Funds of Alternative Investment Funds

Better the devil you know?

Originally published in the July 2007 issue

It is now widely accepted that hedge funds have a role to play in a balanced investment portfolio. Hedge fund investment has for some time not just been the domain of the high net worth individual investor, family offices and endowment funds, with most pension funds and insurers having earmarked a portion of their assets for investment into this class.

However the debate as to whether retail investors should be allowed access to this market rages on. In March 2007, the Financial Services Authority published Consultation Paper 076 on Funds of Alternative Investment Funds (FAIFs) which proposes granting wider access for retail investors to alternative investments, in particular through onshore funds of hedge funds.

What is driving this?

First, the UCITS III Directive has enabled mainstream EU retail funds to use more advanced portfolio management techniques that had previously only been used by hedge funds. Second, an increasing number of other EU jurisdictions are developing fund of hedge fund products for retail investors.

However, the most likely driver would seem to be the increasing range of mechanisms by which retail investors can obtain exposure to the hedge fund phenomena as seen with:

  • Hedge fund index based products, eg Goldman Sachs Absolute Return Tracker Index, Merrill Lynch Factor Index, and Hedge ETS, a London listed daily tradable security, providing investment exposure to the New Star RBC Hedge 250 Index;
  • Closed ended listed funds, eg Brevan Howard Macro and Marshall Wace’s MW TOPS; and
  • Listed hedge fund managers, eg RAB Capital and Polar Capital.

Whilst these alternative products may give a return linked to hedge fund performance, they are not a complete solution. An index-linked product is a low cost way to access the market but involves market timing issues due to the inevitable delay in cloning the strategy and arguably will only provide hedge fund beta not alpha.

Similarly, listed closed ended funds provide access to the strategy but typically trade at a discount to net asset value. The discount means that the assets employed for a new investor’s benefit exceed the amount invested; however, discounts are unpredictable and therefore a source of uncertainty.

The demand from retail investors for access to this market is clearly increasing, and hedge fund managers still seem to have an insatiable appetite for further assets. Therefore, in principle, the ground appears to look good for the launch of the proposed FAIFs. However the current UK tax regime is a significant hurdle to be overcome. Furthermore, there justifiably remains a certain amount of discomfort in a few quarters as to the dangers of allowing inexperienced investors to have exposure to investment strategies that they are unlikely to understand. It is understood that the collapse of a hedge fund like Amaranth only impacted sophisticated investors and arguably would have had a more profound impact on the financial markets, and reputation and confidence in the hedge fund industry if retail investors had been involved.

The FSA is fully conversant with these concerns. However, it acknowledges that a wider range of investment products is increasingly entering the retail market. As “there is little, if any, possibility of preventing this”, its main objective is to ensure the UK investment market provides the right balance between allowing consumers sufficient access to an appropriate range of investment products, while ensuring an appropriate degree of consumer protection: a ‘better the devil you know’ approach.

Bridge over troubled waters?

At present, the products on the market can be placed very broadly into two camps:

  • ‘Traditional’ investment funds – typically ‘onshore’ EU domicile, with heavy regulation of permissible investments, limited borrowing and a European ‘passport’ permitting distribution of the fund throughout Europe; and
  • ‘Alternative’ investment funds – typically ‘offshore’ domicile, with lighter regulation permitting wider investment powers, gearing and limited distribution, eg. by private placement in specific targeted markets.

To date the environment has been such that the traditional funds have had limited access to the alternative markets by virtue of the regulation applying to their investment powers. With the exception of Qualified Investors Schemes as discussed below, at present, the FSA allows regulated UK schemes to invest only 20% of their assets under management (AUM) into unregulated investment schemes, and so alternative funds have remained ‘offshore’ and out of reach to a wide range of investors.

The FSA has set out proposals which it hopes will bridge the gap by permitting the onshore traditional funds to invest in offshore alternative funds. The proposed FAIFs will have an ‘onshore’ domicile, and the investment portfolio will be subject to regulation, but FAIFs will be permitted to invest up to 100% of their AUM into unregulated schemes, such as alternative funds, hedge funds, private equity funds, etc.

