HM Treasury has published a paper in which it asks wealth managers to comment on its proposals to reform the British version of the Alternative Investment Fund Managers Directive, which the UK has inherited from its pre-Brexit days.

The SEF/RVECA regulations
In the paper the Government asks practitioners what it should take into consideration when it reviews the SEF/RVECA regulations. These apply to the managers of Social Entrepreneurship Funds (SEF) and Registered Venture Capital Funds (RVECA). WealthBriefing asked Jonathan Wilson, the director at the wealth management regulatory consultancy of Ellis Wilson, whether he had ever detected any issues there for wealth managers.

"These were European-designed regimes that gained little traction in the markets we were advising on, partly because the broader Alternative Investment Fund Managers Directive (AIFMD) had already established the regulatory framework. The Treasury paper suggests that they may have been ineffective.

"If there was a fund structure that entrepreneurs could be attracted to, to make investments in UK companies, that could be beneficial. It could be targeted at HNWs but while there are a series of exemptions in regulations which allow the financial promotions, the FCA is equating an HNW individual with retail. It makes the marketing possible but more challenging.

"There are opportunities for funds to be responsibly marketed [to HNWs] and sold under the exemptions, obviously as high-risk investments, but that could be under the small registered UK AIFM regime [see below]. They're thinking about changing that."

Venture capital and wealth management
WealthBriefing asked Wilson whether he thought that venture capital fund managers had anything to do with wealth management.

"Yes, wealth managers could – and increasingly do – allocate to venture capital strategies."

Question 4 on the paper asks: How should Government approach the regulation of Venture Capital fund managers in future? WealthBriefing asked Wilson the same question.

"It is surprising that the removal of the Small Registered AIFM regime is under consideration. If you're going to reform the smaller manager market and encourage growth, you might create fund reform to allow more investments and startups. Currently, to raise funds and to manage venture capital and private equity investments, a firm will have to be FCA-authorised OR use a use regulatory host [see below]. The first route can be slow; the second route can be expensive.

"The case doesn't seem to have been made for why the Small Registered AIFM regime needs to go.”

The Treasury also believes that there is a case to be made for a regulatory regime which reflects the objectives and characteristics of venture capital funds that differ from those of other alternative investment funds, Wilson continued.

“I don't think wholesale change is needed. These fund managers can operate under the alternative investment fund management regime, but there are some reporting requirements that are over-burdensome and they could do away with them. There are some arguments around the application of certain rules and whether the FCA should apply them better, or remove them, for venture capital investing. Better thinking about how firms are expected to apply the regulations to different fund strategies is what's needed and that could be done much quicker, without the need for new regulatory regimes.

"Take systemic reporting under the AIFMD. The FSA [the old Financial Services Authority, the FCA's predecessor as financial regulator] used to target the largest 50 or so hedge fund managers across the country who would submit data to it. The FSA then published informative assessments of the alternative fund market’s systemic risk exposure. Since the AIFMD, every alternative investment manager has had to provide systemic risk reporting, including the smallest of VC managers. It's just a large exercise in reporting that fund managers question the need for and the regulator could stop asking for."

Regulatory hosting and 'umbrellas'
An appointed representative (AR) can operate under the regulatory cover of a host or principal. This is a firm that the UK's Financial Conduct Authority has authorised to carry out investment business which is happy to accept responsibility for the activities of its AR(s) and must supervise the AR(s) accordingly.

Between 2013 and 2019 the FCA became increasingly unhappy with these arrangements, ultimately decreeing that there were significant weaknesses in the control and oversight of ARs. The FCA criticised principal firms for weak or underdeveloped governance arrangements, including ineffective risk assessments, internal controls and resources. The regulator significantly identified the "host AIFM models" involving ARs as a particular area of concern. By 2019, authorised firms in the investment management sector had appointed, and accepted responsibility for, more than 1,000 ARs, many of which offered retail services to HNWs.

Additional rules that governed the responsibilities of principals came into force on 8 December 2022 (outlined in FCA Policy Statement 22/11). Principals must monitor delegated functions or tasks and ensure that they do not create any conflicts of interests. They must assess senior managers at ARs and ensure that their ARs act within the scope of their appointments, while ensuring at all times that they do nothing to create an undue risk of harm to HNW consumers. A principal must review its contractual relationship with an AR if it, or its business, grows rapidly in a short time. It must review each of its ARs at least every 12 months – and more often, in some cases. Every year its governing body must sign a self-assessment document (to be kept for six years and available to the FCA for review on request) which focuses on the principal itself, in relation to all of its ARs. It must be very clear about the circumstances in which it should end a relationship with an AR.

Thresholds
The AIFMD has always applied to AIFMs that manage assets above a threshold of €100 million ($114.04 million) or €500 million (if they manage only AIFs that are unleveraged and have no redemption rights for the first five years). For managers below these thresholds, it only requires EU countries to introduce registers. This holds true in the UK in legislation that it 'retained' from its days in the European Union.

In 2013 HM Government duly created the Small Authorised Regime, which applies to nearly all sub-threshold AIFMs (except certain firms which are detailed in the Treasury paper). These firms have to be authorised by the FCA to manage AIFs but are not subject to full-scope (i.e. the most stringent) requirements.

For a minority of firms that the FCA had not previously authorised, the Government decided not to require sub-threshold managers to seek FCA authorisation and instead required them merely to register with the FCA. It therefore did not 'gold plate' the European Directive or extend the perimeter of regulation in this area.

