AIFM Regulatory Hosting: Pitfalls, Risks and Solutions

An increasingly common structure used in Private Funds (alongside other sectors) is the regulatory hosting model. However, the model has recently come under scrutiny from regulators, and decisions in the courts should also cause regulatory hosts and those using the models to be careful to ensure the structures and processes in place protect the fund from the adverse effects of poorly implementing and operating the structure.

Some sponsors looking to set up private funds do not have the required FCA permissions to manage the fund and therefore appoint an FCA-authorised host alternative investment fund manager (AIFM) to manage it. However, those sponsors do have the necessary expertise in the underlying investments that the fund invests in and therefore need to input on the decisions made by the authorised fund manager. Where the underlying investments are also regulated asset classes, advising on the investments can also be a regulated activity.

For this reason, it is a common model for the AIFM to appoint the sponsor as an appointed representative to enable it to advise on the underlying investments by giving it regulatory cover and taking responsibility for its actions as an appointed representative. Additionally, some AIFMs and sponsors use a secondment arrangement where the sponsor seconds an employee into the AIFM to perform portfolio management activities for the fund. Typically, in an English Limited Partnership model, this works as follows:

However, this well recognised and regularly used structure has been criticised and come under scrutiny, including by the FCA recently, so with the mood music perhaps changing on this approach, regulatory host AIFMs and sponsors that use this structure should review their arrangements to make sure they don’t get caught by some of the pitfalls.

Regulatory focus – what could the FCA do?

The regulatory focus from the FCA has been highlighted by it recently publishing a new webpage dedicated to regulatory hosts. Regulatory hosts differ to other principals due to the amount of regulated activity they carry on themselves. A large number of principals carry on regulated activities but may appoint a small number of appointed representatives to carry on certain aspects of the regulated business. The FCA defines “regulatory host” as a “principal firm that carries out little or no regulated activity” but rather “oversees the use if its permissions by Appointed Representatives (ARs).” The FCA’s webpage on regulatory hosts states:“Regulatory hosts receive more complaints and create more FCA supervisory cases on average than other principals.”The FCA is taking a more data-driven approach, so where it sees more complaints and supervisory cases, it will take a more robust approach to supervision and enforcement to tackle the perceived harms.

Where the FCA identifies there could be harms, it can use its full range of supervisory and enforcement powers to investigate and, where appropriate, mitigate the harms. This usually starts with the FCA requesting information from authorised firms under section 165 of the Financial Services and Markets Act 2000. It is important for firms to get the tone and content of the response correct, as following this the FCA could use its powers under section 166 to start a skilled person review of the authorised firm. Skilled person reviews can be very disruptive to authorised firms and lead to the firm losing control over the investigating and resolution of the issues identified. Ultimately, the FCA could also use its other enforcement powers, such as ordering redress or restricting the activities of the authorised firm. Firms will be keen to avoid the FCA using these powers, so should ensure the model is implemented and operated properly.

Risks relating to poor implementation of the regulatory hosting model

In its recent consultations and policy statements when bringing in changes to the appointed representative regime (which also brought in increased compliance requirements for regulatory hosts), the FCA questioned whether the regulatory hosting model used by some AIFMs causes harm. The main consensus was that appointed representatives and AIFMs need to ensure they do not market or give the impression the appointed representative is managing the fund, when this role is legally taken by the AIFM. AIFMs and sponsors should review the fund’s promotional materials and documentation to ensure this is clear to investors.

Another key point is for the AIFM to ensure that it is performing its fund management role sufficiently and that it records this, to show that the arrangements have substance and it is not the case that the sponsor is, in fact, managing the fund.

Finally, the FCA has recently been critical of principals with a large number of appointed representatives, especially where regulatory hosts do not have the resources to oversee the appointed representatives properly. AIFMs may well want to focus on a smaller number of high-quality appointed representative appointments, rather than aiming for high quantity.

AIFMs becoming liable for more than they bargained for

Recent case law, particularly KVB Consultants v Jacobs Hopkins McKenzie and others [2023], shows the court will scrutinise appointed representative arrangements and, in particular, will focus on the substance, not form, of these arrangements. The court covered a number of points of interest for AIFMs, the most notable being delineation between what the principal (the AIFM for the purposes of this article) has taken regulatory responsibility for in appointing the appointed representative and stipulations in the contract about how the appointed representative should act. In this case, the principal had taken responsibility for the marketing of certain investments, which turned out to be collective investment schemes. The appointed representative had marketed the investments to retail investors and, although the contract specifically prohibited marketing to retail investors and prohibited arrangements involving collective investment schemes, the principal was still held liable for the marketing of the investments to these investors. As such, the court held the principal liable for the appointed representative’s breaches of COBS in promoting the investments to retail investors.

This case, alongside the increased regulatory focus on governance and oversight of appointed representatives, should act as a warning to host AIFMs to take seriously the oversight of their appointed representatives ensuring robust processes are in place. We would recommend AIFMs and sponsors take this opportunity to review their fund documentation and processes.

Disclosure of risk

Host AIFMs and sponsors should also consider that, if they are using a regulatory hosting model, this could be a material risk factor for investors in the fund. If the regulatory hosting arrangements are challenged, it could leave the fund inoperable. As such, it should be disclosed in the fund offering materials. It is also conceivable that a challenge to a different mandate of that host AIFM could impact a fund, depending on the consequences for that host firm.

Future of the model

This is by no means the death of the AIFM regulatory hosting model. However, the FCA is being more robust when looking at these models to make sure firms are complying with its rules and, if the FCA’s work indicates the model is causing more harm than the benefits it brings, it could in the future look to limit the use of the model. For now, firms need to be vigilant in ensuring they can evidence to the FCA that they are complying with the rules and the model is not causing harm to investors.

How can we help?

We are very familiar with the regulatory hosting AIFM model, having worked with a number of clients that operate using this model. Our team can help managers avoid the pitfalls when structuring arrangements, as well as making sure fund documentation and promotional materials are drafted correctly.

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If you would like to discuss any of the issues in this article, please contact Adam Edwards or George Metcalfe.