This country-specific Q&A provides an overview of Alternative Investment Funds laws and regulations applicable in Canada.
What are the principal legal structures used for Alternative Investment Funds?
Privately offered alternative investment funds (“AIFs”) are established in Canada pursuant to provincial or territorial law, most typically where the fund manager resides but at times in a province or territory (referred to herein as a “province”) that offers more favourable regulatory treatment.
AIFs are most commonly organized as limited partnerships (“LPs”) or trusts, depending on a number of considerations such as target market and desired tax treatment.
Publicly offered alternative investment funds (“liquid alts”) are most typically organized as trusts.
This summary will focus on AIFs and will make only occasional references to liquid alts, as publicly offered investment vehicles are more heavily regulated and subject to different approval and continuous disclosure requirements, and for the most part regulated in the same manner as retail mutual funds or exchange traded funds.
Does a structure provide limited liability to the sponsor and/or manager vis-a-vis investors?
There is no statutory limited liability offered to fund managers or other service providers to LPs or trusts. “Sponsor” is not a term generally used in the Canadian AIF market – the entity responsible for the creation and structuring of an investments fund is more typically referred to as the “manufacturer”. That entity will most likely be the investment fund manager (“IFM”) (the entity that directs the business, operations and affairs of the fund) and/or the portfolio manager (“PM”), although some manufacturers will outsource both IFM and PM responsibilities. In Canada, both the IFM and the PM must be registered under applicable securities legislation.
AIFs are generally not prohibited by applicable securities laws from contractually limiting the liability of its IFM, PM or other service provider, however regulatory standards of care must be met, and any attempt by an IFM or PM to circumscribe those standards through contractual limitation of liability clauses have been the subject of regulatory intervention through the compliance audit process. Liquid alts are specifically prohibited from relieving the fund manager of liability for breach of its standard of care.
Tax laws in Canada may impose liability on fund managers in certain circumstances (e.g. failure to remit withholding taxes on behalf of the fund).
Is there a market preference and/or most preferred structure? Does it depend on asset class?
Trusts (that meet certain tax requirements) are preferred by fund managers that wish to raise capital from registered plans (registered retirement savings plans, registered retirement income funds and other tax deferred vehicles).
LPs are preferred by fund managers who wish to: (i) offer the certainty of statutory limited liability to investors (particularly if the investment strategies create a higher risk of net liability); (ii) provide a complete flow-through of income and losses to investors (while trusts can allocate out all taxable income and capital gains to investors, and avoid taxation at the trust level, losses may only be carried forward); (iii) participate in profits through a carried interest; and/or (iv) use a capital call feature.
Does the regulatory regime distinguish between open-ended and closed-ended Alternative Investment Funds (or otherwise differentiate between different types of funds or strategies (e.g. private equity vs. hedge)) and, if so, how?
AIFs that are redeemable on demand or within a specified period after demand (defined as “mutual funds” under provincial securities laws) are subject to certain control restrictions and financial reporting requirements in most provinces that closed-end funds (defined as “non-redeemable investment funds” under provincial securities laws) are not. Open-ended liquid alts are subject to more investment restrictions than are closed-end liquid alts.
Canadian regulators also differentiate between investment funds (hedge and other pooled funds that passively invest in securities) and private equity funds (funds that seek to exercise control, and/or to be actively involved in management, of investee companies). Managers of private equity funds are not subject to the same registration (licensing) requirements as are managers of investment funds. Funds that carry on an active business (such as direct lending or mortgage origination) or that invest directly in assets other than securities (such as real estate funds) are generally not regulated by securities laws but may be subject to other regulations specific to their industry. (However, capital raising can be a regulated activity for both the fund and its service providers.)
Tax laws, in particular the ability of tax-deferred registered plans to invest in an investment fund, are generally more liberal for a fund that is open-ended.
Are there any limits on the manager’s ability to restrict redemptions? What factors determine the degree of liquidity that a manager offers investor of an Alternative Investment Fund?
