Sorry, Master Feeder Funds are Unlikely to be a Brexit Solution

It’s easy to see why master feeder funds have emerged as potential solution for Brexit. The big question is: will it work?

Over the last few months, we have started to get more detail on what exactly Brexit may entail.  We now know that the UK’s plan is to trigger Article 50, the formal mechanism to begin exiting the EU, no later than March 2017. With each passing day, we also know the likelihood of a so-called “Hard Brexit”, where the UK breaks all ties with the EU, is increasing. Given this, asset managers have started to take a harder look at their Brexit plans and contemplating what happens if the UK loses access to the EU Single Market.

One of the key issues that asset managers are starting to consider is what happens if a hard Brexit means that reciprocal access for funds between the UK and EU is lost. We touched on this issue back in July but to briefly recap:

The EU classifies the fund world into two categories: UCITS and everything else. And everything else falls under the AIFMD framework. If UK UCITS funds are not granted access to EU investors, they will then be classified as “alternative” by EU rules and governed by the AIFMD framework. This classification could have a huge implication on distribution because alternative funds cannot be sold to retail investors. If formerly UK UCITS funds are denied access to the EU, then the question becomes will EU UCITS be allowed to continue to be sold to UK investors?

As asset managers contemplate how to deal with this potential issue there has been growing chatter that a master-feeder structure may be a potential solution. A master-feeder structure is where a fund (known as the “feeder”) is established to invest solely into another fund (known as the “Master”). Typically in this arrangement the master and feeder funds are domiciled in different countries.  The advantage of this structure is that it gives the asset manager access to a wider investor base, while maintaining the efficiency and economies of scale associated with managing a single pool of assets.

It’s easy to see why this has emerged as potential solution for Brexit. It would be a pretty eloquent solution and, relatively speaking, minimally disruptive. However, the big question is: will it work? Unfortunately, the answer is: not really.

When looking at the potential of a master-feeder solution, it’s important to remember that there are actually two different problems.

EU Investors in UK Funds

For asset managers that sell their UK UCITS funds into the EU, the question is whether EU investors will still be allowed to invest in the UK funds when the Brexit break-up is complete? Additionally, these managers may face pressure from their investors who prefer a UCITS fund. For this cohort, establishing a EU UCITS feeder fund (presumably in Ireland or Luxembourg) isn’t going to cut it. At issue are specific UCITS rules around the operation of a master-feeder structure. In order for a UCITS fund to be a feeder, it must invest at least 85% of its assets into a UCITS master fund; however post-Brexit, all UK funds will become non-UCITS, this option becomes is a no go. This means that a UCITS feeder fund would be governed by the UCITS diversification rules, which limit a UCITS fund to investing no more than 10% into any one non-UCITS fund. On the face of it, it seems the master-feeder structure isn’t workable in this case.

UK Investors in EU Funds

If, post-Brexit, the UK restricts access for EU UCITS, there’s a chance that establishing a UK domiciled feeder fund just might work. From the UCITS framework perspective, there is no regulatory issue with this arrangement. The UK feeder fund would simply be another non-EU investor in the fund. The open question is whether the UK would allow UK domiciled funds to be feeders into non-UK funds? If so, setting up a UK feeder fund may solve the problem for managers with UK investors into their exiting EU UCITS funds.  However, while this may work conceptually, there is still uncertainty. Should the UK decide to mimic the UCITS rules and limit the amount a UK fund can invest into a non-UK fund, then the master feeder solution won’t work.   Asset managers may want to hold off pulling the trigger on this option until further clarity is provided by the UK regulator.

Overall, the trouble with Brexit is there are still more unknowns than knowns. It’s hard to come up with a solution when you’re not exactly sure what the problem is. That said, it seems that pretty clear that the master-feeder idea is unlikely to be the panacea that the industry is looking for.