Spotlight: recent developments in asset management in United … – Lexology

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Overview of recent activity

The regulatory landscape for asset management since early 2020 reflects the impact and consequences of the covid-19 pandemic and, during 2021, the United Kingdom’s departure from the European Union at 11.00pm on 31 December 2020 (IP Completion Day). The United Kingdom incorporated directly applicable EU-level regulation of the asset management sector under the European Union Withdrawal Act 2018 (the Withdrawal Act), which provided a degree of continuity for the sector. Brexit did nonetheless involve profound changes to the UK asset management sector, including the loss of passporting rights between the United Kingdom and the EEA. This was an area neglected by the UK–EU Trade and Cooperation Agreement, and to date no further market access in either the United Kingdom or the European Union has been granted to the other side under local equivalence regimes. More recent focus areas for the industry – and the regulatory framework – include (1) the impact of the Ukraine–Russia conflict and the widespread application of sanctions and (2) the concept of sustainable investment and the relevance of environmental, social and governance (ESG) factors, which is an area that is likely to remain of particular relevance for many years to come.

The Investment Association (IA) has noted that while the United Kingdom’s place as a pre-eminent centre of asset management has been undisputed for a number of years, this status is by no means guaranteed in the future. Aside from Brexit raising several challenges to the asset management industry in the shorter term, the IA also points to longer-term factors, particularly in relation to continued access to international talent and maintaining access to overseas markets in a potentially more protectionist world with associated regulatory divergence.²

General introduction to regulatory framework

i The Financial Services and Markets Act 2000

The main framework for the regulation of asset management activities in the United Kingdom is contained in the Financial Services and Markets Act 2000 (FSMA) and various instruments introduced under the powers contained in FSMA.

Regulated activities

FSMA regulates the provision of financial services, including investment services, in the United Kingdom through the concept of regulated activities that may be carried out only by persons who hold appropriate authorisations or are otherwise able to take advantage of a specific exemption from the usual authorisation requirement.³ Regulated activities are specified activities set out in the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (Regulated Activities Order)⁴ that are carried on by way of business in connection with certain specified investments also listed in the Regulated Activities Order.⁵ Specified investments include a wide range of financial products, including shares, bonds, government securities, deposits, units in collective investment schemes (CISs) and contracts of insurance. The list of specified activities includes:

1. dealing in investments as principal or agent;
2. arranging deals in investments;
3. managing investments;
4. establishing, operating or winding up a CIS;
5. managing an alternative investment fund (AIF);
6. managing an undertaking for collective investment in transferable securities (UCITS) (see Section III.i);⁶ and
7. advising on investments.

Many investment managers and certain investment fund vehicles in the United Kingdom will require FCA authorisation as they are likely to be carrying out regulated activities, such as advising clients on investments, managing investments or dealing in investments as an agent on their clients’ behalf. It is a criminal offence, potentially punishable by up to two years in prison and a fine, for any person who is not authorised or exempt to carry out any regulated activity in the United Kingdom.⁷

Financial promotions

FSMA contains a basic prohibition on any person who is not appropriately authorised, acting in the course of business, from communicating an invitation or inducement to engage in investment activity.⁸ Investment activity for these purposes includes entering or offering to enter into an agreement, the making or performance of which by either party would be a regulated activity. However, this prohibition will not apply where an appropriately authorised person has approved the content of the proposed communication or if an exemption to the basic prohibition applies.⁹

CISs

The concept of a CIS is a central part of the system of regulation of asset management vehicles in the United Kingdom. These are widely defined in FSMA to include:

any arrangements with respect to property of any description, including money, the purpose or effect of which is to enable persons taking part in the arrangements . . . to participate in or receive profits or income arising from the acquisition, holding, management or disposal of the property or sums paid out of such profits or income.¹⁰

Participants in a CIS must not have day-to-day control over the management of the property.¹¹ In addition, the relevant arrangements must involve the pooling of participants’ contributions and the profits or income out of which payments are to be made to such participants, or the property must be managed as a whole by, or on behalf of, the operator of the scheme,¹² or both.¹³ The potentially wide definition of a CIS included in FSMA is narrowed by the Financial Services and Markets Act 2000 (Collective Investment Schemes) Order 2001 (Collective Investment Schemes Order),¹⁴ which excludes, among other arrangements, all bodies corporate (other than open-ended investment companies (OEICs) and limited liability partnerships), contracts of insurance, and occupational and personal pension schemes.¹⁵ A CIS need not have any particular legal form and, subject to the exemptions outlined above, the concept attaches to a wide range of legal vehicles and contractual arrangements.

If an arrangement is classified as a CIS, a number of important regulatory consequences follow. Units (i.e., rights or interests) in a CIS are a specified investment, and establishing, operating or winding up a CIS are specified activities under FSMA that require FCA authorisation.¹⁶ The restrictions on financial promotion summarised above will also become relevant. Furthermore, Section 238 FSMA prohibits authorised persons from promoting or marketing unregulated CISs, such as unauthorised unit trusts (UUTs) and hedge funds, except in certain circumstances (e.g., where the promotion is made only to investment professionals).¹⁷ The promotion of unregulated CISs, together with certain close substitutes called non-mainstream pooled investments, is prohibited to the majority of retail investors.¹⁸

ii FCA

The FCA is the conduct-of-business regulator for all authorised firms. It is also responsible for the prudential regulation of all firms not authorised by the Prudential Regulation Authority (PRA). PRA-authorised firms (being, broadly speaking, banks, insurance companies and certain systemically important investment firms) are dual regulated by the PRA for prudential matters and the FCA in respect of conduct of business. Most investment managers and investment vehicles requiring authorisation are regulated solely by the FCA; however, those deemed to be of significant importance to the United Kingdom’s wider financial system fall within the ambit of the PRA’s supervision.

FSMA confers a wide range of regulatory functions and powers on the FCA. The FCA’s statutory objectives include:

1. ensuring that relevant markets function well;
2. protecting and enhancing the integrity of the UK financial system;
3. promoting effective competition in the markets for regulated financial services in the interests of consumers; and
4. securing an appropriate degree of protection for consumers.

Under FSMA, the FCA has extensive rule and code-making powers; it is permitted to issue such rules that it considers necessary or expedient for the purpose of advancing one or more of its statutory objectives. The rules and guidance applicable to FCA-authorised firms are consolidated in the FCA Handbook, which includes high-level standards, conduct-of-business requirements, regulatory guides and specific specialist sourcebooks applicable to a wide range of asset management vehicles and arrangements.¹⁹

The FCA makes use of a number of supervisory tools in its oversight of the asset management industry, including thematic reviews and market studies, which involve investigations into key current or emerging risks relating to a specific issue or product. Notably, the FCA’s report on its wide-ranging asset management market study in June 2017 presented findings focused on price competition in a number of areas of the asset management industry, fund performance, how asset managers communicate their objectives to clients, and the role of investment consultants and other intermediaries in the asset management sector (see further details in Section V.vi).

