The Financial Services Authority (FSA) is presently conducting the most comprehensive review of the collective investment scheme regime since 1991. This might be good news for fund managers who have so far been frustrated in their attempts to sell alternative investment funds to high-net-worth individuals (HNWI) and other sophisticated, but non-institutional investors. But it remains to be seen whether or not the watchdog’s proposed ‘lighter touch’ regulation will be sufficiently deft to lure them in. Frankly, there is cause for concern.
Traditionally, the range of funds that comprise alternative investments (principally hedge funds, real estate funds, private equity funds, funds of hedge funds and secondary private equity funds) have been regarded as almost exclusively the domain of institutional investors. Restrictions on the promotion of collective investment schemes have made it too cumbersome for many alternative investment fund managers to offer their funds to wealthy clients.
Over the next few weeks there are opportunities for these issues to be properly aired, with both the close of FSA’s imminent consultation on collective investment schemes on 31 October, and the FSA’s embarkation on its two-year review of life after N2.
As much as fund managers would want to attract these super-rich clients, for many it seems more trouble than it’s worth. This is a great shame, especially for the HNWI investors. The received wisdom has been that interested firms are faced with two options, and neither is particularly attractive. They can, as regulated fund managers, take on prospective investors as their clients and then perform detailed suitability checks. That is seen, with some justification, as an overly bureaucratic process with heavy compliance obligations for alternative investment fund managers to bear. The other possibility is selling through a network of independent financial advisers. Again, this is hardly seen as satisfactory as many IFAs are not especially at home in assessing someone’s suitability for these kinds of highly specialist products.
However, there is a third way, but it is one not often taken by alternative investment fund managers. Increasingly, investment banks have been restructuring alternative funds to sell the economics of the investment strategy through structured notes or deposit-based products. These do not fall within the FSA’s collective instruments scheme regime, and so (subject to careful product description), can be promoted much more freely.
They are gaining favour rapidly among the investor community – not least because, if carefully designed, they can offer a degree of capital protection as well as an upside on the underlying alternative investment strategy exposure. Allen & Overy has advised the likes of CSFB, Merrill Lynch and Barclays Capital on such arrangements recently. There is no reason, in principle, why, for example, hedge fund managers and private equity fund managers should not also employ such bespoke solutions. Given that the FSA is unlikely – at least in the short term – to take the lead that the industry would want in this area, the demand for such arrangements is likely to be on the increase.
There are two potential exemptions from the promotion of collective investment scheme rules that, in theory, could apply here – the ‘high-net-worth individuals’ and the ‘sophisticated investor’ exemptions. But both require certification by some form of professional and are rarely used. Unsurprisingly, it would appear that few are willing to certify such investors and expose themselves to the risk of liability. In fact, the restructuring arrangements are the only realistic option for those players who want to make a serious HNWI offering.
In the meantime, the FSA’s Consultation Paper 185, which seeks to simplify and reduce the 500-page collective investment scheme rulebook to a more pocket-size length, is being digested by the financial services industry. Broadly, it can be seen as part of a global trend to liberalise the regulation of hedge funds and other alternative investment vehicles, mirroring, for example, the recent developments in Germany in this area. However, the “non-retail fund” features of Consultation Paper 185 are likely to be met with the same lukewarm reception as did the FSA’s suggestion for a new regulated hedge fund earlier this year. There is no certainty over whether the UK tax regime would be adjusted to match the current benefits enjoyed by hedge funds, typically based offshore, or by private equity limited partnerships, or by real estate funds which are increasingly structured through low or no-tax Luxembourg vehicles. It is not even clear whether or not these sorts of investment strategies will qualify as permitted investments for the FSA’s proposed new regime.
While the risk of total loss of an investment in a hedge fund or private equity fund is generally perceived to be high, in reality the risk of total loss in, for example, a hedge fund, is often no greater than the average shareholding in a UK Plc. In any event, as with an investment in shares or bonds, loss/liability is capped at what investors put in. Indeed, in the case of many structured products, at least some element of capital protection is also built in. HNWIs, more often than not, are every bit as sophisticated as many institutional investors, and are easily able to spot this for themselves, especially if the fund documentation contains appropriate risk warnings and describes the principal features of the fund accurately.
There should therefore be no policy objection to cutting through the swathe of red tape with which the FSA could be about to tie fund managers, and either copy the model of regulation in the US and apply a simple wealth test (for instance, if an individual had more than £1m to invest, then promotion of these sorts of alternative funds to him should be unrestricted), or allow what are, after all, already-regulated fund managers to make their own judgements about an investor’s sophistication without going through the compliance burden of taking them on as clients. Given the risk profile of these investments this is far from a radical proposition, especially when coupled with sensible compliance arrangements to prevent mis-selling. These would include rules about the correct use of the words ‘guaranteed’ and ‘capital protected’ (much as with regulated funds currently), requirements to offer detailed risk disclosures, and careful control over what is said to investors in practice. None of this should come as any great shock or burden to alternative investment managers, but a more suitable degree of protection is offered to the investors.
The FSA’s consultation demonstrates willing and reveals a heartening desire to allow a greater range of investment products to go to the HNWIs. Unfortunately it proposes to do it in too heavy-handed and inefficient a way.
If this half-hearted liberalisation continues, we will see an increasing demand for the vast array of restructured funds through which almost any investment strategy can be sold much more effectively.
John Goodhall is a partner in the regulatory and investment funds group at Allen & Overy