Launching a new fund is difficult. Launching a fund in the wake of a global pandemic – coupled with years of Brexit uncertainty – makes the task even more challenging. But one thing that can smooth that journey is working with a host alternative investment fund managers (AIFMs).
Separate regulated firms that will act as the manager of your fund, AIFMs can help you get to market in advance of obtaining your own Financial Conduct Authority (FCA) licence. In this article, we take a look at some of the key legal and practical considerations for using this structure.
Starting out: A basic structure
For decades the English Limited Partnership (ELP) has been one of the vehicles of choice for European fund managers in the private equity (PE) and venture capital (VC) sectors. The tax transparency of ELPs ensures investors who pool their capital are not placed at a disadvantage as a result of double taxation when compared to direct investors; the return of capital and profits to investors is not subject to any restrictions regarding distributable reserves; the roles of the manager and investors are naturally aligned with the GP/LP structure; and the relative flexibility of the ELP vehicle ensures virtually all geographies, tax regimes, and industries can be catered for.
In addition, the concentration of financial expertise and well-established AIFMs in the UK ensures that compliance with the regulatory requirements of the Alternative Investment Fund Managers Directive (AIFMD) is easily achieved, and further assists with the satisfaction of the “substance” test.
A basic UK focused PE/VC fund structure may look something like this.
The ELP is the main fund vehicle in this structure, pooling investor capital to allow the AIFM to manage fund commitments as a whole. An ELP must have at least one GP and one or more LPs. The relationship between these parties is governed by a limited partnership agreement (LPA). In 2017, a new regime was introduced allowing ELPs to be designated as private fund limited partnerships (PFLPs). These are a sub-set of the traditional ELP with some characteristics particularly suited to fund vehicles. For example, there is a “white list” of activities which the LPs can engage in without losing their limited liability. PFLPs are also not subject to the requirement for LPs to contribute capital which has to be registered at Companies House. As a result, the vast majority of ELPs will now be established as PFLPs.
- The General Partner (GP)
The GP manages the ELP (subject to delegation to the Manager – see 4.), and is generally able to contractually bind the ELP without seeking prior investor consent. The GP has unlimited liability for the financial and contractual obligations of the ELP. For that reason, this entity is typically structured as a new lowly-capitalised entity for each fund, separate from the Manager or Sponsor (a limited liability partnership or limited company).
- The Limited Partners (LPs)
Unlike the GP, LPs enjoy the benefit of limited liability, provided they refrain from participating in the management of the ELP. The investors in this kind of fund will typically be institutional investors or high net worth individuals – these funds are not generally permitted to be marketed to retail investors.
LPs may also have the opportunity to co-invest with the ELP, which is a particularly useful tool where fund managers are prohibited from investing too heavily in one particular asset, sector or geographical area.
The manager (or AIFM) of this kind of fund must be regulated if operating in the UK. Whilst more established managers will perform this role themselves, for those launching a first time fund, the portfolio management and risk management functions are often undertaken by a third party.
The manager’s role, responsibilities and obligations to the ELP will be set out in a management agreement. The management fee payable to a third party AIFM will vary depending on the level of involvement the AIFM takes on in the day-to-day operations of the fund. It will be a matter for investor negotiation as to whether this fee is payable in addition to the Sponsor’s “management fee”, or payable out of that fee (see “Who pays?” below).
- Investment Adviser/Sponsor
If the Manager is a host AIFM rather than the actual Sponsor/Originator of the Fund, it will then sub-delegate deal sourcing and related activities to that Sponsor as the Fund’s Investment Adviser. The provision of investment advice and arranging deals is also regulated, so the Investment Adviser will typically become an appointed representative of the host AIFM in order to allow it to carry out that function (see “Can I retain the management function in house?” below).
- Carry Vehicle
A Scottish Limited Partnership (SLP) is typically selected for the carry vehicle. The SLP is very similar to an ELP (it was established under the same Statute) but it has separate legal personality. For this reason, it is commonly used to invest in an underlying ELP, given that all LPs in an ELP must have legal personality. The SLP will also often be used as the vehicle through which the GP commitment is made. In other words, it serves to channel both the team’s investment and their share of the carry.
