This country-specific Q&A provides an overview of Alternative Investment Funds laws and regulations applicable in Hong Kong.
What are the principal legal structures used for Alternative Investment Funds?
Alternative Investment Funds (“AIFs”) may be established in Hong Kong in the form of unit trusts, open-ended fund companies (“OFCs”) or limited partnership funds (“LPFs”).
As there are no requirements for AIFs offered in Hong Kong to be established locally, they are often set up as special purpose vehicles or limited partnerships domiciled in foreign jurisdictions such as the Cayman Islands.
Does a structure provide limited liability to the sponsor and/or manager vis-a-vis investors?
Generally, all structures provide limited liability to the investors. Unit trusts are required by the SFC to limit the liabilities of holders to their investments in the scheme. The liability of investors of corporate-structured funds are limited to the share capital of their investments and investors of partnership-structured funds are limited to their agreed commitments.
Is there a market preference and/or most preferred structure? Does it depend on asset class?
Unit trusts are not often used for private AIFs and are more popular among retail AIFs. OFCs are used for both retail and private funds and LPFs are more preferred for private funds, although there are no statutory restrictions for using any structures for particular types of investments.
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?
In Hong Kong, the legislative regime does not distinguish open-ended or closed-ended AIFs, or otherwise differentiate between different types of funds or strategies. AIFs generally fall within the scope of “collective investment schemes”, which are defined as “securities” under the Securities and Futures Ordinance (Cap. 571) (“SFO”), and are bound the SFO.
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?
For open-ended AIFs, subject to the terms in the fund’s constitutive documents, a manager may restrict redemption under rare circumstances, such as in cases of unusually high volume of redemption requests (which risks the liquidity or solvency of the fund) caused by economic downturns, natural disasters, corporate action (e.g. mergers or re-organisations) or departure of key personnel.
What are potential tools that a manager may use to manage illiquidity risks regarding the portfolio of its Alternative Investment Fund?
Under the Funds Manager Code of Conduct (“FMCC”), all fund managers in Hong Kong that are responsible for the overall operation of a fund are required to have proper liquidity management controls in place. The associated liquidity risks involved in investing in a fund, the liquidity management policies and an explanation of the tools or exceptional measures that could affect redemption rights should also be included in the offering documents. Potential tools include redemption notice periods, redemption fees, application of redemption gates, temporary suspension of redemptions, redemptions in-specie and side pockets.
Are there any restrictions on transfers of investors’ interests?
Investors are generally bound by anti-money laundering laws and, depending on the legal structure of the fund, investors may also be restricted from on-selling their interest to the public of Hong Kong. Further restrictions may also be set out in the constitutive and offering documents, e.g. obtaining consent from the existing investors or relevant fund governance body.
Are there any other limitations on a manager’s ability to manage its funds (e.g., diversification requirements)?
Managers of private AIFs are generally restricted to the extent of the limitations in the management agreement, which should clearly outline the investment objectives, strategies, policies and scope, including the different types of investments or products, investment restrictions, diversification requirements, borrowing limits and hedging arrangements. Additionally, as required by the FMCC, fund managers in Hong Kong need to ensure that all transactions are in accordance with the offering documents (where there is one), but also that it should take into account the funds’ stated objectives and not trade excessively on behalf of the fund.
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?
Regardless of the investor type, there are no withholding tax regimes in Hong Kong for any dividends, distributions, capital gains or other gains paid to the investors. For individuals, personal investment income and capital gains are generally not subject to tax in Hong Kong unless such income or gain is part of that individual’s trade, profession or business. For corporate investors, profit tax may be payable if it carries on a trade, profession or business, and derives profit from such activities, in Hong Kong.
For private AIFs, they may be eligible for the Unified Funds Exemption, whether or not the vehicle is resident in Hong Kong, if certain eligibility requirements are met. The Unified Funds Exemption exempts the income arising from “qualifying transactions” and transactions incidental to the carrying out of “qualifying transactions” of up to 5 percent of the fund’s total trading receipts. “Qualifying transactions” being investments in specified asset classes including securities, futures contracts, foreign exchange contracts, bank deposits, exchange-traded commodities, foreign currencies and OTC derivative products.