AIFs are not limited by securities laws from restricting redemptions, however restrictions on redemption (lock-ups, long notice periods, gates and discretion to suspend redemptions) may affect whether the AIF is regulated as a mutual fund or as a non-redeemable investment fund, as well as its eligibility for tax-deferred registered plans. Liquid alts are generally prohibited from restricting or suspending redemptions except in extraordinary circumstances.
What are potential tools that a manager may use to manage illiquidity risks regarding the portfolio of its Alternative Investment Fund?
Redemption fees, redemptions in kind and the issuance of notes on redemptions can be used to create a disincentive to redeem or provide a method of managing liquidity without affecting a fund’s status as a mutual fund vs. non-redeemable investment fund or its eligibility for tax-deferred registered plans, provided such provisions are within industry norms. Other tools include initial lock-up periods, minimum notice periods, fund-level or investor-level redemption gates and general discretion to suspend redemptions in times of illiquidity. Redemptions in kind and side pockets can also help manage illiquidity, however tax consequences to the fund or to the redeeming stakeholder must be considered.
Are there any restrictions on transfers of investors’ interests?
Yes, interests in AIFs that were initially offered under private placement exemptions are subject to resale restrictions. Any transfer must be made pursuant to a further private placement exemption. There is no regulatory restriction on the resale of an interest in a liquid alt in a province in which the liquid alt was originally qualified for distribution to the public. It is industry practice to require manager consent for any transfer, as an investor’s tax status or residency can have an adverse effect on a fund.
Are there any other limitations on a manager’s ability to manage its funds (e.g., diversification requirements)?
Liquid alts are subject to numerous regulatory investment restrictions, including restrictions that limit concentration and illiquid holdings.
Mutual funds organized under the laws of most provinces are subject to regulatory control restrictions and self-dealing restrictions.
IFMs are generally subject to a fiduciary-like statutory standard of care, which governs their relationship with the funds they manage. Registered PMs are subject to a regulatory standard that ensures that they deal fairly, honestly and in good faith with their clients (including the funds that they manage). Registered PMs are also subject to regulatory conflicts of interest restrictions and self-dealing prohibitions that apply to AIFs whose investment portfolios are managed by the PM.
What is the local tax treatment of (a) resident, (b) non-resident, and (c) pension fund investors (or any other common investor type) in Alternative Investment Funds? Does the tax treatment of the target investment dictate the structure of the Alternative Investment Fund?
Canadian resident taxpayers are subject to tax on their worldwide income. Non-residents may be subject to taxation in Canada if they invest in an AIF that is resident in Canada or carries on business in Canada on distributed or attributed income and capital gains (a trust, for example, would distribute taxable income and capital gains to its investors so that the trust itself does not pay income tax and non-resident investors may be subject to Canadian withholding tax on those distributions; a limited partnership is disregarded as a taxable entity for income tax purposes and so taxable income and capital gains earned by the limited partnership are allocated to partners in the manner provided in the limited partnership agreement and may be subject to Canadian tax if they result from business carried on in Canada). Certain indirect taxes (including provincial sales taxes and/or a federal value added tax payable on fees earned by service providers to the fund, including the IFM and the PM) will be borne by all investors. An AIF that has non-resident investors may be subject to certain withholding taxes, depending on the source of the income or gains, which may be recoverable by Canadian tax payers but not by non-residents except to the extent that they have tax treaty protection. Funds are often structured in a way to mitigate or eliminate adverse tax consequences to investors, however generally anti-avoidance rules under federal income tax legislation must be considered.
Pension funds and tax-deferred registered plans are not subject to income tax in Canada but do bear their indirect share of indirect taxes paid by the fund, and must be mindful of becoming subject to tax in other jurisdictions as a result of activities of the fund.
What rights do investors typically have with respect to the management or operations of the Alternative Investment Fund?
