The FSA is going ahead with its proposal to allow funds of alternative investment funds to be authorised onshore and to be marketed to retail investors. The move is set to allow the promotion of funds of hedge funds to the general public and will also permit the marketing of funds that invest in private equity funds and other alternative assets.
The initial consultation on retail-oriented funds of alternative investment funds ("FAIFs") began in March 2007 with the publication of Consultation Paper 07/6. The consultation closed in June 2007 and the FSA has recently published a further consultation paper (CP08/4) which provides feedback on CP07/6 and consults on three further key issues.
Under the proposals, FAIFs will operate within the regime for non-UCITS retail schemes ("NURS"), rather than through a separate regime and they will not be referred to specifically as FAIFs. A FAIF will be subject to the NURS rules, except where changes to the rules are proposed through the consultation papers.
In our briefing dated May 2007, we summarised the proposals set out in CP07/6. This briefing sets out the principal changes made to the original proposals and a summary of the issues requiring further consultation.
Independent valuation In CP07/6 the FSA proposed not imposing independent valuations on NURS. The principal driver behind this was that hedge funds, notably from the US, are not subject to independent valuation. In response to differing opinions, the FSA has taken the view that the best approach is not to change its original proposal but to strengthen its due diligence guidance. In addition, the FSA also notes the development of codes of practice relating to valuation which provide detailed guidance and which can be used as a supplement to due diligence.
Redemption and notice periods
In its original consultation, the FSA proposed that FAIFs should be able to apply the six monthly redemption limits which currently apply to NURS but noted that it would not allow notice periods. Whilst the general consensus from respondents was that the six monthly redemption limits were acceptable, it was felt that a lack of notice period would not work given their importance in relation to managing a funds liquidity.
Despite the feedback, the FSA has said that it does not intend to change its approach relating to notice periods. This is largely due to the fact that the FSA does not see how notice periods can be applied to open-ended collective investment schemes. However, in our view, a lack of notice period may make it difficult for FAIF managers to match the redemption timetables enforced by the underlying funds. The FSA welcomes further views on its proposals.
The 15% Rule
Currently, NURS are prohibited from investing in a second scheme except where the second scheme itself is prohibited from investing more than 15% of its assets in collective investment schemes. The rule was created to prevent the recurrence of the problems created by split capital investment trusts. In CP07/6 the FSA proposed redrafting the rule such that it is up to the manager of the NURS to make the necessary determination by getting an appropriate agreement from the manager of the underlying scheme and then monitoring the portfolio to ensure their agreement is complied with.
Although there was a mixed response to this proposal, the FSA's concerns about circularity of capital mean that the FSA still believes it is the best approach and it intends to proceed on the basis set out above. This means that NURS will be able to invest all of their assets in one underlying feeder but only where the underlying master itself operates its investment policy in a manner consistent with spreading risk.
This approach is consistent with the one taken by the FSA in its Investment Entities Listing Review in relation to feeder funds.
In its original consultation the FSA proposed that FAIFs should be subject to the same 10% borrowing limits as other NURS. Although leverage proved to be a controversial issue among respondents, the FSA remains of the view that significant fund borrowing is inappropriate and it does not therefore intend to alter the existing NURS rules regarding leverage.
Investment limit for unregulated collective investment schemes and unapproved securities
Currently, NURS are not permitted to invest more than an aggregate of 20% into unregulated schemes and unapproved securities at any one time. The FSA proposed abolishing the 20% limit for unregulated schemes but retaining it for unapproved securities on the basis that unapproved securities are more illiquid than unregulated schemes. Despite some opposition to this proposal, the FSA remains concerned about the illiquid nature of unapproved securities and the consequential impact that relaxing this rule may have on fund liquidity and the ability of the retail consumer to withdraw its funds from the FAIF within a reasonable period. Consequently the FSA does not intend to make any further changes to its original proposal.
Existing NURS rules require a repayment standard of four business days. Although the FSA did not propose any changes to these rules in CP07/6, the general consensus among respondents was that change is required to accommodate the fact that most funds of funds have to obtain valuations from underlying funds which in itself can be a timely process. The FSA has therefore asked for views on whether the repayment standards need to be changed and if so, what changes need to be made in order to accommodate FAIFs.
In CP07/6 the FSA discounted the idea of allowing NURS to become feeder funds which invest 100% of their own assets in their master fund. It chose to retain the current requirement for at least three underlying schemes (35% limit), mainly because it believed that a FAIF would need to invest in substantially more than three schemes to provide sufficient flexibility to meet redemption requests from its own investors.
However, since the original consultation, three things have persuaded the FSA to reconsider its original stance: the European Commission has published a paper on UCITS which includes a proposal permitting UCITS to be able to act as feeder funds; the feedback to the consultation argued strongly in favour of allowing master/feeder structures; and the Treasury has published a paper on the introduction of a new tax regime for property authorised investment funds and the master/feeder structure may be required by life companies to avoid breaching PAIF regulations.
Consequently, the FSA has accepted that NURS should be allowed to act as feeder funds and has asked for feedback on how to address the associated regulatory and consumer protection risks. The FSA's preferred approach is to include a requirement within its rules that where a NURS is a feeder fund, the manager must ensure that its master scheme and any scheme into which the master scheme invests, operates on a basis that is consistent with the rules relating to NURS in COLL.
Due diligence approach
In response to feedback on CP07/6 the FSA has strengthened its due diligence rules and guidance. Broadly, its original approach provided guidance relating to:
- the pricing and valuation methodology of the underlying scheme;
- the level of liquidity offered by the portfolio of underlying schemes;
- the underlying scheme's governance arrangements; and
- the experience and expertise of its managers.
The amended guidance has been strengthened and includes criteria for managers where the NURS is acting as a feeder fund. The FSA notes that although the guidance provides a basic framework for good practice, firms will need to consider how it applies to the individual requirements of each FAIF. The FSA also recommends supplementing the due diligence process with additional guidance such as the International Organisation of Securities Commission 'Principles for the valuation of hedge fund portfolios' (November 2007).
Genuine diversity of ownership
Given the difficult tax issues involved in the proposed FAIF regime, in particular in relation to the UK offshore funds tax regime, the FSA notes in CP08/4 that it has continued to work closely with HM Treasury to find a way for FAIFs to operate competitively within the UK retail market.
The FSA notes that FAIF-style investments are already available to retail customers in a number of forms – offshore, via listed securities and via the internet. Allowing onshore products will provide retail investors with the benefit of UK regulatory protection. To make the FAIF regime effective, the FSA is proposing to match the genuine diversity of ownership conditions that will apply to PAIFs. The conditions are set out in full in CP08/4. Firms choosing to produce FAIFs would need to include these conditions in the instrument of incorporation or the trust deed and the prospectus of the OEIC or AUT as appropriate.
The consultation period for CP08/4 ends on 22 May. A Feedback Statement and final rules will be brought out in Q3 2008.