Administrators can take control of a wide range of tasks such as reviewing subscription documents, FACTA/CRS compliance, and KYC – a particularly time consuming exercise – as well as fund accounting and managing drawdowns and distributions.
Appointing a third party Administrator can significantly minimise the time and investment required in hiring experienced staff in-house to perform such functions, and by doing so, ultimately leaves these important regulatory tasks to firms with the requisite industry knowledge and expertise.
The role of the Depositary under AIFMD is to monitor the cash flows of the fund, and to hold an ownership interest in the underlying assets of the fund. A Depositary is not always required, as the obligation to appoint one only applies to full-scope AIFMs (see “In or Out? Full Scope or Sub-Threshold?” below), or if the fund is to be marketed into certain European jurisdictions. It is therefore unlikely to be required by a first time fund unless the fund is working with a full-scope host AIFM.
Managers who are required to appoint a Depositary can deviate in their approach to Depositary appointments. Some favour an AIF-by-AIF appointment, while others opt for a single framework agreement which governs all funds under their management.
For many first timers, third-party service providers are key to a successful fund launch as they provide invaluable knowledge and experience, and can take responsibility for crucial activities that would otherwise distract from core investment decisions. While care must be taken to ensure all regulatory obligations are covered, it comes as no surprise that these external service providers can save fund managers substantial time and effort both at fund launch and throughout the life of the fund. The role of the host AIFM can be particularly important.
In or out? Full scope or sub-threshold?
Fundraisers located within the EU will be familiar with AIFMD and the significant regulatory burdens associated with it – in return for its pan-European marketing passport. The role of the host AIFM, at a minimum, is to undertake the portfolio management and risk management services under AIFMD – although the extent to which AIFMD will apply ultimately depends on whether the host AIFM has assets under management (AUM) above the following thresholds:
- AUM exceeding €100m; or
- AUM exceeding €500m if (i) the Fund is unleveraged; and (ii) investors have no redemption rights for the first five years
If the AIFM has AUM in excess of the thresholds above, the manager must seek authorisation from the Financial Conduct Authority (FCA) to operate as a full-scope UK AIFM. Where the thresholds are not met, AIFMs will be “small” or “sub-threshold” but, if in the UK, must still be registered or authorised by the FCA. First timers will usually fall below these thresholds, which is a notable advantage in terms of compliance and regulatory burden, although it carries some disadvantages in terms of marketing.
If the AIFM is managing a real estate fund or a VC fund it may also be able to avoid full authorisation by using the alternative and more light touch regime for small registered UK AIFMs. Within the UK there are host AIFMs who are both full-scope and sub-threshold, giving Sponsors a choice of who to work with, depending on a number of factors including cost and access to marketing passports.
For VCs, the European Venture Capital Fund Regulation (EuVECA) is a voluntary regime that enables European fund managers that meet specific criteria to benefit from a marketing passport even if they are sub-threshold, without having to comply with the extensive regulatory obligations under AIFMD. This has proved very useful for the VCs that have taken advantage of it, in terms of opening up European markets. Some host AIFMs in the UK are registered as EuVECA managers. It is also possible for the Sponsor to register as a small registered AIFM under this category, but there are some regulatory capital requirements to be aware of if they do, which often mean that working with a host AIFM with EuVECA status is still preferred. Of course, the benefits of the marketing passports under both AIFMD and EuVECA are subject to the discussion below regarding Brexit.
Can I retain the management function in house?
The activity of managing a fund requires FCA authorisation (or registration for the sub-category of managers who may fall within the small registered UK AIFM categories). So if the fund Sponsor is not itself so authorised or registered, it cannot act as the manager of the fund. Although a certain level of responsibility and control can be retained “in-house”, such a Sponsor will have to seek the assistance of a host AIFM to manage the fund, and that entity will need to take all investment and divestment decisions on behalf of the fund. It is now common practice for first time managers to kick off with a host AIFM, before setting up their own regulated entity once the first fund is up and running.