Investors are typically not given rights over the day-to-day management or operations of an AIF. However, the governing agreements for AIFs sometimes provide investors with the right, under limited circumstances and upon a specified majority vote, to remove the IFM or PM of the AIF, terminate the AIF or suspend additional investments. In addition, an AIF manager’s statutory or regulatory standard of care, and rules applicable to them as registered entities, that require them to identify, manage or avoid conflicts of interest, may require them to obtain the prior consent of AIF investors before proceeding with a transaction involving a conflict of interest (e.g. an investment in an entity of which a director or officer of the PM is a director or officer) or to avoid the transaction altogether (or obtain regulatory approval to proceed) (e.g. a purchase or sale of portfolio securities from or to another fund managed by the same PM).
Are managers or advisers to Alternative Investment Funds required to be licensed, authorised or regulated by a regulatory body?
Yes, IFMs (as investment fund managers) and PMs (as advisers) of mutual funds or non-redeemable investment funds must be registered with the applicable regulatory authority, depending on where the IFM or PM is resident, where the fund is resident and/or where the fund is marketed and sold to investors. Entities involved in the marketing and sale of fund interests are generally required to register in a category of dealer, depending on the nature of the fund and the nature of their activities. Third party distributors of fund products generally always trigger the dealer registration requirement, as do managers of mutual funds and non-redeemable investment funds that sell interests of such funds directly to investors. Managers of other types of AIFs (such as private equity and private lending funds) may also trigger the dealer registration requirement, depending on the nature and extent of their capital-raising activities.
Limited registration exemptions are available to non-resident IFMs, PMs and distributors of non-Canadian AIFs that are sold to Canadian investors, however their activities must generally be limited to sales to “permitted clients”, a category of investor that includes financial institutions, pension funds, ultra-high net worth individuals and entitles, and registrants. PMs of non-Canadian AIFs sold to Canadian investors do not trigger the adviser registration requirement if both the AIF and the PM reside outside of Canada and all discretionary trading activity takes place outside of Canada, however they may require IFM registration (or an exemption) if the PM is also the IFM.
Are Alternative Investment Funds themselves required to be licensed, authorised or regulated by a regulatory body?
Generally, no. However, certain corporate AIFs may trigger the IFM registration requirement (and if a non-Canadian AIF, may file for the non-resident IFM exemption) if the board of directors of the AIF retain day-to-day oversight and decision-making responsibility rather than delegate such function to a separate management entity.
Are there local residence or other local qualification or substance requirements?
AIFs structured as limited partnerships, and their general partners, may be considered to carry on business, and therefore required to register in certain provinces (referred to as extra-provincial limited partnership registrations) and to appoint local agents for service of process, depending on the province in which their interests are marketed and sold.
Similarly, non-resident IFMs, PMs and dealers who wish to rely on registration exemptions that are available to them must make certain initial and ongoing filings that include the appointment of local agents for service of process and ongoing reports to the securities regulatory body of the province in which such exemptions are required.
What service providers are required?
No local service providers are required for AIFs sold in Canada. However, if registration as a dealer is triggered by the AIF’s IFM, PM and/or distributor and such entity is unable to become registered or to rely on an available exemption, a local dealer (usually a firm registered as an exempt market dealer, a relatively registration-lite category of dealer registration) may be engaged to sell its AIF in Canada.
Are local resident directors / trustees required?
No. (Canadian corporations in some provinces require 25% (and at least 1) of their directors to be resident in Canada, however this is not required in all provinces.)
What rules apply to foreign managers or advisers wishing to manage, advise, or otherwise operate funds domiciled in your jurisdiction?
A non-resident IFM of an AIF sold in Canada, including an AIF domiciled in Canada, is not required to register as an IFM in Canada if the IFM has no office and carries on no fund management activities in Canada. However, certain securities regulators deem an IFM to carry on business in their province, even if the IFM has no office or otherwise operates in Canada, and require the IFM to register, or file for the non-resident IFM exemption, if the AIF is actively marketed and sold to investors in that province.