This Small Registered Regime now applies to three categories of sub-threshold AIFM and exempts them from having to seek FCA authorisation when managing certain AIFs. Managers of SEF/RVECA funds are one group. Also included are managers of Unauthorised Property Collective Investment Schemes, i.e. AIFMs that manage the assets of unauthorised funds (mostly holding land), plus managers of ‘Internally Managed Companies,’ i.e. investment companies which are not collective investment schemes and which do not appoint external AIFMs.

The "halo effect"
In its paper the Treasury observes that the Small Registered Regime exemption appears to be having a broader effect than intended. It has detected evidence that, to use a term that it seems to view as slightly pejorative, firms are 'structuring' funds as Internally Managed Companies to qualify for the Small Registered Regime, even though they do not follow business models that are typical for investment companies. It suspects that these firms are benefiting from a “halo effect” provided by FCA registration, despite the FCA having limited powers to prevent managers from registering with them.

To protect HNW investors in this area, HM Government is thinking of requiring the managers of sub-threshold Internally Managed Companies to seek FCA authorisation, as managers of AIFs. This is obviously likely to force fund managers to incur up-front costs. The Treasury is therefore asking fund firms whether they agree with its proposal, although the outcome appears to WealthBriefing to be a foregone conclusion.

It is fairly uncommon for firms to be internally managed and, at the moment, such firms are often associated with regulated entities such as investment managers.

Wilson commented: "The claim is confusion caused by the "halo effect" around FCA registration or authorisation. That could be mitigated by requiring better clarity as to whether the fund or fund manager is FCA-authorised – or FSCS – [Financial Services Compensation Scheme] protected, so I don't see a need to remove the category of fund altogether. There is a case for the Small Registered AIFM regime to be more widely available – if it allows entrepreneurs to come to market and helps to feed growth, that seems to be a good thing."

Listed closed-ended investment companies
The Treasury's paper takes stock of the fact that many fund firms have been calling for Listed Closed-Ended Investment Companies to be entirely removed from the scope of AIFM Regulation. It is reluctant to make this happen but is willing to listen to alternative views. It therefore asks practitioners whether they anticipate any unintended consequences associated with Listed Closed-Ended Investment Companies, including those which are internally managed, dwelling under AIFM regulation as they do at the moment. Jonathan Wilson classified these funds as investment trusts.

These funds (which do not include open-ended structures such as exchange-traded funds or ETFs) are traded on the Main Market of the London Stock Exchange. They now represent more than 30 per cent of the FTSE 250 and invest in more than £250 billion of assets. AIFM regulations have applied to their managers since 2013. Before that, such companies were not regulated as investment funds in the UK, although many had external, FCA-regulated investment managers.

Wilson remarked: "The investment trusts have never fitted comfortably under the AIFMD because they were set up under UK company law and they had their own listing requirements and so on, and there's always been a friction between them as separately structured listed companies with their own directors, while the AIFMD was trying to address structuring and the marketing of non-UCITS funds to non-retail investors. It is notable that there remains a proposal to continue regulating these funds under the AIFMD framework."

Question 9 of the paper also asks: If the Government were to consider an alternative approach, such as removing certain investment companies from the scope of the regulation, should this be limited to closed-ended investment companies listed on the London Stock Exchange, or should other types of closed-ended investment company be captured?

Wilson commented: "Closed-ended investment companies have been operating on the London Stock Exchange for years and are subject to the [FCA's] listing rules, so I feel that if they are going to remove them from regulation it should be those types of listings that have been listed for many years and are long-established UK investment vehicles.

"A side-effect of bringing in the AIFMD was that they were brought into regulation. There’s an opportunity now to put things back as they were."

The Treasury states that listed closed-ended investment companies may, in future, be subject to its upcoming Consumer Composite Investments regime. This is intended to replace disclosure requirements that flow from the onshored European PRIIPS (packaged retail investment and insurance products) and UCITS (Undertakings for the Collective Investment in Transferable Securities) regimes.

Notification periods
Under the AIFM regulations, full-scope UK AIFMs of UK or Gibraltar AIFs are required to notify the FCA of their intention to market such AIFs to professional investors, i.e. investment firms and/or a small number of highly-qualified HNWs, and the FCA has 20 working days to grant or refuse approval.

Firms have said that the requirement delays the appearance of new products and makes it less attractive to market funds into the UK. Because the AIFs are marketed predominantly to professional investors, HM Treasury sees no need for the 20-day notification period. In question 13 it asks the industry to comment on the subject.

Wilson agreed with the plan: "If they're not marketing to retail investors, which they shouldn't be with these funds, then it would seem appropriate that the pre-notification should be removed and it would allow those firms to get to market.

"The FCA should also look at how it authorises new alternative fund managers. There's a little bit of a curiosity here because while there's a 20-day pre-notification once you're authorised, the FCA authorisation process requires a manager to have a fund ready to go before it will be authorised.

"This is an area where the FCA could improve its processes by approving the manager’s fitness and propriety first, before requiring specific fund documentation. Then, once authorised, the FCA should just require the length of notification period it considers it requires to protect investors."

External valuations
The AIFM regulations allow for AIFMs to appoint external valuers to carry out valuations of their AIFs. However, they also make each external valuer liable to the AIFM in question for any losses that it causes it by being negligent or intentionally failing to perform its tasks. The Treasury has heard that this liability is making valuers cautious about doing business in this area and that they are finding it hard to obtain professional indemnity insurance for it. Question 15 of the paper asks respondents whether the Government should review the liability for external valuers and whether any additional safeguards might be appropriate.

Wilson said that managers are normally responsible for the valuation of the portfolios. He added: "This, again, is something which is a legacy of the European regulators, who assumed that an external valuation agent would be used."

HM Treasury's paper, which contains the questions, is available here.

* Jonathan Wilson can be reached on 020 3146 1860 or at info@elliswilson.co.uk