One key area of interest for the FCA over the past few years has been potential conflicts of interest between asset management firms and their clients, particularly in relation to the clarity of fund charges, inducements given or received by investment firms, and the way in which commissions charged to customers were spent. For example, under the Markets in Financial Instruments Directive 2014/65/EU (MiFID II) inducements regime, asset managers who provide research and execution services are prevented from charging clients for research on a bundled basis, and must either pay for the research directly from their own balance sheets or charge the costs back to clients via a special research payment account.²⁰

Further, the FCA has been expanding its interest in innovation, big data, technology and competition. The FCA has set fintech as one of its cross-sector priorities, particularly noting that it is driving change in markets and encouraging innovations. The FCA has launched programmes to enable the development of fintech, for example, by providing assistance to firms using innovation to improve consumer outcomes through its Innovate programme. Firms can test the commercial and regulatory viability of their innovative concepts before investing in them in the FCA’s regulatory ‘sandbox’. In the context of asset management specifically, the FCA launched its Advice Unit to provide regulatory feedback to firms developing automated models to deliver lower-cost advice and guidance to consumers, and on 21 May 2018 published guidance in relation to automated investment services,²¹ and specifically its approach to the supervision of automated or ‘robo’ advice.²²

In 2023, the FCA also introduced a new ‘consumer duty’ in the United Kingdom, requiring all UK-regulated firms that manufacture or distribute investment products to retail customers to carry out detailed and proactive monitoring of consumer outcomes throughout a product’s life cycle.

iii Brexit

The United Kingdom’s withdrawal from the European Union was given legislative effect by the Withdrawal Act, which repealed the European Communities Act 1972 and took effect on 31 January 2020 (Exit Day). The Withdrawal Act was subject to an implementation period between 31 January 2020 and 31 December 2020 (Brexit Implementation Period) agreed between the United Kingdom and the European Union under the Agreement on the withdrawal of the United Kingdom of Great Britain and Northern Ireland from the European Union and the European Atomic Energy Community (Withdrawal Agreement), which was implemented in the United Kingdom by the European Union (Withdrawal Agreement) Act 2020 (Withdrawal Agreement Act). The Withdrawal Agreement Act provided that EU law would continue to have effect in the United Kingdom as if it were still a Member State, until the end of the Brexit Implementation period. New EU laws that came into force in the interim likewise would apply to the United Kingdom during the Brexit Implementation Period in a similar way as they would have prior to Exit Day.

The Withdrawal Act also provided a mechanism to onshore EU law into UK domestic legislation by:

1. preserving any domestic legislation, subordinate legislation or rules that had implemented EU laws without direct effect (e.g., EU directives);
2. converting directly applicable legislation (e.g., EU regulations and decisions) into UK domestic legislation; and
3. preserving any other EU rights that took effect as law (e.g., directly effective EU treaty rights) as UK domestic law.

The Withdrawal Agreement Act amended the Withdrawal Act such that EU law would be onshored into UK domestic law at the end of the Brexit Implementation Period, as opposed to Exit Day. The Withdrawal Act gives HM Treasury the power to remedy deficiencies in retained EU law arising from the onshoring process and apply any other conforming changes necessary for such law to be effective (e.g., to reflect the United Kingdom’s position outside the European Union). Legislation that was not adopted, or was adopted but not in effect, before the end of the Brexit Implementation Period was not onshored. One of the effects of this onshoring process is that the United Kingdom may now revoke or amend any onshored EU law through the normal legislative procedure applicable to UK legislation, for example under an Act of Parliament.

Subordinate legislation made under the Withdrawal Act also gives the PRA, the FCA and the Bank of England (among other UK regulators) the power to make instruments (which must be approved by HM Treasury) correcting similar deficiencies in any secondary EU legislation (such as implementing technical standards and regulatory technical standards) that has been onshored. HM Treasury and the regulators have exercised these powers to pass numerous statutory instruments that, for the most part, came into force at the end of the Brexit Implementation Period. The PRA and the FCA have also made a number of changes to their rules and guidance to reflect the United Kingdom’s withdrawal from the European Union and the legislative changes referred to above.

The Bank of England, the PRA and the FCA have also clarified²³ that guidance issued by the European Supervisory Authorities (which supplement EU legislation) should continue to be observed by firms insofar as it is relevant in light of the United Kingdom’s withdrawal from the European Union, despite not having binding effect under UK law.

Cross-border services

During the Brexit Implementation Period, asset management firms based in the United Kingdom were able to continue to make use of passporting rights to provide cross-border services into the EEA (and vice versa). Those rights fell away on IP Completion Day, which means that those firms are therefore required to apply to competent authorities in the EEA Member State for permission to carry out financial services on a jurisdiction-by-jurisdiction basis. Currently, the only exception to this default arrangement would be under the ‘equivalence’ regime, whereby under certain EU regulatory regimes, if the UK’s regulatory regime is deemed ‘equivalent’ to that of the European Union, and if the United Kingdom establishes a reciprocal regime for EEA-based firms to market products and services into the United Kingdom, UK firms would be able to rely on their authorisation in the United Kingdom to provide their products and services into the EEA. However, this mechanism was not addressed in the UK–EU Trade and Cooperation Agreement and no determinations have between taken by the European Union or the United Kingdom that would enable firms to use this regime. The equivalence regime would in any event be of limited use to firms, given that it applies on a per-service or per-activity basis and does not cover all services and activities – for example, there is no equivalence regime applicable to UCITS schemes – and could be withdrawn at short notice.

Common asset management structures

A range of legal vehicles is commonly used for asset management activities in the United Kingdom. These include limited companies, trusts and limited partnerships, as well as certain bespoke legal forms specific to the investment funds context. The choice of legal form of an investment fund will often be influenced by the tax treatment of that fund and the regulatory implications for both the fund and the fund manager that follow from that choice.

i Open-ended investment vehicles

Open-ended funds issue and redeem securities to and from investors in a fund on an ongoing basis at a price that is based directly on the underlying net asset value of the investment portfolio held by the fund. In the United Kingdom, an open-ended investment vehicle may take the form of a UUT or one of three forms of authorised CISs: authorised unit trusts (AUTs), OEICs and authorised contractual schemes. Such authorised CISs may, in turn, be UCITS schemes, non-UCITS retail schemes or qualified investor schemes, as discussed below.

Unit trusts and AUTs

Unit trusts are the original form of open-ended fund in the United Kingdom. Unit trusts rely upon the English common law concept of the trust, under which a trustee (typically, a financial institution experienced in offering trust services) holds the legal title to the trust property on behalf of the beneficiaries (in this case, the investors) who themselves have a beneficial interest in the underlying trust assets. Unlike other general forms of trusts, there will also be a separate fund manager to formulate and implement the unit trust’s investment strategy, working alongside the trustee. Trusts themselves do not have any legal personality under English law and therefore cannot contract in their own name. Instead, they are characterised by the trust relationship between the trustee and the beneficiaries, which will be established by the relevant document constituting the trust (which, in the case of unit trusts, is typically termed the ‘trust deed’).

An AUT scheme is defined in FSMA as a unit trust scheme authorised in accordance with Section 243 FSMA.²⁴ The FCA may authorise a unit trust scheme if it is satisfied that the requirements contained in that Section are met, the rules in the FCA’s Collective Investment Schemes Sourcebook (part of the FCA Handbook, commonly referred to as COLL) have been satisfied, and it has been supplied with a copy of the trust deed constituting the AUT and a certificate signed by a solicitor that states that the requirements in Section 243 and COLL have been met.

AUTs enjoy two key advantages that flow from FCA authorisation. First, an AUT is able to make invitations or financial promotions to participate in the scheme directly to the public in the United Kingdom.²⁵ Second, AUTs are not liable to pay UK tax on the chargeable gains realised on a disposal of assets in their underlying investment portfolios.²⁶

It is possible for unit trusts to be unauthorised, meaning that no FCA approval has been granted under Section 243 FSMA. This has the advantage that the UUT is not subject to the detailed requirements in COLL, but it does not benefit from the exemption on the prohibition on financial promotions to the public in the United Kingdom and, unless all of the investors in the UUT are exempt from UK tax on capital gains other than by reason of their residence or the UUT benefits from pre-6 April 2014 grandfathering, it will broadly be taxed as though it was a UK-resident company. This tends to mean that unauthorised trusts are attractive to a narrower range of professional investors and are unsuitable for use as retail investor schemes.