If using this model, the Sponsor will obviously still want to retain a key role in sourcing the fund’s investment opportunities and ongoing monitoring of its investments. Typically this is achieved by that entity being appointed as an appointed representative (AR) of the host AIFM (as principal). This regime allows the AR to carry out certain regulated activities (typically advice and arranging), with the principal taking responsibility for it vis-à-vis the FCA. It can act as an initial step toward the AR obtaining its own approval. There are certain benefits to this approach, including that: (i) all FCA fees and returns are dealt with by the principal itself, and (ii) the (often lengthy) wait for direct FCA approval as an AIFM will not be required. It is not possible to provide fund management services under the AR regime.
How long will all of this take?
Obtaining FCA approval is no small feat. For those seeking to gain AIFM authorisation from the outset, you should allow a minimum of six months from the date you submit your application to the FCA for approval, noting that the preparation of the submission itself can often take months to prepare. (The timeline for small registered UK AIFMs is more favourable.)
If using a host AIFM, the AIFM will be required to notify the FCA of the new AIF under management before the launch of the fund. If the AIFM is “full-scope”, it then requires the FCA’s approval before the new fund can be managed or marketed, and the notification process which require near-finalised fund documentation for the FCA’s review. The fund can only be launched following the expiry of a 20 business day window triggered by the initial notification to the FCA, and subsequent notifications will also be required before the implementation of a material change to the condition for initial authorisation.
If the AIFM is “sub-threshold”, a notification is required but approval is not, so it is not necessary to wait for 20 business days.
It’s not an AIF, but could it be a CIS?
There may be more than one AIF in the fund structure. There may also be entities (typically the carry scheme) which may qualify as a collective investment scheme (a “residual CIS”) but not an AIF. It’s important to check whether the proposed AIFM is authorised to manage both.
What about Brexit?
The main impact of Brexit when it comes to these arrangements will be in terms of marketing this kind of fund to European investors. At the moment (until the end of the transitional period, which is due to be 31 December 2020) a fund structured as an ELP which uses a London-based host AIFM can be marketed to professional investors in the EEA if the AIFM has the benefit of a marketing passport under either AIFMD or EuVECA. But those passports will no longer operate once the UK loses its current level of access to the single market. Sponsors will need to consider whether they can market without such a passport. If not, they will need to consider the pros and cons of setting up an alternative structure within Europe (for example, in Luxembourg).
Interacting with the AIFM and third party service providers
The inclusion of a third party can slow down the day-to-day decision making in the fund so it is important to choose a host AIFM that is aligned with the Sponsor and can work to the required timelines (whilst also providing the necessary level of regulatory scrutiny). It goes without saying that co-operation, continuous communication and mutual recognition are vital to developing a successful long-term relationship.
Host AIFMs accept a varying degree of responsibility and risk, often dependent on the particular nature of the fund and underlying requirements of the principals. Nevertheless, there are a few common issues that arise from the outset. In our experience, tackling these issues pre-launch can likely guarantee fewer delays and optimise the chances of a timely fund launch.
- The PE/VC market differs to Real Estate funds, in that the AIFM fee is typically deducted from the overall management fee payable by investors. There are, though, some variances to this approach – and if the host AIFM is in a different jurisdiction to the Sponsor, a different approach is often taken.
- The management fee is usually charged as a percentage of investor commitments during the investment period. Once this window of investment has expired, it is generally accepted that the management fee will “step down” to a percentage of the total capital invested.
- Thought should be given as to how the fee is paid where a third party AIFM has been appointed. The flow of funds between the Fund and the AIFM can often result in unnecessary VAT leakage. Tax specialists should be consulted to ensure that where possible this leakage is minimised.
- It is important to determine which entities in the structure are acting as data controllers, and which as data processors. Host AIFMs, Administrators and Depositaries will typically already each have their own data policies – but legal assistance is often required to ensure these match-up across the structure as a whole.
The current environment presents a unique challenge for those raising capital. First time fund managers should be prepared for an extended timeline to launch – market leaders suggest that, at present, 12-18 months is a realistic timeline from inception to launch.
Working through these legal and practical considerations as soon as possible is one way to push ahead of the competition and, with the support of established service providers, can minimise any unnecessary delay and prevent an exponential rise in costs before a fund goes live.
Helen Parsonage (https://www.osborneclarke.com/lawyers/helen-parsonage/)
Seema Chandaria (https://www.osborneclarke.com/lawyers/seema-chandaria/)
George Skinner (https://www.osborneclarke.com/lawyers/george-skinner/)