UK 'regulatory hosts' in fund structures offer benefits and raise FCA concerns

The role of a "regulatory host" is pivotal to the launch of many funds but has been under increased Financial Conduct Authority (FCA) scrutiny. The current UK regulatory host model is important particularly for alternative investment fund launches and – notwithstanding the UK financial regulator's recent criticisms and actions – offers benefits to emerging fund managers.

How the regulatory host model works

For a UK firm embarking on the daunting journey of launching its first fund, working with a regulatory host – either by acting as alternative investment fund manager (AIFM) of a UK-based fund or allowing the UK firm to provide regulated services to a fund set up outside the UK – can help smooth the process. 

In respect of funds set up in the UK, the regulatory host is a separate FCA-authorised entity that is appointed as the manager of the fund and is responsible for the fund's portfolio and risk management functions. It then often delegates deal sourcing and related activities to the original firm, or sponsor, as the fund’s investment adviser. The sponsor is allowed to retain a central role in sourcing the fund’s investment opportunities and ongoing monitoring of its investments.

The sponsor's provision of investment advice and arranging of deals are regulated activities. Consequently, the sponsor typically becomes an appointed representative (AR) of the host AIFM or seconds key individuals to the host AIFM. These arrangements enable the sponsor or its employees to perform their function while the host AIFM takes responsibility for the regulated activities vis-à-vis the FCA and supervises accordingly the AR or secondees.

Application of AIFM law

The extent to which the Alternative Investment Fund Managers Regulations 2013 – the AIFM law – will apply depends on whether the host AIFM has aggregated assets under management (AUM) above the following thresholds: the AUM exceeds €100m; or it exceeds €500m, if all managed funds are unleveraged and no investors have redemption rights for five years after their initial investment.

If the AUM of the AIFM exceeds these thresholds, it must hold an authorisation as a "full-scope UK AIFM". If not, the AIFM will be “small” or “sub-threshold”, which notably lessens its compliance and regulatory burden. The UK is relatively unusual compared to most EU jurisdictions, in that host AIFMs are available which are either sub-threshold or full-scope.

For funds set up outside of the UK, the regulatory host will not be engaged directly in the management of the fund but will provide regulatory cover to allow the UK-based sponsor to provide advisory and arrangement services to the offshore fund.

The role of the regulatory host is to provide portfolio and risk management and, often, a suite of regulatory and administrative services, which simplifies the launch of a fund into the market. Consequently, it has been common practice for emerging managers to start with a regulatory host as their principal before setting up their own FCA-authorised entity once they have become more established.

FCA and the AR model

The AR model is a key part of the relationship between the sponsor and its regulatory host firm. Sponsors should be aware that, over recent years, the FCA has been increasingly concerned about this model and has increased the obligations that apply to the principal and AR relationship.

In May 2019, the FCA published a review highlighting significant weaknesses in AR oversight by principals, including poor governance, inadequate risk frameworks, and insufficient resources. The regulatory host model was specifically criticised over issues such as conflicts of interest management, in which AR employees carry out functions for the principal, and a lack of appropriate control and risk management frameworks to oversee the funds. This served as a warning to regulatory hosts not to take an overly light-touch approach to supervising their sponsors – as well as to sponsors to anticipate increased scrutiny from their regulatory hosts.

Prompted by the failure of Greensill Capital in 2021, new FCA rules became effective from 8 December 2022 to strengthen principals' responsibilities and minimise harm caused by unsuitable ARs. These rules included new oversight and data and reporting requirements for principals – and, therefore, added to the procedural burden for regulatory hosts.  While the FCA did not extend the AR model as far as it could have; notably, this model remained under its review.

Liability risks

Additionally, a High Court decision in the case of KVB Consultants Limited v Jacob Hopkins McKenzie Limited in 2023 provided a warning to principals of the potentially significant liability risks they face if they do not clearly define and thoroughly supervise the activities of their ARs.

The FCA published its findings on 6 September as to how principals are monitoring and overseeing their ARs, taking into account its new rules. While the FCA's findings identified some instances of good practice, the regulator was critical of some areas with regards to a number of principals, including self-assessments of compliance with obligations, the treatment of monitoring of ARs as a tick-box exercise and a lack of sufficient rigour in onboarding and offboarding of ARs. The FCA will continue its focus on the AR model, which may become subject to further changes if the regulator remains dissatisfied overall with principals' compliance with regulatory standards.

Osborne Clarke comment

Despite the FCA's concerns with the regulatory host model, in practice it is often the only way an emerging fund manager can realistically enter the market, given the lengthy time it takes sponsors to obtain their own regulatory authorisation.

Firms seeking to gain authorisation from the outset currently need three to six months from the date they submit an application to the FCA for approval, not counting the time taken to prepare the submission itself and providing the FCA deems the application complete.

As the FCA expects applicant firms to be ready to commence the undertaking of regulated activities before submitting their applications, the process is also fundamentally at odds with the unpredictable nature of fundraising, with firms not knowing so far in advance of the first close of their fund whether they will be successful in raising capital or not. 

Regulatory hosts are, therefore, critical to the launches of many funds by emerging managers in the UK and go some way to reducing the friction of raising a fund in the UK compared to, for example, the US where the process of launching a small fund can be significantly more straightforward. 

The UK is home to many well-established regulatory hosts that can provide their sponsors with invaluable knowledge and experience across numerous areas, including compliance, marketing, reporting, valuations, document production, fundraising, risk monitoring and strategy development.  This means sponsors can learn on the job under the guidance of the regulatory host prior to obtaining their own authorisation.

Provided the regulatory hosts are taking their responsibilities seriously (and the FCA scrutiny in the last few years should have increased the number that are), the model provides the dual benefits of allowing innovation in the form of new managers coming to market while also ensuring that their operations have compliance oversight at their core.

It, therefore, seems to boost the UK investment fund industry and align squarely with the chancellor's declaration in her speech at the Labour Party conference in September that "growth is the challenge and investment is the solution". Unless the FCA wishes to create an alternative route to allow emerging managers to enter the market with appropriate regulatory cover, we hope to see it continue to support the regulatory host model.

Kendra Perry, Trainee Solicitor at Osborne Clarke, contributed to this Insight.

If you are considering launching your first fund and would like help navigating the regulatory host model, please contact our experts.