OEICs

OEICs were introduced in the United Kingdom partly as a response to the unfamiliarity of overseas investors with the trust structure underlying unit trusts. They represent a compromise position in English law by permitting a company to have a variable capital structure.²⁷ In many ways, OEICs are similar to AUTs (the statutory and regulatory provisions applying to both often use similar wording and concepts), but OEICs are not based on the English law concept of the trust and are bodies corporate that will hold the beneficial interest to the investment portfolio (while the investment assets must be entrusted to a depositary, which will hold legal title to them).²⁸ Therefore, investors in an OEIC are, to an extent, in a similar position to shareholders in a traditional limited company. An OEIC must also have an authorised corporate director that will assume responsibility for the OEIC’s ongoing operating duties.²⁹

The Treasury is empowered under FSMA to make rules that regulate OEICs,³⁰ and the current regulatory framework operates through two distinct sets of regulations: the Open-Ended Investment Companies Regulations 2001 (OEIC Regulations)³¹ and those parts of COLL relevant to OEICs. OEICs are not regulated by the general company law provisions contained in the Companies Act 2006, despite their status as bodies corporate under English law.

The formation of OEICs is governed by Part II of the OEIC Regulations, which states that an OEIC is incorporated upon the coming into effect of an authorisation order from the FCA.³² Since the only method of incorporating an OEIC is through this FCA authorisation procedure, it is not possible to have an unauthorised OEIC in the United Kingdom (unlike a unit trust, which may be either authorised or unauthorised).

To grant authorisation, the FCA must be provided with a copy of the company’s instrument of incorporation and a certificate from a solicitor that attests that the instrument of incorporation complies with FCA requirements, including the inclusion of certain key statements and matters set out in Schedule 2 to the OEIC Regulations.³³ As with AUTs, OEICs must also permit shareholders to have their shares redeemed or repurchased on request at a price related to the net value of the OEIC’s investment portfolio and determined in accordance with the OEIC’s instrument of incorporation and the rules in COLL.³⁴ Alternatively, or in addition, shareholders must be entitled to sell their shares on an investment exchange at a price that is not significantly different from the redemption or repurchase price.³⁵ UK OEICs are not subject to the restriction on the promotion of CISs contained in Section 238 FSMA.³⁶

Authorised contractual schemes

The Collective Investment in Transferable Securities (Contractual Scheme) Regulations 2013 (Contractual Scheme Regulations) came into force on 6 June 2013³⁷ and provide for a new form of authorised CIS: an authorised contractual scheme (ACS). AUTs and OEICs are not tax-transparent (although neither AUTs nor OEICs are generally liable to pay UK tax on the chargeable gains realised on the disposal of investment assets, nor are they generally liable to pay UK tax on their dividend income). ACSs, which are not within the charge to direct taxes, and tax liability is at the investor level, were intended to increase the competitiveness of the UK asset management industry.

The ACS may take the form of a co-ownership scheme or a limited partnership scheme.³⁸ An ACS is defined in FSMA as a contractual scheme that is authorised in accordance with Section 261D(1) FSMA.³⁹ The FCA may authorise a contractual scheme if it is satisfied that the scheme complies with the requirements of Sections 261D and 261E FSMA, the scheme meets the requirements of the contractual scheme rules (set out in COLL), and it has been provided with a copy of the contractual scheme deed and a certificate signed by a solicitor stating that the deed complies with the necessary requirements.⁴⁰

The general restriction on the promotion of CISs does not apply to ACSs.⁴¹ However, to protect retail investors, an ACS must not allow retail investors to be participants in a scheme unless they invest £1 million or more.⁴²

UCITS schemes

UCITS schemes are not a separate type of open-ended investment vehicle; rather, they are AUTs, OEICs or ACSs that meet the criteria laid down in the UCITS Directive (EEA UCITS) or the CIS EU Exit Regulations (UK UCITS). The United Kingdom implemented the requirements of the UCITS Directive primarily through the FCA’s COLL Sourcebook and the insertion and amendment of certain provisions in FSMA by the UCITS Regulations 2011.⁴³ Following the United Kingdom’s departure from the European Union, UK-authorised funds lost their legal status as UCITS under the UCITS Directive, and therefore as part of the onshoring process of the UCITS Directive, the Collective Investment Schemes (Amendment etc) (EU Exit) Regulations 2019 (SI 2019/325) (CIS EU Exit Regulations) amended provisions in FSMA to establish a separate UK regime for the authorisation, marketing and management in the United Kingdom of UK-authorised UCITS.

UK UCITS schemes and EEA schemes operating under the temporary permission regime must comply with the following criteria to be marketed in the United Kingdom: it must be an AUT, an OEIC or an ACS; the sole object of a UCITS scheme must be collective investment in transferable securities⁴⁴ or in other permitted financial instruments⁴⁵ operating on the principle of risk spreading; and the units in the fund must, at the request of the unitholders, be repurchased or redeemed, directly or indirectly, out of the scheme’s assets (which includes action taken by or on behalf of the scheme on a stock exchange to ensure that the value of its units does not vary significantly from their net asset value).

Alternatively, a UCITS scheme may be an umbrella scheme, having sub-funds that each would be a UCITS scheme if they had separate FCA authorisation.

A scheme will not constitute a UCITS scheme for the purposes of the rules in the FCA Handbook if its instrument of incorporation (for an OEIC), trust deed (for an AUT) or contractual scheme deed (for an ACS) contain a provision that means that its units may be sold to the public only in non-UK or non-EEA states, depending on the domicile of the fund.

UCITS schemes must comply with the general obligations applicable to UCITS funds under the UCITS Directive,⁴⁶ as implemented in the United Kingdom through the Undertakings for Collective Investment in Transferable Securities Regulations 2011 (as amended) and the UCITS IV Directive Instrument 2011 (FSA 2011/39), as well as specific investment and borrowing power rules.⁴⁷ The general UCITS investment limits have been incorporated into the UK regulatory regime through COLL and include spread limits and specific rules for government securities and for derivatives.⁴⁸ The investment powers and borrowing limits for UCITS feeder funds are also included in COLL; these include a general obligation that a feeder UCITS must invest at least 85 per cent in value of its property in units of a single master UCITS.⁴⁹

Non-UCITS retail schemes

Like UCITS schemes, non-UCITS retail schemes (NURSs) are not a separate type of investment vehicle but rather are AUTs, OEICs or ACSs that do not comply with the requirements to be a UCITS. The regulatory regime applying to NURSs in the United Kingdom is less stringent than that which applies to UCITS schemes, and the applicable investment restrictions are therefore more relaxed. For example, NURSs are permitted to invest up to 20 per cent of the value of the scheme property in unlisted securities or unregulated investment schemes and may also invest in gold and real estate assets.⁵⁰ In addition, the limit for investment in the units of another authorised scheme is 35 per cent of the NURS’s assets⁵¹ (which permits a higher level of investment concentration than the 20 per cent limit applicable to UCITS schemes),⁵² while the limit for a NURS’s exposure to a single counterparty in an over-the-counter derivative transfer is limited to 10 per cent of the scheme value,⁵³ rather than the usual 5 per cent limit for UCITS schemes.⁵⁴

Nonetheless, there are still important limitations on the investment powers of NURSs that are intended to retain a degree of investor protection in the absence of the demanding UCITS requirements. A NURS (except for a feeder NURS)⁵⁵ cannot invest in the units of a CIS unless that CIS meets certain minimum requirements, including that the CIS is effectively subject to an equivalent level of regulation as a NURS or UCITS fund (or otherwise that no more than 20 per cent by value of the NURS’s assets are invested in that CIS); the CIS operates on the principle of the prudent spread of investment risk; and the CIS is prohibited from having more than 15 per cent in value of its property in units in other CISs.⁵⁶

NURSs are also subject to certain of the same provisions in COLL⁵⁷ regarding:

1. limiting the amount of cash that can be retained in the scheme property;⁵⁸
2. general borrowing powers;⁵⁹
3. the ability to lend money and other property;⁶⁰ and
4. the power to provide guarantees or indemnities.⁶¹

In October 2018, the FCA began consulting on proposals to reduce the potential for harm to retail investors in funds that hold illiquid assets.⁶² Consequently, the FCA announced a number of changes to its rulebook in September 2019, including the introduction of a new category of ‘funds investing in inherently illiquid assets’, a requirement for funds to be enhanced to increased depositary oversight, suspend trading in certain circumstances, produce risk contingency plans and disclose more information about liquidity management tools.⁶³ These amended rules are targeted at NURSs in particular that invest in illiquid assets, such as property, and came into force in September 2020.