A non-resident PM must register (or avail itself of an available exemption) in each province in which its clients (including managed funds) reside.
Firms involved in the marketing and sale of AIFs in Canada must be registered (or exempt from registration) in each province where the AIF is marketed and sold regardless of where the AIF is domiciled.
What are common enforcement risks that managers face with respect to the management of their Alternative Investment Funds?
Securities regulators in Canada (most notably the Ontario and British Columbia Securities Commissions) regularly publish their results of compliance reviews, common deficiencies and best practices by IFMs, PMs and dealers.
Failure to be properly registered, failure to identify clients and their status (e.g. as accredited investors), failure to discharge know-your client and suitability determination obligations, failure to adequately identify, address and/or avoid conflicts of interest and failure to make ongoing regulatory filings, are common and recurring themes.
What is the typical level of management fee paid? Does it vary by asset type?
The range of “market” management fee rates can vary depending on an AIF’s size and strategy, and the investors to whom the AIF is sold. It is unusual to see a management fee in excess of 2.0% of the net asset value of the AIF.
Is a performance fee typical? If so, does it commonly include a “high water mark”, “hurdle”, “water-fall” or other condition? If so, please explain.
AIF managers that offer an “alpha” component, and even some that don’t, may charge a performance fee or directly or indirectly earn a carried interest (that is calculated in the same manner as a performance fee) (in either case, a “performance allocation”). There are tax considerations that will influence whether a performance allocation is structured as a performance fee or as a carried interest (and to whom the carried interest is given).
AIFs that are private equity funds, or are similarly closed-ended and have a finite lifespan, tend to follow the traditional waterfall distribution models based on realized profits (either annually or as cash is available for distribution).
AIFs that are mutual funds or non-redeemable investment funds, or are otherwise “evergreen”, generally pay a performance allocation annually (in some cases semi-annually or quarterly, if returns are more predictable) based on net realized and unrealized income and capital gains in the portfolio (i.e. based on increases in net asset value of the fund). A “permanent” high water mark is generally applied (i.e. it will go up each time a performance allocation is paid and will not be reduced or reset following a period of negative performance). Hurdles (either in the form of a fixed annualized percentage or by reference to a relevant index) come in an out of vogue, depending on the nature of the investment strategy and the general performance of the markets (i.e. the general effect of beta on the strategy) and are typically applied to the high water mark. The performance allocation may be calculated based on fund performance in excess of the high water mark, provided that the hurdle has been met or exceeded, or based only on fund performance in excess of the hurdle.
Are founder shares (which offer a reduce fee structure for initial investors) typical in raising assets for new fund launches?
Yes, founders and early investors are often offered a class of interests bearing lower management fees and/or performance allocations. Sometimes the lower rates have a sunset or may otherwise be ratcheted up over time.
Are management fee “break-points” offered based on investment size?
Yes, management fees may be reduced for investors who meet and maintain minimum investment thresholds.
Are first loss programs used as a source of capital (i.e., a managed account into which the manager contributes approximately 10-20% of the account balance and the remainder is furnished by the investor)?
This is not a common practise in Canada.
What is the typical terms of a seeding / acceleration program?
It is not uncommon for a fund manager to offer investors a lower fee class if they agree to a longer lock-up period or redemption gates that other (higher fee paying) investors are not subject to, depending on the nature of the fund’s investment strategy. This is more common where the investment strategy requires patient capital but the fund manager still wishes to raise capital from investors who demand greater liquidity and are willing to pay higher fees for that liquidity. This practice requires careful consideration by the manager of conflicting investor needs when making investment decisions.
What industry trends have recently developed regarding management fees and incentive fees?
AIFs are tending to offer increasingly large numbers of “fee bands” (multiple classes) as a result of the diversification of target markets and increasing sophistication (and negotiating power) of investors and their investment advisors, as well as greater competition within the industry. Fees are generally being pushed lower, however a “2 +20” fee structure can still be found in at least one class of interest for most AIFs.
