to adhere to. No more than 35% of the assets of a FAIF may be made up of units in any one underlying scheme. However, this requirement does not apply to feeder FAIFs established to invest in related master structures (see Master-feeder structures below).

Aside from the broad discretion to invest in any type of collective investment scheme (subject to due diligence requirements), the investment and borrowing parameters generally follow those for other NURS including:

(i) no more than 20% of the scheme property is to consist of deposits with a single body;

(ii) subject to certain exceptions, no more than 10% of the scheme property may be invested in transferable securities or approved money-market instruments issued by any single body;

(iii) the exposure to any one counterparty in an OTC derivative transaction must not exceed 10% in value of the scheme; and

(iv) direct borrowing is limited to 10% of NAV.

Redemption requirements

Managers of FAIFs will be allowed up to 185 days from the receipt and acceptance of a redemption notice to pay redemption proceeds. In most cases, this should provide FAIF managers with sufficient time to manage redemption requests by arranging the redemption of underlying investments in an orderly manner without resulting liquidity or investment performance issues.

The FSA appears to have taken into account industry responses to CP08/4 which asserted that the FAIF model would only work if FAIFs were afforded reasonable flexibility in relation to the calculation of NAV and the payment of redemption proceeds. The existing NURS provisions requiring the payment of redemption proceeds within four business days of the relevant NAV would not be feasible given the likely illiquid nature of a FAIF’s underlying investments.

Master-feeder structures

Bespoke provisions will allow an FAIF to invest substantially all of its assets in a single master fund where:

(a) that master fund forms part of a master-feeder structure;

(b) the master-feeder structure is in place to achieve the feeder FAIF’s objectives; and

(c) the master fund complies by the rules applicable to the feeder FAIF.

It will be the responsibility of the FSA-authorised manager of the feeder scheme to ensure the master fund complies with the FAIF rules. Although this responsibility will require a degree of ongoing oversight, the incorporation of appropriate parameters into a master fund’s constitutional and offering documents could serve to manage a significant part of this responsibility.

Due diligence

Unsurprisingly, post-Madoff, FAIF will only be allowed to make underlying investments in collective investment schemes if such schemes:

(a) operate on the principle of a prudent spread of risk;

(b) are prohibited from investing more than 15% in value of that scheme in units in other collective investment schemes (or the FSA-authorised manager of the FAIF is satisfied that no such investment will be made); and

(c) provide that investors are entitled to have their units redeemed at a price related to the NAV of the property to which the units relate. In addition, before making underlying investments, the FAIF manager must perform due diligence such that it is satisfied on an ongoing basis that:

  • the property of the underlying scheme is held in safekeeping by a third party which is subject to prudential regulation and is independent of the investment manager;
  • the NAV calculation of the underlying scheme and maintenance of accounting records are segregated from the investment management function;
  • the underlying scheme is audited by an independent auditor in accordance with international standards; and
  • the manager and its processes and systems have been properly considered.

Although relatively prescriptive, we do not believe that any of these requirements goes any further than an investor would reasonably expect from a suitably qualified and experienced fund manager.


In conjunction with the widening of the FAIF regime discussed above, on 10 February 2010, the Authorised Investment Funds (Tax) (Amendment) Regulations (the “Regulations”) were made, bringing in a new set of rules for the taxation of authorised investment funds investing in ‘non-reporting’ offshore funds (so-called “FINROFs”), with effect from 6 March 2010.

Prior to the Regulations, UK authorised investment funds disposing of certain interests in non-distributing offshore funds (now superseded by non-reporting offshore funds under the UK’s new offshore funds regime) would be taxed as if any gains arising were offshore income. This meant that tax could fall on a fund itself rather than being passed to an investor on the disposal of its interest in that fund.

Under the Regulations, authorised investment funds will automatically be treated as FINROFs if more than 20% of their gross assets have been invested in nonreporting offshore funds or other FINROFs. A FINROF will not be taxable on its income from a non-reporting offshore fund, but investors in a FINROF may be taxed on any gain arising from a disposal of an interest in the FINROF as if that gain were income (i.e. potentially being subject to a higher rate of tax for individual investors). In other words, the Regulations move the tax charge from FINROFs to their investors so as to make such investors subject to effectively the same tax treatment as if they had invested directly in the underlying offshore fund.

The Regulations have generally been welcomed by the funds industry and certain UK tax-exempt investors (e.g. individuals investing through ISAs), but they may also increase tax costs for UK taxable investors in FINROFs. In addition, the Regulations do not offer much comfort to investors in FINROFs which hold other investments (i.e. as well as interests in non-reporting offshore funds) – investors may be subject to income tax treatment on all gains arising on the disposal of an interest in a FINROF, as opposed to a proportion of that interest representing the FINROF’s investment in underlying non-reporting offshore funds.

Going forward, investors in FINROFs should carefully consider the potential impact of the Regulations. It should also be noted that the Explanatory Memorandum to the Regulations states that it is the Government’s intention to continue to work with the funds industry and to consider further development of the Regulations.


The ongoing uncertainty in relation to the implementation, precise scope and timing of the AIFMD may dissuade some managers from acting at this time. Nonetheless, the FAIF rules undoubtedly provide fund managers with an opportunity to offer retail investors real exposure to an “unregulated” sector previously out of their reach. Although the rules incorporate not insignificant due diligence requirements on the part of the FAIF manager, they do not seem unreasonably burdensome. The concurrent changes to the tax regime may render an investment in a FAIF tax efficient for certain UK investors.