The regulatory changes

In order to facilitate the launch of FAIFs in the UK, the regulator will need to amend its non-UCITS Retail Schemes (NURS) regime, which is the current UK regime for regulated collective investment schemes without a passport for pan-European marketing. The key regulatory change proposed is to lift the 20% investment restriction into unregulated collective investment schemes currently applying to NURS. However, the FSA will have to introduce other structural and operational safeguards to support this newly created fund range. The consultation paper issued earlier this year details the FSA’s proposals in respect of such issues.

As with any regulated scheme, the FAIF will be required to separate the depositary function from the fund management function. A depositary is responsible for ensuring that a fund’s governance arrangements are appropriate and commensurate. In particular, the role of the depositary is to ensure the fund’s compliance with FSA rules on investment and borrowing powers; to provide oversight of the fund’s dealing; to ensure fund valuation and pricing are aligned with FSA requirements and to see that income accounting, allocation and distribution is compliant.

The FSA is also planning to introduce a ‘due diligence approach’ to the FAIF manager, which applies when making a ‘substantial investment’ – ie, an investment of more than 20% of the FAIF’s property. The due diligence approach is laid out as guidance, rather than rules, in the current draft FSA text. The FSA’s view is that the principles set out in the guidance are already business practice in the funds of hedge funds world. The due diligence guidance is intended to ensure that the FAIF is able to meet foreseeable investors’ redemption requests and is priced according to its net asset value.

In the authorised funds world, Qualified Investors Schemes (QIS) are already able to invest in unregulated schemes without restrictions. The FSA is looking to apply the same quality criteria relevant for a QIS underlying to a FAIF underlying. This quality criteria ensures that a QIS underlying is subject to an independent annual audit; that it has its value verified by a person independent from its operator; that there are systems in place for timely redemption of FAIF units; that the underlying operates in accordance with the principle of risk spreading; and that the underlying is prohibited from having more than 15% of its property in units of other schemes.

Finally, given the novelty of FAIF and the potential for consumer misunderstanding, the FSA sets out qualitative criteria for a FAIF distribution framework. The FSA emphasises the responsibilities of the FAIF providers and distributors to ensure there are appropriate protections around the marketing of FAIFs to retail clients such that they are only sold with appropriate advice.

The current tax regime

The principle which has applied to the taxation of traditional funds in the UK is that the investor should be taxed on an investment in a fund in a manner which would broadly compare to the investor holding the underlying portfolio directly. This has been achieved by permitting the fund to accrue capital gains tax free, with the investor effectively only taxed on the inherent gains on disposal of their investment in the fund, and having income taxed within the fund and on the investor when deemed to be distributed on an annual basis (even if not paid to the investor). To prevent an investor from deferring tax on income by investing in offshore accumulation funds, the UK ‘offshore funds’ tax legislation effectively provides that, unless an offshore fund obtains ‘distributor status’ a UK investor’s capital gain on an eventual disposal will be taxed as income: thus preventing access to the various capital gains tax reliefs, eg. annual exempt amount and taper relief.

To achieve distributor status an offshore fund must:

  • distribute not less than 85% of the higher of its net income or what would be deemed to be its UK taxable income if it were resident in the UK; and
  • invest not more than 5% of its assets in other non-distributing offshore funds.

For many hedge funds, attaining distributor status is not feasible as they are regarded as trading rather than investing, in which case to achieve distributor status, trading profits would need to be distributed. Accordingly, the distribution obligation is too onerous. Similarly a fund of hedge funds is unable to satisfy the 5% investment restriction.

The impact of the interaction between the current tax legislation regarding UK onshore funds and offshore funds is that the onshore fund of fund’s profits arising on the investment in an offshore fund are likely to be deemed to be income subject to UK corporation tax, unless distributor status is obtained by the underlying offshore funds. There is then a further layer of tax when the investor disposes of the interest in the UK onshore fund. This makes such an investment inefficient for tax purposes. In summary, the current UK tax environment has constrained investment in alternative offshore funds, whether via an onshore or offshore fund of funds, as double taxation on gains renders such investments unattractive to the UK investor.

