Aiming For The Top

How fund structures conquered the junior market

Originally published in the December 2006/January 2007 issue

Don’t mention it too loudly or talk about it at London Stock Exchange functions, but much of the new money raised this year on The London Stock Exchange’s junior market, AIM, has been raised by fund structures as opposed to trading companies. It was not meant to be this way.

AIM was established in 1995 as a less regulated market that would allow smaller companies, with no particular track record, to “go public” and raise money in a cost-efficient manner. The rulebook is slim and easy to understand and The London Stock Exchange/UKLA do not (unlike with its big brother, the Official List) agonise over the documentation or suitability of the applicant. With AIM this is left to the “nominated adviser”, a broker or investment bank who must, at the end of the flotation process, confirm to The London Stock Exchange that it believes the applicant suitable to be admitted to AIM. A few tax breaks were also thrown in and a “model” junior market was born.

So far so good. After a faltering start AIM became established and the heart of every small widget manufacturer was gladdened by the fact that there was a way of raising money for a growing business that did not involve selling his arms and legs to a stony faced venture capitalist. AIM also neatly dovetailed with the Official List market – just as the person who buys a Porsche Boxster will always aspire to a 911, it was inevitably the case that once a company had done its time on AIM it would gravitate to the Official List.

However, in recent years things have changed. Pinpointing the exact moment when this change began is difficult-20022003 quite probably- but some very clear milestones could be seen along the way.

For many years the traditional “closed ended” investment entity with which the UK market was familiar was the investment trust. Investment trusts are required to be listed on the Official List of The London Stock Exchange, derive their income and gains from securities and comply with a number of complex rules, in return for which they do not pay tax on gains. The big investment management houses developed whole portfolios of investment trust offerings which invested in a wide spread of securities from Japanese equities to more conservative UK Footsie stocks.

In addition to the big investment institutions, you could plough your savings into investment trusts and enjoy further tax benefits if done so via an ISA or PEP. These funds were safe and respectable. However, by the nature of the rules these funds were also conservative. They could not directly invest in property and hedge fund style investment strategies were simply beyond the pale.

In spite of these restraints, a wave of innovation swept the investment trust sector with the advent of the “split capital” investment trust. Simply speaking, within the structure of one trust you could elect for high income (by subscribing for income shares) or a defined capital return at the end of the life of the trust (by subscribing for zero dividend preference shares). These vehicles proliferated and investors lapped them up – the income was good and apparently the capital return was as safe as a Volvo.

“It was inevitably the case that once a company had done its time on AIM it would gravitate to the Official List”

However, all was not right. Many of the structures had geared themselves up to the gills in order to maximise the income return and further, many had invested in each other. The economic wheel turned and the inevitable happened with many splits going to the wall labouring under mountains of their own debts.

Outrage followed – this was not just faceless institutions losing out but also by dint of the efficient marketing machines of the private client brokers and investment management houses, individuals (and more importantly voters) had lost out. Questions were asked in the house and something had to be done.

The result, after an enquiry, was more rules and tighter regulation. Thus, it became more difficult to launch an investment trust. Meanwhile, things were stirring in Brussels. Whilst London was quietly getting on being a successful global financial centre our friends across the water were making plans and we didn’t really see it coming. The next thing we knew, amongst other unnecessary missives, the Prospectus Directive landed on our doorsteps with a significant thump. Our evolved and sensible documentation was replaced by “building blocks”, rules that made little sense or that no one could understand and summaries that had to be 2500 words long. Compliance culture went mad.

All this led to an increased level of regulatory complexity and burden. The government and theregulators maintained their ambivalent attitude to real estate investment funds (government: a good idea; Inland Revenue and regulators: make it so complex that few will be launched and we don’t lose any tax revenue).

So what does all this have to do with AIM? Well, whilst all the above was going on, AIM sailed on oblivious with its slim rulebook and self-regulation.

It was probably inevitable that the investment community would spot that you could replicate the tax benefits of an investment trust by establishing funds in an offshore tax haven such as the Cayman/ BVI or the Channel Islands and you could also invest in property and other exotic asset classes.

Furthermore, there are no rules preventing hedge funds from listing on AIM. Accordingly, they have begun to do so. Also, they have been ingenious in developing “closed ended” AIM quoted feeder funds that invest directly into the units of underlying open-ended structures. Close All-Blue Fund Limited is a good example.

As a result, in the year to date, of approximately £11 billion raised by AIM companies (on both flotations and secondary issues) it would be surprising if at least half of this was not raised by fund structures as opposed to trading entities. The streamlined flotation process, lower fees and flexible rules make AIM an attractive proposition when compared to the Official List.

This was not what AIM was intended for. They have already increased the level of regulation for the fund structures by informally imposing some rules from the Official List. Consultation is going on and The London Stock Exchange is debating whether or not fund structures should continue to be permitted on AIM.

From my own personal perspective, I hope that AIM is preserved as a funds platform. After all, it generates valuable income for both The London Stock Exchange and the various professionals in London that advise on such matters (lawyers, nominated advisers etc). By all means, add sensible checks and balances in terms of regulation, but I very much hope they resist the temptation to over-regulate.

But the future is, as always, uncertain. Perhaps instead NASDAQ will buy The London Stock Exchange and AIM will die a quiet death in order to stem the tide of “Sarbox Orphans” fleeing the regulatory mire that the US market has become.

Nick Heather is a partner at Lawrence Graham, the corporate law firm.