Funds of alternative investment funds

COLL includes provisions governing the operation of funds of alternative investment funds (FAIFs) that are NURSs (or sub-funds of umbrella NURSs) operated in accordance with specific rules set out in COLL 5.7 (some of which incorporate general rules that are applicable to all NURSs from COLL 5.6). The regulatory regime for FAIFs is therefore essentially a relaxed version of the rules that apply to NURSs, providing increased flexibility in respect of investment powers.

The key attribute of FAIFs is that they are permitted to invest all of their assets in CISs, provided that those CISs prudently spread risk and do not themselves invest more than 15 per cent in value of their assets in units in CISs (or, in the absence of any such restriction, provided that the fund manager of the FAIF is satisfied on reasonable grounds that no such investment will in fact be made).⁶⁴ There is no requirement that the CIS in which a FAIF invests must itself be subject to the rules governing NURSs or the UCITS requirements. However, the fund manager of a FAIF must carry out appropriate due diligence on any CIS in which the FAIF intends to invest.⁶⁵ The guidance in COLL 5.7 makes clear that this due diligence should include an assessment of, among other factors, the experience and qualifications of the CIS’s investment manager, the adequacy of the CIS’s governance arrangements and risk management processes, the level of liquidity and the redemption policy offered by the CIS, and any relevant conflicts of interest between the CIS’s investment manager and any other parties.⁶⁶

Qualified investor schemes

As with UCITS schemes and NURSs, qualified investor schemes (QISs) are not a specific legal form of investment vehicle. Rather, QISs are authorised CISs that are designed to be marketed only to certain types of sophisticated investors,⁶⁷ rather than to general retail customers, and the fund manager of a QIS is required to take reasonable care to ensure that the units in the QIS are sold only to such persons.⁶⁸

The regulation of QISs is more relaxed than that of UCITS schemes and NURSs, and QISs have greater flexibility in respect of their investment and borrowing powers. The assets in which a QIS invests must be permitted investments under the QIS’s constitution and its marketing prospectus,⁶⁹ but otherwise they can consist of a wide range of assets, including shares, debentures, alternative finance bonds, real estate, precious metals, exchange-traded commodity contracts, options, contracts for difference and units in CISs.⁷⁰ Unlike UCITS schemes and NURSs, there are no specific rules that would limit concentration of a QIS’s assets in certain investments (except for units in certain CISs), although there is a general requirement that the fund manager of a QIS must take reasonable steps to ensure that the investments provide a suitable spread of risk in light of the investment objectives of the scheme.⁷¹ In relation to investments in CISs, a QIS may invest only in regulated CISs or schemes that otherwise meet certain minimum requirements (and if the scheme is of the latter type, the QIS must not invest more than 20 per cent in value of its assets in unregulated schemes or other QISs unless the fund manager has taken reasonable care to ensure that the target scheme complies with all relevant legal and regulatory requirements).⁷²

The limitations on the borrowing powers of QISs are similarly relaxed. There is a general rule that the borrowing of a QIS must not exceed 100 per cent of the value of its assets, and the fund manager must take reasonable care to ensure that arrangements are in place that will enable borrowings to be closed out to ensure compliance with that rule.⁷³ However, there is no requirement that borrowings can be only of a temporary nature.

Long-term asset fund

The FCA has published its final rules concerning the creation of a new open-ended authorised fund regime for investing in long term assets, to be known as long-term asset funds (LTAFs).⁷⁴ The LTAF vehicle is designed to enable funds to access and efficiently and flexibly invest in long-term, illiquid assets, including private equity and real estate.

ii Closed-ended investment vehicles

Closed-ended funds differ from open-ended funds by issuing a fixed number of securities, usually determined by the fund’s constitutional documents or by the general requirements of the law regulating the type of fund entity, or both, with investors realising their investment either by selling the securities in the secondary market or upon the winding up of the fund at the end of its life. Therefore, unlike open-ended funds, closed-ended funds do not undergo the constant expansion and contraction of the number of securities in issue throughout their life in response to ongoing investment and redemption. In the United Kingdom, the most common closed-ended structures are investment trusts (which are actually companies) and partnerships.

Investment trusts

Investment trusts, despite their misleading name, are not trusts but rather are public limited companies that are listed on a recognised stock exchange. As such, the usual company law provisions contained in the Companies Act 2006 apply to investment trusts, and there is no separate legal regime governing their form and structure (e.g., as there is for OEICs). However, to constitute a valid investment trust for tax purposes, a company must meet the criteria set out in Section 1158 of the Corporation Tax Act 2010 and be approved as such by HM Revenue & Customs (HMRC).

Unlike open-ended funds, the shares in an investment trust may trade at a discount or a premium to the net asset value of the company’s underlying assets, depending on levels of supply and demand on the stock exchange. It is usual for the shares of investment trusts to trade at a discount, which can lead to considerable time being spent on attempting to manage the level of this discount. In particular, investment trusts commonly seek general shareholder authority (usually on an annual basis) to make purchases of their own shares in the market from time to time to support the price at which their shares trade.

As listed entities, investment trusts are subject to the Listing Rules (LRs) that form part of the FCA Handbook and are published by the FCA acting in its capacity as the UK listing authority. In particular, Chapter 15 of the LRs contains specific rules with which listed closed-ended investment funds (which includes investment trusts) must comply.⁷⁵ In addition to meeting the minimum requirements for listing that apply to all listed securities, the LRs stipulate that investment trusts must invest and manage their assets in such a way as to spread investment risk,⁷⁶ and that the board of directors of the investment trust must be able to act independently from its investment manager.⁷⁷ In addition, an investment trust must make investments in accordance with a published investment policy, and any material changes to that policy must be approved by shareholders and, if the change is not proposed to enable the winding up of the investment trust, by the FCA.⁷⁸

Investment trusts themselves do not require authorisation under FSMA. However, following the implementation of the AIFMD, managers of investment trusts require either FCA authorisation or, in certain limited instances, to be registered with the FCA to carry out the activity of managing the investment trust.

Under the Collective Investment Schemes Order,⁷⁹ investment trusts do not qualify as CISs; therefore, the restrictions on the promotion of CISs in Section 238 FSMA do not apply.⁸⁰

Limited partnerships

Limited partnerships are formed under the Partnership Act 1890 and registered under the Limited Partnerships Act 1907 (LPA 1907). A limited partnership is defined as consisting of one or more general partners who are liable for all the debts and obligations of the partnership, and one or more limited partners whose liability is limited to the amount of capital that they contribute.⁸¹ It is a key requirement of limited partnerships that the general partner alone is responsible for the day-to-day operation and management of the partnership’s affairs: if a limited partner becomes involved in the management of the partnership’s business, that limited partner will lose the benefit of limited liability and will be treated as a general partner.⁸² For this reason, in the asset management context, it is usual that an entity connected with the investment manager of a fund that is established as a limited partnership acts as general partner or that management responsibility is delegated to a third party, while investors act as limited partners.

Limited partnerships must be registered with the Registrar of Companies (which acts, for these purposes, as the Registrar of Limited Partnerships) in accordance with the provisions of the LPA 1907.

