Professional Investor Funds could fill the UK fund sector gap

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The UK has an unfortunate gap in its fund offering, compared with many other jurisdictions. It does not have, but in my view needs, a closed-ended or hybrid solution for pension funds and other institutional investors to hold UK real estate investments. Ideally, the fund should be unlisted, tax transparent and offer tradable units.

Melville Rodrigues, Head of Real Estate Advisory at Apex Group, shares his views with Practical Law Financial Services subscribers on topical developments or key issues relating to fund management.

In the March 2021 column, he considers HM Treasury’s call for input on its review of the UK funds regime and explains the opportunity for creating a new UK fund vehicle for real estate investors.

The gap in the UK fund market

The UK has an unfortunate gap in its fund offering, compared with many other jurisdictions. It does not have, but in my view needs, a closed-ended or hybrid solution for pension funds and other institutional investors to hold UK real estate investments. Ideally, the fund should be unlisted, tax transparent and offer tradable units.

Fund managers are currently limited to alternative fund choices, which have drawbacks:

  • Open-ended authorised fund structures. These must comply with regulatory operational requirements that erode returns and may be inappropriate for holding illiquid assets.
  • Offshore alternatives. These face the challenges of (and costs associated with) multiple legal, tax and regulatory regimes, including maintenance of sufficient offshore substance.

Call for input on review of UK funds regime

HM Treasury, via its January 2021 call for input on the UK funds regime, is now offering a window of opportunity to rectify the gap, which could significantly improve the real estate funds sector through the introduction of a professional investor fund (PIF).

The call for input is discussed in Legal update, HM Treasury call for input on review of UK funds regime. The overarching objective of the review is to identify options that will make the UK a more attractive location to set up, manage and administer funds, and which will support a wider range of more efficient investments better suited to investors’ needs. Specifically, HM Treasury asks for views by 20 April 2021 on issues that cut across the tax and regulatory elements of the UK funds regime and welcomes proposals on new fund structures.

The proposed Long-Term Asset Fund (LTAF) is discussed in the call for input. This is a proposal for anew authorised open-ended fund structure designed to enable investors, particularly defined contribution pension schemes, to more confidently invest in illiquid assets (such as venture capital and infrastructure) than they can using existing fund structures. The call for input also describes the Association of Real Estate Funds’(AREF) proposal for a PIF, which is the subject of this column given the gap in the market described above.

The PIF is supported by AREF, as well as the UK funds regime working group (UKFRWG), the Alternative Investment Management Association (AIMA), the European Association for Investors in Non-Listed Real Estate Vehicles (INREV) and the Investment Property Forum. As a conduit for institutional productive capital, the PIF can facilitate the government’s goals forCOVID-19 reconstruction, infrastructure revolution and “levelling up” the nation (that is, by supporting jobs outside of London). Real estate, and its funds sector, have much to contribute, for example, by attracting capital and reinvigorating town centres, supporting social and affordable housing and developing social infrastructure. Other sectors could also utilise the PIF, given it is designed to be unconstrained in terms of eligible asset classes and investment strategies.

I understand that HM Treasury will prioritise their top three proposals, and then progress with legislative change for those proposals. Interestingly, the PIF proposal could be implemented via secondary legislation that amends the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001(SI 2001/544) (RAO) and by FCA consultation. There is no need for primary legislation.

Regulatory and tax considerations

The PIF is modelled on existing authorised contractual scheme (ACS) legislation, but is not open-ended. For regulatory purposes, it will be classified as a UK alternative investment fund (AIF) and benefit from the flexibilities of an unregulated collective investment scheme (CIS).

It is envisaged that the PIF will be formalised by deed, initially made between a PIF’s alternative investment fund manager (AIFM) and depositary. On admission, investors in a PIF will become parties to the PIF deed. The AIFM will make decisions on behalf of the PIF investors about the acquisition, management and disposal of assets, as well as risk management, subject to provisions within the PIF deed, and those decisions will be binding on PIF investors.

Other features include:

  • Investor status. The PIF will be restricted to professional institutional investors that commit at least £1 million, while other investors can only gain access through feeder funds that satisfy the professional institutional investor status.
  • Registration. The PIF will be established and registered at a registry similar to that which applies in the case of an English limited partnership. This is a solution that means there is no need for prior application to, or approval from, the FCA.
  • The PIF will operate with protected-cell sub-funds, providing a legally enforceable segregation of the assets and liabilities of each sub-fund. PIF managers will be able to operate a broad range of funds more efficiently. The sub-funds (or cells) are separately managed, charged, accounted for and assessed for tax, but do not have a separate legal personality.

The PIF will adopt the co-ownership ACS framework, which is effectively tax transparent with tax liability applying to investors as follows:

  • Income and capital gains. Income will be taxed on the share attributable to each investor, and capital gains will be taxed on each investor disposing its PIF units (but not on gains realised at the PIF portfolio level).
  • Stamp duty. Stamp duty is also modelled on the ACS. For example, in the case of PIFs holding UK real estate, it is proposed that no transaction tax, including stamp duty land tax (SDLT), will apply on the transfer of units in a PIF, and, as is the case with the co-ownership ACS and property authorised investment funds (PAIFs), SDLT seeding relief will apply to the PIF. This will assist in launching new

PIF projects with a similar clawback mechanism as applies for co-ownership ACSs and PAIFs to limit the scope for tax avoidance.

There is a unique opportunity to address the current gap in the UK’s fund offering and improve the prospects for future generations of real estate fund managers.

Written by Melville Rodrigues, Head of Real Estate Advisory.

Published on Thomson Reuters Practical Law Financial Services

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