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Article by Funds-Axis Limited Friday 26th February 2010	UK Focus: Alternative Investment (Hedge) Funds
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Two years on from its second consultation on the subject, the FSA has published its proposals for the Fund of Alternative Investment Funds (FAIFs) regime, which will come into force from 6 March 2010.
 

FAIFs will be able to invest up to 100% of assets in a selection of hedge funds based in non-EU countries. Accordingly the regime will enable retail investors to access regulated Funds of unregulated Hedge funds with the comfort that the funds (the FAIFs) and the underlying hedge funds are subject to diversification limits, independent valuation and custody.

FAIFs are Non-UCITS Retail Schemes (NURS) but operating under the requirements for FAIFs and the FSA has created a separate section (COLL 5.7) entitled ‘Investment powers and limits for non-UCITS retail schemes operating as funds of alternative investment funds’.

Why now?

Whether the FAIF’s regime proves a success or not will have to wait to be seen. Certainly, much has happened in the two years since the FSA’s second consultation on FAIFs, not least Madoff, and the following can be noted.

• As things currently stand, these funds will be covered by the AIFM Directive and hence the new regime may be subject to change
• There is a rush by hedge funds to, in the FSA’s words, “join the UCITS bandwagon.” This very possibly removes the need for the FAIFs regime (as you can have a UCITS fund of UCITS hedge funds or a UCITS fund of listed closed end hedge funds).

Investment Limits

The key comparisons between FAIFs and standard NURS regime are that:

• FAIFS will be allowed to have up to 100% in these unregulated funds, subject to a maximum of 35% in any one fund. NURS may only have 20% in unregulated funds.
   
• Master / Feeder structures will be permitted. The master scheme may be based in the UK or abroad, but the manager of the UK-authorised FAIF (the feeder) is responsible for ensuring the master scheme operates consistently with the FSA rules specifying the investment powers and borrowing limits for FAIFs. Master funds may also themselves be feeder funds.
   
• A FAIF may set up its redemption arrangements so that up to 185 days elapse between the acceptance of a redemption order and the payment to an investor of the redemption proceeds.
   
• Borrowing remains at 10%.
  
  
• The limit of 20% investment into unapproved transferable securities remains (meaning a FAIF can invest up to 100% into open ended unregulated hedge funds but only 20% in closed end unregulated hedge funds??)

Madoff and Due Diligence Requirements

Madoff is recognised throughout the FSA’s Policy Statement, including in the requirements as regards the Manager’s initial and ongoing due diligence on the underlying schemes it is investing in into and over the independent custody and valuation arrangements for the underlying fund.

Detailed due-diligence requirements are set out at COLL 5.7.9

Custody

The FAIF manager will be required, when investing in an underlying scheme, to carry out initial and ongoing due diligence to determine that the property of that scheme is held by a third party independent of the underlying scheme’s manager.

Valuation

The FAIF manager must now carry out initial and ongoing due diligence to ensure that the calculation of an underlying scheme’s NAV and the maintenance of its accounting records, are segregated from the scheme’s investment management function.

Liquidity

The due diligence requirements require the Manager to consider the level of liquidity, redemption policy and dealing arrangements offered by the second scheme and whether they are sufficient for the investing scheme to be able to meet its obligations in respect of redemptions.

Further, the authorised fund manager may need to consider how many second schemes the investing scheme should invest in to ensure that that scheme can meet its redemption obligations.

The above is important, but in Funds-Axis view misses the point that that such funds face the very real threat of the underlying funds being suspended and hence the FAIF having to be suspended. The FSA approach seems to be to treat this purely as a scheme management risk, whereas it surely also needs to be considered as an investment risk. Managers will need comfort over the FSA’s position, should the fund ever need to be suspended – particularly given recent FSA comment on fund suspensions - click here for deails.

Authorisation

The FSA plan to carry out the FAIFs authorisation process as an extension of the current NURS process. They have stated that they may ask management companies to provide additional information, which may focus on any due diligence procedures, processes and resources in place, as required by COLL.

Investor Protection

As FAIFs will be available to retail customers, they must be marketed and distributed appropriately. FSA have used the Policy Statement as an opportunity to restate the responsibility of the ACD for the product literature and to remind Intermediaries that need to understand how any particular FAIF they are planning to distribute operates. To this end, the FSA has included a factsheet (see Annex 1) aimed at helping intermediaries understand what they need to consider when distributing FAIFs.

Taxation

The FSA note that they have assisted HM Treasury and HM Revenue & Customs with their work developing appropriate taxation regulations for authorised investment funds. Several new regulations will come into force on 6 March 2010, including some that are specifically relevant to funds which invest in non-reporting offshore funds. These are likely to be included in the underlying investments of some FAIFs.

Genuine diversity of ownership

The FSA have agreed with HM Treasury and HM Revenue and Customs that genuine diversity of ownership requirements concerning FAIFs are no longer needed in the FSA Handbook.