English limited partnerships do not have separate legal personality and therefore cannot hold property or contract in their own name. Scottish limited partnerships differ in this respect: Section 4(2) of the Partnership Act 1890 makes it clear that a Scottish partnership is a legal person distinct from the persons of whom it is composed. Both English and Scottish limited partnerships are treated as fiscally transparent in the United Kingdom. In July 2015, HM Treasury consulted on proposed changes to the LPA 1907 as it applies to funds by a legislative reform order. It stated that it remains committed to exploring the possibility of allowing English limited partnerships to elect for legal personality, but that such a change would be fundamental and hence would not be possible using the proposed legislative reform order. Further work will be needed to explore the implications and legislative changes required.⁸³

Private fund limited partnerships

The private fund limited partnerships (PFLP) regime came into force on 6 April 2017 pursuant to the Legislative Reform (Private Fund Limited Partnerships) Order 2017⁸⁴ (PFLP Order), which amended the LPA 1907 in certain respects. The PFLP regime is the result of the government’s initiative to make the United Kingdom a more competitive jurisdiction for fund formation by relaxing or removing some of the more burdensome requirements of the LPA 1907 in relation to such funds while retaining the flexibility and fiscal advantages of limited partnership structures.

A limited partnership must apply to be designated as a PFLP before it can avail itself of the PFLP regime. To be a PFLP, a limited partnership must satisfy two conditions: it must be constituted by an agreement in writing and it must be a CIS (as defined in Section 235 FSMA, but ignoring any order made under Section 235(5) FSMA).

Limited liability partnerships

Limited liability partnerships (LLPs) are a relatively recent introduction in the United Kingdom, having been created by the Limited Liability Partnerships Act 2000. They are a form of hybrid legal entity that are bodies corporate with their own legal personality⁸⁵ but that enjoy the organisational flexibility and tax transparency of traditional partnerships coupled with limited liability for each member. LLPs must be incorporated through the Registrar of Companies.⁸⁶

It is possible for an investment fund incorporated as an LLP to constitute a CIS under Section 235 FSMA in circumstances where the investors do not have control over the day-to-day management of the property of the LLP.⁸⁷ In practice, this will depend upon how the LLP is established and operates. Unlike limited partnerships, every member of the LLP is capable of being involved in its day-to-day operation. Similarly, FCA guidance confirms that it is possible for LLPs to fall within the definition of an AIF under the AIFMD.⁸⁸ In such cases, the appropriate FCA authorisation will be required.

iii Alternative investment funds

The UK implementation of the AIFMD, by means of, among other things, the Alternative Investment Fund Managers Regulations 2013 (AIFM Regulations),⁸⁹ has resulted in a further regulatory category for investment funds: AIFs. An AIF is a collective investment undertaking⁹⁰ that raises capital from a number of investors, with a view to investing it in accordance with a defined investment policy for the benefit of those investors, and that is not a UCITS scheme.⁹¹ Like UCITS schemes, AIFs are not a separate type of investment vehicle. Rather, the AIFMD regime constitutes a further layer of regulation applicable to managers of investment funds that meet the definition above. An AIF can be open-ended or closed-ended and constituted in any legal form, including under a contract, by means of a trust or under statute.⁹² This broad definition of AIF means that many of the categories of investment fund described above and below fall within its scope, including authorised CISs that are NURSs or QISs, investment trusts, hedge funds, real estate funds and private equity funds. The majority of pension funds (unless they are co-investing with other pension funds) and all insurance funds are excluded. Where a fund does constitute an AIF, the fund itself will remain regulated in the manner set out above, but the manager of such a fund will be regulated pursuant to the AIFMD (although some obligations may indirectly affect the way in which the manager operates AIFs).

Authorisation

An AIFM must be authorised under Part 4A FSMA to carry on the regulated activity of managing an AIF. To be authorised under Part 4A, the AIFM must comply with a number of obligations, including the following:

1. an initial capital requirement;⁹³
2. the AIFM must be the only AIFM of each AIF it manages;
3. the persons who conduct the business of the AIFM must be of sufficiently good repute and sufficiently experienced; and
4. the shareholders or members of the AIFM must be suitable, taking into account the need to ensure prudent management.

The AIFMD allows for managers of portfolios of AIFs the value of whose assets under management does not exceed €100 million, or €500 million where each managed AIF is unleveraged and has a lock-in period of five years (small AIFMs),⁹⁴ to be subject to a lighter regulatory regime.

Full-scope UK AIFMs authorised under Part 4A are subject to the full requirements of the AIFMD as set out in the AIFM Regulations and the Investment Funds Sourcebook (FUND). Small AIFMs may also be authorised to carry out the regulated activity of managing an AIF; however, certain small AIFMs that meet the conditions in Regulation 10 of the AIFM Regulations need not be authorised under Part 4A and need only be registered as a small registered UK AIFM.⁹⁵ Small AIFMs are not required to comply with the requirements of the AIFMD, with the exception of certain registration, reporting and notification requirements contained in Article 3 of the AIFMD.⁹⁶ A small authorised UK AIFM will also be subject to the relevant parts of the FCA Handbook.

A UK AIFM may manage a non-EU AIF that is not marketed in the European Union provided that it complies with the AIFMD (with the exception of the requirements for a depositary and annual report). There must also be appropriate cooperation arrangements in place between the FCA and the supervisor in the country in which the AIF is established. This is the continuing position under the temporary permissions regime set out in the AIFMD EU Exit Regulations.

Prudential and conduct of business requirements

AIFMs must comply with a number of conduct, organisational and prudential requirements.

In particular, AIFMs must implement adequate risk management systems, including by monitoring liquidity risks for each AIF under management and setting a maximum level of leverage.⁹⁷ AIFMs must also have adequate procedures and policies in relation to conflicts of interest.⁹⁸ AIFMs must establish, implement and maintain remuneration policies that promote effective risk management and apply to, inter alia, any senior managers and other staff whose professional activities have a material impact on the risk profiles of the AIFM or AIFs under management.⁹⁹ There are also restrictions on the levels of remuneration paid to such staff: at least 40 per cent of variable remuneration (i.e., bonuses) must be deferred for a period of at least three to five years unless the life cycle of the AIF concerned is shorter than this period. If the bonus is particularly high, at least 60 per cent must be deferred.¹⁰⁰

In respect of delegation, there are a number of restrictions.¹⁰¹ An AIFM must notify the FCA before any delegation arrangements become effective, and the AIFM must be able to justify the delegation objectively.¹⁰² The AIFM must not delegate its functions to the extent that it becomes a letterbox entity, and the services provided by the delegate must be reviewed on an ongoing basis. The AIFM’s liability towards the AIF and its investors is not affected by the AIFM delegating its functions to a third party or by any further sub-delegation. The meaning of ‘letterbox entity’ has been the subject of considerable debate. Article 82 AIFMD Level 2 Regulation (reproduced in FUND 3.10.9 of the FCA Handbook) lists a number of non-exhaustive situations in which an AIFM will be deemed a letterbox entity and not the manager of the AIF.

AIFMs must appoint a single depositary for each AIF, and the assets of the AIF must be entrusted to the depositary for safekeeping.¹⁰³ Rules and guidance relating to the use of such depositaries are set out in FUND 3.11. AIFMs must also ensure the proper valuation of AIF assets, conduct at least annual valuations (either internally or through an independent valuer) of the assets of each AIF and disclose the results of the valuation to investors.¹⁰⁴

Transparency and disclosure

The AIFMD requires certain information to be made available to investors and the FCA by AIFMs. A UK AIFM must disclose specified information to investors (set out in FUND 3.2) for each AIF that it manages or markets, both prior to investment and on a periodic basis thereafter. For instance, it must disclose the investment strategy of the AIFM, a description of the AIF’s risks and risk management, and a description of all fees that are borne directly or indirectly by investors.

The AIFM must also make an annual report available to investors¹⁰⁵ and regularly report to the FCA on the matters set out in FUND 3.4 (including the main instruments in which it is trading, its risk profile and, if the AIF employs leverage on a substantial basis, details of the level of leverage employed). Managers of private equity funds and hedge funds, among others, may have to report significantly more information to their investors under this regime than they previously had to.

