Introduction
There are a variety of structures available to manager or promoter teams looking to create an investment fund – that is, to (i) raise money from a range of investors, (ii) invest that pooled money in a number of investment opportunities and (iii) manage those investments on behalf of the investors.
The principal reasons for investing in a fund, rather than directly into individual assets, include:
Investment funds provide access to investment opportunities that would not otherwise be available to many investors.
Investment funds provide access to the expertise of the fund manager, which may be highly specialized.
Investing in funds provides greater diversification of risk and exposure, within a particular asset class, than investing on a unilateral basis can normally achieve.
Among the features that distinguish the various types of investment fund are:
The fund’s investment strategy, which is influenced by (i) the asset class (for example, private equity or real estate); (ii) geographic scope (global, regional or country specific); and (iii) the nature of returns targeted (capital, income or both).
The fund’s target investor base which could be (i) “retail investors” (the general public), (ii) high net worth individuals or sophisticated investors or (iii) market professionals.
The choice of fund structure from the perspective of the promoter is driven by factors like (i) whether the fund is open-ended or close-ended, (ii) who the fund is to be marketed to, and (iii) the nature (if any) of the tax structuring.
Open-ended v Closed-ended
Open-ended investment funds are funds where the participants have a right to redeem their interest or sell their interest more or less at any time at a price which is related to the then current market value of the assets held by the fund. The most typical examples of open-ended investment funds are unit trusts and open-ended investment companies.
A closed ended fund is, broadly, anything other than an open ended fund; their fundamental characteristic is that it is not possible to withdraw from the fund other than through a sale to a third party on a private sale basis. It is for this reason that close ended funds generally have fixed winding up dates so as to provide an exit for investors. The most common examples are public companies formed for the purposes of investing in other companies (or property).
Collective investment schemes
Open-ended funds constitute “collective investment schemes” (“CIS’s”) under the Financial Services and Markets Act 2000 (“FSMA”). The essence of a CIS is that it involves the pooling of assets enabling the persons taking part in the arrangements to share in the profits or income but where the assets are managed on their behalf.
Establishing, operating or winding up a CIS is an activity constituting investment business and is therefore an authorisable activity under FSMA. Therefore any promoter of a CIS will need Financial Services Authority (“FSA”) authorisation which involves satisfying the FSA that they are fit and proper to undertake this function and have the requisite skills and experience.
There are two types of “regulated” CIS’s in the – authorised unit trusts and open ended investment companies with variable capital. These regulated CIS’s involve a further set of rules designed to ensure that they are appropriate to the “man (or woman) in the street” relating to matters like the promotion, term and structuring and operation of the fund. All other CIS’s are described as unregulated.
Investment companies
The main structures which fall outside the definition of CIS’s are investment companies and closed ended limited partnerships. Investment companies are “standard” public companies created with the object of making investments. Funding is raised through subscription for shares in the company like any corporate fundraising. No authorization or approval is required from the FSA to establish an investment company but any fundraising is subject both to the Prospectus Rules 2005 and section 21 of FSMA/the Financial Promotion Order 2005. In addition, most investment companies have either a Full List or AIM listing in order to ensure a “ready market” or “liquidity” in the shares. If a prospectus is required it will be necessary for the prospectus to be reviewed and approved in advance by the listing division of the FSA.
No listing is required and it is possible to avoid the full prospectus requirements if an investment company is marketed only to a small number of persons (under 100) and/or to qualified investors only (rather than the public as a whole). Similarly, the financial promotion rules will not apply if the fund is marketed only to certified high net worth individuals and/or sophisticated investors. This makes the marketing of an investment company to a relatively low number of “sophisticated investors” one of the more straightforward “low regulation” routes available.
However FSA regulation is relevant to investment companies through the requirement that the manager of the fund and the custodian of the assets are FSA approved. The custodian is likely to be an existing professional custodian while the manager is likely to be the individual/team behind the investment fund. A similar FSA authorization process applies to that referred to in paragraph 8 above.
There is a relatively new investment fund vehicle for large scale property investment - the “real estate investment trust” or “REIT”. These must be listed, resident and are not suitable for a relatively small number of investors or small investment projects.
Limited partnerships
In addition to companies and trusts there is a third type of investment fund – limited partnerships registered under the UK Limited Partnership legislation. These structures are a popular vehicle for private equity funds established in the because of their tax transparency (see below) and their relatively light touch regulation since they are not subject to the Companies Act legislation or the full remit of the FSA rules for regulated CIS’s. However they do require at least one general partner with unlimited liability and the manager will need to be FSA authorised. They are unlikely to be suitable for the participation of a significant number of investors or where an open-ended exit structure is needed.
Tax treatment
When considering investment fund structures the aim is normally to achieve a result that is tax-neutral (i.e. that the investor in the fund does not end up with a greater tax liability than had he invested directly in the assets). There are three ways of achieving this - by (i) establishing a fund that is fiscally transparent because it has no separate legal entity – a limited partnership, (ii) establishing a fund that enjoys preferred tax status like an authorised unit trust or investment trust or (iii) establishing the fund in a jurisdiction with no or reduced tax charge. If the fund is structured as an investment company and it wishes to avoid the potential double charge to tax for investors who are taxpayers, it will be necessary to consider some form of offshore structure. Set against the tax drivers there may well be the the additional costs/regulatory burden of a more complicated structure.
Conclusion
Our table sets out the main characteristics of the four most common structures for investment funds. There are a variety of investment fund structures available but many are more suited to (and utilised by) the professional asset management industry. More specialist funds that raise money from a limited number of “sophisticated investors” and are not tax driven typically adopt a closed ended investment company taking advantage of an offshore location where possible.
For more information or advice on investment fund options, please contact
Robert Lee.