What restrictions are there on marketing Alternative Investment Funds?
AIFs must be sold pursuant to exemptions from the requirement under provincial securities laws for an issuer to sell its securities to the public only pursuant to a prospectus that has been filed, vetted and “receipted” by the applicable securities regulator(s). These rules (and the private placement exemptions) are mostly harmonized across the provinces, however there are notable exceptions to such harmonization.
The exemptions are codified in National Instrument 45-106 Prospectus Exemptions (“NI 45-106”) of the Canadian Securities Administrators. The most commonly relied on exemptions in NI 45-106 are the “accredited investor” exemption, which is available in respect of all investors who meet the definition of an “accredited investor”, and the “minimum amount investment” exemption, which is available in respect of entities that invest a minimum of $150,000 in the fund (this exemption is not available to individuals or to entities formed solely for the purpose of relying on the exemption). The availability of these exemptions is not affected by marketing activities.
The offering document pursuant to which the AIF is marketed to Canadians may have to be filed with the local securities regulator, depending on the province, following the first sale of securities pursuant to that offering document (the document is filed but generally not reviewed), and the offering document or subscription booklet may need to be supplemented to provide certain disclosures and disclaimers mandate by applicable securities laws. All private placements under the “accredited investor” and “minimum amount investment” prospectus exemptions (and certain other prospectus exemptions) must be reported either within 10 days of the sale, or in the case of mutual funds and non-redeemable investment funds, within 30 days of the end of the year in which sales took place.
In addition, the marketing and sale of AIFs in Canada will trigger the dealer registration requirement for all persons who are directly marketing to Canadian investors (which can include the fund manager if an intermediary that is registered or has the benefit of an available exemption is not engaged in a meaningful way), and may trigger the investment fund manager registration requirement for the IFM, depending on the province in which the marketing takes place.
Is the concept of “pre-marketing” (or equivalent) recognised in your jurisdiction? If so, how has it been defined (by law and/or practice)?
No, but certain activities that might be described as “pre-marketing” may or may not trigger registration requirements, depending on the nature of the activities and the product or service being marketed.
Can Alternative Investment Funds be marketed to retail investors?
No. Only liquid alts that have filed and cleared a prospectus may be marketed to retail investors (i.e. investors in respect of whom a private placement exemption is not available). Only in limited circumstances and in certain provinces may an AIF be marketed to a non-accredited-investor level person.
What are the minimum investor qualification requirements?
As set out above. “Accredited investors” include, among other categories, institutional investors, pension plans, registered firms and individuals, entities that meet minimum asset tests and individuals that meet minimum asset or income tests.
Are there additional restrictions on marketing to government entities or pensions?
Not under securities laws. Local government laws will determine restrictions on marketing to certain levels and locations of governments.
Are there any restrictions on the use of intermediaries to assist in the fundraising process?
Yes, and dealer registration requirements may require that intermediaries that are registered or exempt from registration as a dealer, in the applicable category and in the applicable province, must be engaged.
Is the use of “side letters” restricted?
No, however the use of side letters may give rise to conflicts of interest that must be managed or avoided by the fund manager.
Are there any disclosure requirements with respect to side letters?
Failure to disclose the existence of side letters, and any material terms that would be relevant to another investor making or maintaining an investment in the fund, may be viewed as a failure by a fund manager to discharge its statutory obligations to the fund and its investors, or could constitute a “misrepresentation” giving rise to statutory rights of action or rescission to investors in certain provinces.
What are the most common side letter terms? What industry trends have recently developed regarding side letter terms?
As elsewhere, Canadian side letters typically contain a most-favoured-nations clause, a modified fee arrangement, rights to transfer to affiliated entities, preferential redemption terms and/or enhanced reporting obligations. Care must be exercised if granting a combination of enhanced reporting and preferential redemptions rights, as it could provide the recipient with an unfair advantage over other investors and may be viewed by securities regulators as creating an irreconcilable conflict of interest.