Private equity provisions

An AIFM must notify the FCA when an AIF that it manages acquires, disposes of or holds significant holdings in a non-listed company.¹⁰⁶ Further, when an AIF acquires, individually or jointly, control of a non-listed company, its AIFM must notify the company, the company’s shareholders and the FCA, and must make various disclosures as to the intentions of the AIF with regard to the future business of the company.

In addition, there are asset stripping provisions whereby the AIFM must use its best efforts to prevent any distributions, capital reductions, share redemptions or the acquisition by the company of its own shares in the first two years after the AIF acquires control.¹⁰⁷ This restriction is subject to certain qualifications; for instance, only distributions that would cause the company’s net assets to fall below the subscribed capital or that would exceed available net profits are prohibited.¹⁰⁸ These requirements are particularly relevant to managers of private equity funds; hence, they are known colloquially as the private equity provisions.

Marketing and passporting

Guidance on management and marketing for UK purposes is set out in the FUND, Supervision (SUP) and PERG Sourcebooks in the FCA Handbook. The AIFM Regulations implemented the AIFMD passporting regime under which authorised EU AIFMs could manage and market EU AIFs to professional investors in other Member States without additional authorisation. Following the cessation of passporting rights on IP Completion Day, the AIFM EU Exit Regulations introduced the temporary marketing permission regime (TMPR) to enable AIFs that had been passporting into the United Kingdom prior to IP Completion Day to continue being marketed in the United Kingdom on a temporary basis until funds obtained authorisation from the FCA. The TMPR will cease to operate at the end of 2023.

EEA AIFMs wishing to commence the marketing of AIFs, and UK AIFMs wishing to commence the marketing of non-UK AIFs, after IP Completion Day are unable to use the TMPR to operate in the United Kingdom and must instead market AIFs under the national private placement regime (NPPR). To market under the NPPR, an AIFM must comply with certain requirements, including notification to the FCA, and compliance with the transparency requirements and private equity provisions.¹⁰⁹

Main sources of investment

An estimated £10 trillion of funds were under management in the United Kingdom at the end of 2021,¹¹⁰ although the combined effect of the uncertainty caused by Brexit and the covid-19 pandemic on this figure has yet to be quantified. London is the leading centre for fund management in the United Kingdom, but other large fund management centres include Aberdeen, Liverpool, Manchester, Edinburgh, Bristol, Oxford, Cambridge, Glasgow and Birmingham.¹¹¹

The UK fund management industry has a strong international orientation: approximately 46 per cent of UK assets under management are managed on behalf of overseas clients, up from 37 per cent since 2016.¹¹²

Key trends

i Asset allocation

The past 15 years have seen a gradual reduction in the allocation of funds to equity investments, an increase in investment in bonds and generally more diversification of investments.

ii Corporate governance

The UK Stewardship Code (Stewardship Code) was first published by the Financial Reporting Council (FRC) in July 2010, with the aim of improving the engagement of firms that manage assets on behalf of others with the companies in which they invest. It is directed at institutional investors with equity holdings in UK listed companies and sets out 12 principles covering the monitoring of and engagement with companies on matters such as strategy, performance, risk, remuneration and corporate governance. Since 6 December 2010, UK-authorised asset managers have been required by the FCA to disclose whether they comply with the Stewardship Code, with a large majority of institutional clients of these firms expecting them to exercise stewardship.¹¹³

The revised UK Stewardship Code 2020, which took effect at the start of January 2020,¹¹⁴ specifically considers the separate positions of asset owners, such as pension funds and insurance companies, and service providers, as well as asset managers. It also includes new requirements for investors to report how their purpose, values and culture enable them to meet their obligations to clients and beneficiaries. Lastly, it refers to ESG factors and expects investors to exercise stewardship across a wider range of assets where they have influence and rights (i.e., beyond listed equity). In September 2020, the FRC published a Review of Early Reporting to the Code, setting out its expectations in respect of effective reporting and the Code’s principles.

The Stewardship Code is of particular significance to those pension funds that delegate investment management to others. They are expected to satisfy themselves that they have in place a process for monitoring how their asset managers apply the Stewardship Code,¹¹⁵ ensure that managers are adhering to a fund’s stewardship policy and seek to hold their managers to account for their stewardship activities.¹¹⁶

iii The asset management market study

In November 2015, the FCA launched the asset management market study, a review of the asset management sector, with a view to understanding how the retail and institutional asset management sector works for investors. In its final report, published in June 2017,¹¹⁷ the FCA stated that it had concerns about weak price competition in the asset management sector, particularly in relation to active mandates for retail clients, in respect of which it concluded that price competition is not working as effectively as it could be. The FCA also considered whether there is a relationship between fund performance and the level of fees charged by managers and concluded that both actively managed funds and passive funds – for retail and institutional investors – failed to outperform their own benchmarks once fees were taken into account. Additionally, the regulator noted that it had concerns about how managers communicate investment objectives with their clients, particularly in relation to retail investors. Finally, the FCA voiced concerns about the role of investment consultants and other intermediaries in the asset management sector, particularly in relation to competition among investment consultants.

In response to the issues identified, the FCA proposed to strengthen the duty of asset managers to act in the best interests of their clients (including requiring authorised fund managers (AFMs) to carry out and publish an annual assessment of whether funds managed by them will deliver value to investors)¹¹⁸ and to consult on requiring managers to return certain box profits to their funds and making it easier for managers to switch investors to cheaper share classes. The FCA also restated its support for the disclosure of an ‘all-in’ fee to investors and the consistent and standardised disclosure of costs and charges to institutional investors and made a reference to the Competition and Markets Authority (CMA), which culminated in the CMA publishing a final report in December 2018 and a package of reforms, including a recommendation to HM Treasury to broaden the FCA’s regulatory scope to include the activities of investment consultants.¹¹⁹ Additionally, new rules make it easier for AFMs to move investors to cheaper but otherwise identical classes of the same fund by removing the need for an AFM to seek consent from each investor before converting them to a different share class. In February 2019, the FCA also set out final rules that require AFMs to explain why they have used a benchmark in a fund’s prospectus and other consumer-facing communications that include fund-specific information and that, where an AFM describes a fund’s past performance, it should describe such performance against the relevant benchmark.¹²⁰ The new rules also include requirements relating to how performance fees are calculated and disclosure of fund objectives and investment policies. The FCA has separately carried out an additional review of governance standards for unit-linked funds (whose performance determines the benefits due to holders of unit-linked insurance contracts). The results of this review, published in September 2019, highlighted concerns around the limited consideration of unitholders’ interests in decision-making around levels of fees and charges, low levels of price competition in the market and the limited impact of independent governance bodies. The FCA is currently assessing the findings of this review and may implement remedies in the future.¹²¹

iv Responsible and sustainable investment

Growing concerns around the impact of climate change, along with increased scrutiny surrounding equality and diversity, have resulted in a marked growth of interest in responsible and sustainable investment, with an apparent increased integration of ESG factors across asset managers’ strategies.

On climate change in particular, there has been a hive of activity in recent years. In 2017, the Financial Stability Board’s Task Force on Climate-Related Financial Disclosures (TCFD) developed voluntary, climate-related financial risk disclosures, with the aim of providing decision-useful information to companies’ stakeholders. On 2 July 2019, the UK government announced in its Green Finance Strategy the expectation that listed companies and large asset owners should disclose in line with the TCFD recommendations by 2022. Subsequently, in December 2020, the FCA published a policy statement in support of adopting a reporting and disclosure framework based upon the TCFD framework. Also in December 2020, a new LR and related guidance aimed at accelerating good practice by companies came into force. The Rule (LR 9.8.6R(8)) and guidance (LR 9.8.6BG) require companies to include a statement in their annual financial report as to whether the company has made the disclosures recommended by the TCFD in their annual report.

