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FSA Issues Proposals for Retail Funds of Alternative Investment Funds (FAIFs)

March 28, 2007

On 27 March the FSA issued proposals that would allow UK retail consumers to invest in funds which are managed by authorised firms in the UK and where the underlying assets consist exclusively of investment in hedge funds and other alternative investments. The consultation closes on 27 June.

There seems little doubt that these proposals are motivated by a desire to bring the UK into line with other European countries, such as Ireland, which allow retail investors to invest in funds of hedge funds. However, there is also little doubt that unless there is a change to the UK tax treatment of offshore funds, these proposals, even if implemented, will have little or no effect. In that context, it is encouraging to note that the UK Treasury is proposing to modernise the offshore funds tax regime to address the barriers that currently prevent the development of offshore funds of funds, and that the FSA and the Treasury are working together to ensure that the Treasury changes are appropriate to FSA's new regime.

The FSA's proposals for funds of alternative investment funds (FAIFs) do not introduce a new asset class. Instead, FAIFs will simply be a new class of Non-UCITS Retail Scheme (NURS), for which rules currently exist in FSA's new Collective Investment Schemes Sourcebook. Those rules will be amended to increase from 20% to 100% the investment that a NURS can make in unregulated collective investment schemes, thus allowing FAIFs to develop.

The FSA also proposes that any manager should exercise a 'due diligence' approach when investing more than 20% of the property of the fund in unregulated schemes. This will consist of considering, amongst other things, the experience of the unregulated scheme's managers and adequacy of its systems and controls, the level of liquidity in the unregulated scheme, and whether there are any investors who have preferential redemption or other rights. The FSA believes that such an approach, concentrating on high-level matters, is consistent with its current emphasis on more principles-based regulation.

More controversially, and in contrast with the current arrangements for qualified investor schemes (QIS) (in broad terms, schemes that can be promoted only to sophisticated investors), though the FSA is proposing to amend the QIS requirements to make them equivalent to those that will apply to FAIFs, the 'due diligence' approach mooted for FAIFs does not require the manager to satisfy itself that the value of the unregulated scheme has been independently verified. Whilst conceding that it is 'important' that investors have the reassurance of independent valuation, and that the valuation of the underlying fund is directly linked to the price of the FAIF, the FSA is content to propose that the FAIF manager should merely understand the systems and controls that determine the underlying fund's value well enough to be satisfied of the robustness of the valuation polices and practices. The driver for this seems to be a desire to allow FAIFs to invest widely in US - managed hedge funds (a 'substantial proportion' of which the FSA believes would fail a requirement for independent valuation), thus maximising the chance for FAIFs to flourish. Investor protection, on this occasion, seems to have taken second place as it also seems to have done in FSA's proposals for redemptions from FAIFs. Here the FSA appears to be prepared to allow retail investors to invest in funds where redemptions may be allowed only once every six months. It is true that NURS property funds, or funds with an objective of producing a specified return, are allowed to provide for redemption this infrequently, but the FSA's proposals for FAIFs take this concept much further.

Finally, whilst proposing that a FAIF may invest 100% of its assets in an underlying fund, the FSA will require the manager of the FAIF to be reasonably satisfied that no investment of more than 15% in other collective investment schemes be made (this is to guard against the circularity of capital through mutual cross-holdings between schemes). The FSA suggests that this can be satisfied by securing an agreement from the manager of the underlying scheme and, subsequently, monitoring the portfolio of the scheme to see that the agreement is in compliance.

Copyright ©2007 by Kaye Scholer LLP. All Rights Reserved. This publication is intended as a general guide only. It does not contain a general legal analysis or constitute an opinion of Kaye Scholer LLP or any member of the firm on the legal issues described. It is recommended that readers not rely on this general guide in structuring individual transactions but that professional advice be sought in connection with individual transactions. References herein to "Kaye Scholer LLP & Affiliates," "Kaye Scholer," "Kaye Scholer LLP," "the firm" and terms of similar import refer to Kaye Scholer LLP and its affiliates operating in various jurisdictions.

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