Establishing a hedge fund in the United Kingdom is a more complex process than in the United States and will take, at minimum, three months. The process is so complex that many new firms hire an outside company to help with establishment and to ensure the fund is fully compliant with all laws and regulations. Below, we discuss the key elements needed to start a hedge fund in the United Kingdom.
- London is home to many hedge funds, although starting up a fund in the U.K. is a bit more complicated than in the U.S.
- Hedge funds in the U.K. are more highly regulated and transparent, overseen by the Alternative Investment Fund Managers Directive (AIFMD).
- Founders of a hedge fund must meet strict regulatory requirements, file the necessary documents, and seek approvals for it to operate.
Regulations and Approvals
The first and most fundamental step of starting a hedge fund firm in the UK is learning how to navigate the governing body. Regulation and authorization approval in the UK falls under the Financial Services Authority (FSA) which was renamed the Financial Conduct Authority (FCA) after the global financial crisis. UK hedge fund managers are required under the Financial Services and Markets Act 2000 to gain approval to establish a new fund. Funds must submit applications to the Financial Conduct Authority approval can take up to six months. Part of the approval process requires the investment manager to demonstrate adequate financial resources and appropriate staff, systems, and controls to manage the fund. There are several prerequisites:
- Establish financial resource requirements depending on whether the fund falls within the Markets in Financial Instruments Directive (MiFID) of the European Community.
- Prove investment staff competency by passing an exam in full or part based on experience in management outside the U.K.
Hedge funds can be monitored for up to a year after approval. Included are rules related to conduct of business, financial records and reporting, compliance, and complaints. Fund marketing is governed by the Alternative Investment Fund Managers Directive (AIFMD). To market funds in a European Union (EU) country, investment managers must receive approval from the regulator in its established country.
In addition to navigating the external regulations and authorizations, there are many internal factors that founders must consider when forming a hedge fund. These include deciding on the jurisdiction, structure, oversight and providers, and components for the new hedge fund.
Jurisdiction, or where the fund is based, is important because it establishes the fund’s tax structure. For example many funds are based offshore in places like the Cayman Islands, Bermuda, Luxembourg, or Ireland. Offshore jurisdictions are beneficial to the hedge fund because the investor, not the fund, is required to pay tax on the appreciation of the fund’s portfolio.
Fund structure is chosen based on type of investors and their needs, such as tax status, ability to use leverage, and voting rights. The typical structures are stand alone, master/feeder and umbrella funds, and segregated portfolio companies. In a stand alone structure, there is a single fund in which several investors can purchase shares. At the other extreme is a segregated structure, which is a separate legal entity where each investor has a separate fund account with its own assets and liabilities. Master/feeder or umbrella structures are somewhere in the middle of these two extremes. Firms use this structure when there are different investor requirements, such as tax status or leverage restrictions, where sub or feeder accounts are created based on different needs. Explained simply, feeder accounts feed into the master fund, which then trades on behalf of the feeder funds.
Oversight and providers are the critical personnel that control and run the fund. Although operating a hedge fund can seem overwhelming and many turn to management companies, that is not always necessary. A self-managed fund where the management team are the appointed officers of the fund can save both time and costs. UK law calls for the fund to have at least two independent directors, who for UK tax reasons must be based offshore. However, the Investment Manager Exemption (IME) allows a hedge fund to appoint a UK-based investment manager if they meet certain criteria.To receive the IME, the manager must act independently when providing investment management services and all transactions need to be done in the ordinary course of business. In return, the manager must receive customary fees. Also, the investment manager cannot comprise more than 20 percent of the fund’s assets. Other providers for starting a hedge fund include an administrator, an independent auditor, a custodian and/or prime broker, legal council, and a tax advisor.
Fund components include other aspects a manager needs to establish, such as share classes, fees, and restrictions on withdrawals. These are decisions the management needs to make prior to establishing the fund and can take on many forms. 1) Share classes: Many hedge funds create different share classes, such as management and investment share classes. Usually management shares hold voting rights, while investment shares are nonvoting. Also separate share classes can be established for the officers and employees of the investment manager, to avoid paying fees. There can also be a share class for UK-taxable investors. 2) Fees: Historically hedge fund fees were structured as two and twenty meaning a 2 percent management fee and a 20 percent performance fee of the appreciation or hurdle rate exceed. Now fees come in many forms. 3) Withdrawal restrictions: Lockup or redemption fees are common provisions. Lockup mean assets are unable to be withdrawn from the fund for a specified time period. Redemption fees can be applied if assets are withdrawn.
Other Necessary Components
The last items worth considering pertain to investment qualifications and a track record. The length of track record depends upon potential investors’ conditions for investment as does the manager’s pedigree or experience. At minimum, investors like to see a track record, either at a current or prior firm, with the same strategy. Seed capital is also necessary, including for regulatory requirements. It is important to make sure the set up and operational costs do not negatively impact the track record performance. The right structure could ensure the costs are external to, and do not supplant, performance.
Marketing and Gathering Assets
As stated above, the AIFMD governs hedge fund marketing and soliciting of assets. The AIFMD are explicit rules on how firms can market their funds and solicit assets. UK-based hedge funds who are only going to solicit assets in three ways—1) market in the UK only, 2) market outside the EU, or 3) rely on reverse solicitation where the investor approaches the hedge fund and not the over way around—were able to simply adhere to UK private placement rules and not follow the AIFMD rules through 2018. Since 2018, AIFMD must be followed. For managers who will solicit assets in the EU, these rules need to be complied with to establish a marketing license.
The Bottom Line
Hedge funds in the UK are subjected to more regulatory establishment criteria than hedge funds in the United States. To ensure compliance with stringent rules and regulations, start by contacting the governing bodies. Depending on the complexity of your planned hedge fund firm, you may choose to hire an outside company to help navigate the process. Your understanding of and compliance with all requirements will help provide a strong backbone to the new hedge fund.