Sectoral regulation

i Insurance

The UK insurance industry is the largest in Europe and the fourth largest in the world. It contributes significantly to the UK economy, managing investments of over £1.6 trillion and paying nearly £16.1 billion in taxes to the government in 2020.¹²² UK insurance funds represented 13 per cent of funds under management in the United Kingdom in 2019.

In terms of asset allocation, the proportion of UK quoted shares held by insurance companies was estimated at 4 per cent at the end of 2018,¹²³ continuing the fall seen in recent years and the lowest percentage since 1963 (when records began).¹²⁴ This decrease reflects a move from investment in UK equities to overseas securities and mutual funds. This trend is partly attributable to the introduction under the Solvency II Directive (Solvency II)¹²⁵ of, among other things, higher capital charges on certain asset classes compared with others.

HM Treasury is considering regulatory reform to support the UK insurance sector. Existing aspects of the UK regulatory regime that may affect investments made by insurers include the permitted links regime and requirements that apply to with-profits business.

ii Real propertyBackground

Traditionally, UK commercial property has often been held through various offshore vehicles, including Jersey property unit trusts, to take advantage of favourable offshore tax treatment. It is also common for investors to hold property through UK listed property companies (in addition to unit trusts) that allow pooling of assets to overcome cost-related barriers to entry into the property market and to take advantage of a lower rate of stamp duty levied on transactions involving shares than is payable in respect of direct transactions involving real property. However, investing in this manner puts shareholders at a disadvantage when compared with investing directly in property, because of the possibility of double taxation.

Real estate investment trusts

Since 2007, it has been possible in the United Kingdom to establish real estate investment trusts (REITs), which, like other investment trusts, are actually companies that invest specifically in real estate and receive an advantageous tax treatment in that profits and gains arising from the company’s property rental business are exempt from corporation tax. To obtain this tax treatment, a number of detailed conditions have to be fulfilled and notice must be given to HMRC.¹²⁶ These conditions include requirements that the REIT distributes at least 90 per cent of the profits from its real estate investment business and that the REIT’s ordinary share capital is listed or admitted to trading (and is actually trading) on a recognised stock exchange. The latter requirement is satisfied if the shares are traded on the Alternative Investment Market (AIM) of the London Stock Exchange or a similar recognised stock exchange overseas. REITs must also be widely held, unless they are owned by certain ‘institutional investors’ such as pension funds.

There are 55 REITs with a market cap of over US$70 billion listed on the London Stock Exchange.¹²⁷ Data published by the Investment Property Forum indicates that in 2018, UK REITs and listed property companies together held commercial property valued at £71 billion,¹²⁸ down from £74 billion in 2016.¹²⁹

UK REITs are not CISs for the purposes of the definition in Section 235 FSMA; however, they may be AIFs.¹³⁰ The FCA has indicated that a REIT is a concept used for tax purposes, so there is no presumption as to whether a REIT is an AIF: this will be considered on a case-by-case basis.¹³¹

Property authorised investment funds

Since 6 April 2008, it has also been possible to establish a property authorised investment fund (PAIF) in the United Kingdom to act as a tax-efficient vehicle for a property investment business. In contrast to REITs, PAIFs do not need to be listed or traded on a recognised stock exchange, but they must be structured as OEICs, meaning that they do not benefit from the exemption from the definition of CISs available to other bodies corporate and must therefore be authorised by the FCA.

To constitute a valid PAIF, a number of detailed conditions have to be fulfilled, and the fund manager must have given notice to HMRC for the PAIF rules to apply. Once an OEIC comes within the ambit of the regime, it benefits from favourable corporation tax treatment relating to its property investment businesses.

iii Hedge funds

As hedge funds are typically located in offshore jurisdictions (largely owing to the favourable tax treatment that can be obtained in those territories), there are relatively few UK-based hedge funds. However, London remains one of the largest global centres for hedge fund managers. In practice, the regulation of hedge funds under English law has therefore tended to focus on the managers themselves, rather than the fund entities, which tend to be beyond the United Kingdom’s jurisdictional reach. All hedge fund managers, like other investment managers, are likely to be undertaking activities that constitute a regulated activity for the purposes of FSMA and the Regulated Activities Order.¹³² As a result, they must have the necessary FCA authorisations to carry out such activities.

Certain funds that invest in underlying hedge funds (funds of funds) may be based in the United Kingdom and may be listed on the London Stock Exchange as investment trusts. As discussed earlier, investment trusts are not CISs for the purposes of FSMA and do not require FCA authorisation themselves. Nonetheless, the investment manager of an investment trust will still need to be authorised. The advantage of a UK listed fund of funds is that it can provide an indirect route to investment in multiple underlying hedge funds while still requiring adherence to the continuing obligations and reporting requirements contained in the UK listing authority’s LRs.

Having historically taken a light touch approach to hedge fund supervision, the FCA has significantly increased its scrutiny of the hedge fund industry, including through enforcement action taken against hedge fund managers and their staff. Hedge funds pose potentially systemic risks by their disorderly failure, particularly as counterparties to trades with financial institutions and others within the financial markets.¹³³ In January 2020, the FCA published a ‘Dear CEO’ letter to firms managing ‘alternative’ investment vehicles (such as hedge funds and private equity firms) highlighting a number of risks that AIFMs posed to customers, such as low standards of governance, insufficient consideration of the appropriateness of investment products offered and insufficient controls around client assets. The letter suggests that the FCA intends to take future action in this sector to address these issues.

UK regulation of hedge funds is also led by the overarching provisions introduced by EU legislation such as the AIFMD. There has been recent growth in the number of UCITS-compliant hedge funds,¹³⁴ the managers of which will not be required to comply with the AIFMD but will nevertheless likely require FCA authorisation for carrying out regulated activities as described above.¹³⁵ Non-UCITS hedge funds are likely to fall within the definition of AIFs; the managers of such funds, as AIFMs, are subject to the requirements of that regime.

iv Private equity

In the United Kingdom, private equity firms typically use limited partnerships as investment vehicles to take advantage of their tax-transparent nature and their lower disclosure requirements as compared with limited companies or LLPs. The limited partners in the partnership are typically the institutional investors in the private equity fund, while the private equity firm will usually act as the general partner and will therefore be responsible for the day-to-day management of the partnership’s activities.

Traditionally, private equity has been a relatively lightly regulated area of asset management in the United Kingdom, although, in common with other asset management entities, private equity firms have required FCA authorisation if they are undertaking regulated activities specified in the Regulated Activities Order. Therefore, private equity funds voiced concerned over the impact of the AIFMD regime, as implemented in the United Kingdom, on private equity activities.¹³⁶ For example, rules on remuneration have an impact on private equity firms’ policies regarding deferred remuneration. Furthermore, the private equity provisions (intended to limit asset stripping of companies) may interfere with some of the usual funding structures adopted by private equity funds, potentially restricting corporate reorganisations and targeted disposals of parts of a target company’s business. The FCA indicated in its ‘Dear CEO’ letter of January 2020 to managers of alternative investment vehicles that it may also take future regulatory action in this sector.

There are ongoing initiatives to improve the transparency of the private equity industry in the United Kingdom to address criticism that the activities of private equity funds are opaque and to counteract the perception that they are insufficiently regulated. In November 2007, the Walker Guidelines were introduced to encourage improved disclosure by private equity bodies.¹³⁷ These voluntary guidelines recommend that private equity firms that meet certain specified criteria¹³⁸ should publish annual reviews or regular updates on their websites containing information about their investment approaches and portfolios and should provide various performance data on a confidential basis to an independent third party appointed by the British Private Equity and Venture Capital Association (BVCA). The Guidelines were amended in July 2014 to enhance the reporting requirements therein to include the information required by the Companies Act 2006 (Strategic Report and Directors’ Report) Regulations 2013. Furthermore, the Institutional Limited Partners Association (ILPA) has published private equity principles with the aim of encouraging improvements in private equity practice by furthering the relationship between general partners and limited partners for the long-term benefit of participants in the industry and encouraging a greater focus on transparency and governance. These were first published in September 2009 and subsequently revised in January 2011.