What does the future hold? You gotta have FAIF

HM Treasury and HMRC appear to recognise that without changes to the UK tax legislation, the proposed FAIFs are unlikely to get off the ground. Moreover, that it would be unfair to obtain a higher aggregate tax yield from retail investors into underlying hedge funds than direct high net worth and institutional investors. Accordingly, they are currently in discussion with interested parties with respect to possible changes. However, it is not yet known what a revised tax regime might look like. There are a number of possibilities, but it is clear that there needs to be a balance that is agreeable to all the relevant stakeholders, which include traditional and alternative product providers; industry bodies, eg. AIMA and the IMA; the regulators, eg. HMRC, the FSA and HM Treasury; and of course, the investors.

Option 1

An ideal solution for investors and product providers would no doubt be to leave the investor taxation for authorised funds as it currently stands, namely that they are taxed annually on amounts accounted for as income within the FAIF and subject to capital gains tax on profits on disposal of the investment in the FAIF. The FAIF is taxed on amounts accounted for in the income account and exempt from tax on amounts accounted for in capital (including the profits arising from a holding in, and disposal of, offshore funds). However, it seems unlikely that the tax authorities would agree on an approach which would provide investors with a more efficient tax result than if they invested directly in the offshore funds themselves (assuming the offshore funds do not have distributor status such that the offshore fund rules apply).

Option 2

If the current offshore fund legislation is to remain in place then an arguably fairer alternative would be to treat the FAIF as an ‘offshore fund’ in the hands of the UK investor. To provide a fair playing field between onshore funds, offshore funds and FAIFs, it would be necessary under this option for HMRC to seek not to tax any gains of the FAIF, whether capital or income.

Option 3

An alternative approach would be for the FAIF to be taxed in the hands of the UK investor on a similar basis as an authorised UK fund, but with some nominal compensating tax charge within the FAIF.

Option 4

On the other hand, there has to be an argument that, if the authorities are serious about widening the market for alternative funds, the offshore fund legislation needs at the very least an overhaul, or perhaps even abolition. As part of a wider review of the taxation of onshore funds, such funds may become exempt from UK corporation tax on all profits, and in addition, the offshore funds legislation abolished. There might then be a revised tax regime applying to UK investors in both onshore and offshore funds. In addition, HMRC needs to consider the interaction of the onshore andoffshore fund rules with the loan relationship rules. As most hedge funds are structured with large amounts of collateral, it is arguable that a UK FAIF’s investment in a hedge fund may for tax purposes be a loan relationship, and not an interest in an offshore fund. If this is the case, any profits on the loan relationship would be accounted for as capital in the FAIF, and exempt from tax, thereby achieving an optimal tax outcome for the FAIF.


Given that the consultation closes at the end of June, feedback from the respondents will help the industry to understand whether it would ultimately be worthwhile for the alternative investment industry to launch FAIF products. The future success of the UK FAIF, like all products, depends on the product specifications involved: in this case, the most influential being the tax and regulatory features of the product. However, the FSA’s consultation paper and discussions held by HM Treasury and HMRC would seem to indicate that the UK authorities are recognising the need to evolve with the developments in the hedge fund industry. This is not only welcome, but necessary in order to encourage the UK hedge fund industry to flourish, maintain the City’s status as one of the leading global centres for hedge funds and maintain some degree of consumer protection for UK retail investors.

If a suitable environment is developed for the FAIF it would be interesting to see what the appetite from the product providers would be. What we may see happening is a split in the fund of hedge fund community, with the traditional fund houses and larger hedge funds/fund of hedge fund houses being well placed to take advantage of this new development as they would already have in place appropriate systems, controls, and procedures to address most of the FSA draft rules requirements.

In contrast, the smaller fund of hedge fund providers may not want to get involved in these products which come with additional cost and regulations, subjecting their previously lightly regulated businesses to much greater scrutiny by the FSA. As profitable niche businesses with institutional investors and high net worth investors, they may not see any benefits of entering the retail market, at least at this stage.

Fiona Sheffield is a tax partner in Ernst & Young’s hedge fund tax practice, Kevin Charlton, is a tax director, who specialises in the management and distribution of investment funds, and Alexandra Merlino is a manager in Ernst & Young’s regulatory practice, specialising in hedge fund regulation.