Tax law

According to the UK Treasury’s January 2021 call for input into the review of the UK funds regime,¹³⁹ tax neutrality is a guiding principle of the United Kingdom’s approach to funds taxation. A detailed discussion of the UK tax treatment of investment funds and investors is beyond the scope of this publication, which can highlight only a few key aspects.

i Taxation of domestic funds

Taxation at the fund level is determined by the type of fund vehicle and, depending on the vehicle type, detailed eligibility criteria may have to be met and notifications given to, or approvals obtained from, HMRC before the desired treatment is available. Generally speaking, the differences between fund types in respect of the taxation of income are more pronounced than in respect of the taxation of capital gains.

In most cases, capital gains should not be taxable at the fund level. Notable exceptions are REITs (as gains from investments other than real estate would generally be taxable at the normal corporation tax rate, which is currently 25 per cent, and non-exempt UUTs (where all gains would be subject to corporation tax).

Dividend income should not generally be subject to tax at fund level, given that most types of funds are taxable on corporation tax principles or transparent. Other types of income may also be exempt depending on the fund type (e.g., income from real estate investment would, for instance, be exempt for REITs and PAIFs) or a tax charge may not arise as the fund is transparent or distributions to investors are treated as tax deductible. To the extent that income is taxable at fund level, tax may be charged at corporation tax rates (e.g., in the case of a REIT or investment trust) or at the basic income tax rate of 20 per cent (e.g., in the case of an AUT or an OEIC).

ii Taxation of foreign funds and of investors

Subject to certain exceptions (some of which are highlighted below), a foreign fund would not be subject to UK tax unless it carries on a trade in the United Kingdom, and a foreign fund will not be treated as carrying on a trade in the United Kingdom merely by virtue of engaging an independent investment manager in the United Kingdom to carry out transactions on its behalf, provided that certain conditions as to the manager’s activities, relationship with the foreign fund and remuneration are met.¹⁴⁰

Even if a foreign fund does not carry on a trade in the United Kingdom, the fund may be liable to tax in the United Kingdom in the form of transfer taxes, withholding taxes on UK-source payments (other than dividends as the United Kingdom does not generally impose a withholding tax on dividends), taxes on income from a UK property business and taxes on gains from the disposal of UK real estate or shares in a UK real estate rich company. It is also possible that foreign investors in domestic or offshore funds holding UK real estate or shares in UK real estate rich companies may also be subject to UK tax on a disposal of their interest in the fund or, if the fund is treated as fiscally transparent for the purpose of the UK taxation of capital gains, a disposal by the fund of such real estate or shares.

Investors, regardless of their jurisdiction of tax residence, are unlikely to suffer UK withholding tax on distributions from UK domestic funds. A notable exception to this general rule is distributions from PAIFs and REITs, which may attract withholding tax at 20 per cent. In most cases, it should be possible for investors to transfer or surrender their interests in UK domestic funds without having to pay stamp taxes. Exceptions to this general position include the transfer of shares in an investment trust or a REIT.

Tax law4

Outlook

i Brexit

Brexit and its potential impact on the UK financial sector continues to be a key topic of discussion. In December 2020, before the end of the Brexit transition period on 31 December 2020, the United Kingdom reached a Trade and Co-operation Agreement with the European Union. The Agreement contained provisions relating to the supply of services generally, as well as provisions relating to financial services specifically; however, the agreement contains only limited and high-level commitments and fails to provide a detailed understanding of the future relationship between the United Kingdom and the European Union regarding financial services.

Statements made by the European Securities and Markets Authority (ESMA) in July 2017 raised doubts about the continuing viability post-Brexit of the ‘delegation model’ employed by many international fund management groups, in which a fund manager authorised in one country delegates fund management or advisory duties to an affiliate in another jurisdiction (which may be outside the European Union).¹⁴¹ More recently, however, the chair of ESMA, Steven Maijoor, noted that ESMA is not seeking to undermine or put in doubt the delegation model. ESMA acknowledges that the delegation model is a key feature of the investment funds industry that has contributed to the success of the industry by providing the requisite flexibility to organise centres of excellence in different jurisdictions. ESMA has sought to clarify that it does not envisage changing the legal requirements, but rather is seeking to aid their practical application and help authorities when supervising delegation arrangements so that national regulators are able to interpret the requirements consistently.¹⁴² In August 2020, ESMA published a letter to the executive vice president for an Economy that Works for People of the European Commission, highlighting areas of the AIFMD that it considers to be in need of improvement.¹⁴³ In its letter, ESMA noted that it sees merit in providing legislative clarifications on delegation and substance requirements in the AIFMD and UCITS frameworks, including in relation to, among other things, the maximum extent of delegation suitable, which regime is applicable in the case of delegation and the use of seconded staff. The letter was followed by ESMA’s review of the AIFMD, which launched in October 2020 and in respect of which a proposal for a directive was planned for 2021’s third quarter.¹⁴⁴

ii Regulatory scrutiny

In its business plan for 2021–2023, the FCA identified certain priority themes that are relevant to the UK asset management industry. Chief among these are proposals for the potential restructuring and simplification of the regulation of asset manager firms, particularly as regards the interplay between the AIFM and UCITS regimes. The FCA also identifies the area of sustainable investment – and ESG more generally – as being a key area relevant to the asset management market.

iii Covid-19

The covid-19 pandemic resulted in unprecedented disruption to both the real economy and the financial markets, the full extent of which is not yet known and likely will not be for some time to come. However, unlike the 2008 global financial crisis, this crisis is not the result of asset quality or credit concerns and, despite initial spikes in market volatility, the FCA has indicated that the markets have substantially continued to operate in an orderly manner.¹⁴⁵

The ESMA stress test in 2019 suggested that 40 per cent of high yield bond funds would not have sufficient liquid assets to meet redemption requests following a severe shock. The covid-19 pandemic has manifested just such a shock. In fact, the most significant challenge faced by asset management, as was the case in the aftermath of the Brexit referendum, will be a fund’s ability to manage liquidity, especially when confronted with a higher volume of redemption requests as investors seek to cut losses and preserve, or indeed increase, their cash holdings. The FCA has indicated its intention in the wake of the pandemic to focus on ensuring that redemption arrangements are in the interests of both those remaining in the fund and those wishing to exit.¹⁴⁶

Additionally, funds with a focus on illiquid underlying assets, for example property funds, are challenged by valuation uncertainty in the face of covid-19. The combination of sharp falls across many asset classes paired with an increase in investor redemptions has seen some funds having to suspend redemptions. The FCA has recognised that suspensions may, in these circumstances, be appropriate to protect the interests of investors, provided that they are implemented in accordance with applicable regulator obligations. In a distressed market, such as the one spurred on by covid-19, funds are likely to face difficult choices between suspension to preserve value for remaining investors or selling in a distressed market to meet an increasing demand for redemption.

iv ESG developments and greenwashing risk

Asset managers are under increasing obligation to play a central role in providing a market-orientated solution to direct more capital towards sustainable investments, and recent developments in ESG transparency and reporting obligations enable investors to obtain a clear picture of progress in this space. The United Kingdom is keen to be seen as a global leader in ‘greening’ the financial system, and regulatory developments are, in many respects, aligned with that objective.

Greater transparency obligations, more sophistication in understanding and unpicking ESG credentials, and pressure on firms to be able to market a ‘green’ product solution combine to bring higher risk of litigation or enforcement for ‘greenwashing’. The FCA is showing signs of taking a tougher stance on greenwashing risks, and it is likely that there will be more enforcement in this space over coming months.