For tax purposes, investors’ preference/status may dictate the structure of the AIF. This is usually most relevant for AIFs with potential US investors as, due to US laws and regulations, certain investors will prefer investing in “pass-through” entities (e.g. partnerships) and others prefer investing in “blockers” (e.g. corporates).
What rights do investors typically have with respect to the management or operations of the Alternative Investment Fund?
Typically, investors have the right to participate in the income and profits arising from the management of the assets and transactions of the AIF; investors do not have any rights over the management or operations of the AIF. Subject to the constitutive documents, investors may also have rights to remove the manager or general partner of a fund, but in very limited circumstances, such as in the event of a material breach of its obligations.
Where customization of Alternative Investment Funds is required by investors, what types of legal structures are most commonly used?
If, for certain reasons, a separate vehicle is required to be established to cater for investors’ needs, such separate vehicle will usually be structured in the form of a feeder vehicle, a parallel vehicle or an alternative investment vehicle, and depending on the circumstances can be structured in the form of a separate corporate entity, unit trust or limited partnership.
Are managers or advisers to Alternative Investment Funds required to be licensed, authorised or regulated by a regulatory body?
Managers and advisers are required to be licensed by the SFC if they carry on a business, or hold themselves out as carrying a business, in a regulated activity in Hong Kong. For managers, this would be “asset management” (Type 9 regulated activity), which gives them full discretionary investment authority with respect to the funds they manage, whereas for advisers, this would be “advising on securities” (Type 4 regulated activity).
Additionally, in a circular issued by the SFC on 7 January 2020, the SFC clarified that general partners of PE funds are generally required to be licensed in Type 9 regulated activity, unless they have fully delegated asset management functions to another Type 9 licensed entity. The SFC further emphasised that for PE firms which offers co-investment opportunities to other persons will likely fall within the scope of “dealing in securities”, thereby requiring a Type 1 license too.
Are Alternative Investment Funds themselves required to be licensed, authorised or regulated by a regulatory body?
Private AIFs are typically offered to professional investors in Hong Kong, or in other manner as restricted under law (for example, to employees and no more than 50 persons, etc.) so that the AIFs themselves will not be required to be authorized by the SFC.
However, if the AIF is to be marketed or offered to retail investors in Hong Kong, it needs to be authorized by the SFC and in accordance with the requirements set out in the UT Code or the OFC Code, which may or may not be possible depending on the investment strategy and other factors.
Does the Alternative Investment Fund require a manager or advisor to be domiciled in the same jurisdiction as the Alternative Investment Fund itself?
For LPFs there is such a requirement – the investment manager must be a Hong Kong resident who is at least 18 years old, a Hong Kong company or a foreign company registered as a non-Hong Kong company under the Companies Ordinance (Cap. 622). For OFCs, there is a requirement to appoint a Hong Kong manager that is licensed to conduct Type 9 regulated activity (asset management).
Are there local residence or other local qualification or substance requirements?
For local structures, a local presence is usually required, which may be in the form of a local company, registered office or authorized person. Managers in Hong Kong are also required to be licensed by the SFC.
For foreign AIFs offered in Hong Kong, there are generally no local residence or qualification or substance requirements.
What service providers are required?
With respect to private AIFs: (i) OFCs are required to appoint an investment manager, a custodian and an independent auditor; (ii) unit trusts are required to appoint a trustee and a management company; and (iii) LPFs are required to appoint an investment manager and an independent auditor; custodians are not mandatory as long as there is proper custody of assets.
Additional requirements may be required for retail AIFs.
Are local resident directors / trustees required?
For non-Hong Kong vehicles, there are no requirements for directors or trustees to be residents of Hong Kong.
For private AIFs established in Hong Kong: (i) directors of OFCs do not need to be Hong Kong residents but local process agents must be appointed; (ii) the trustees of unit trusts do not need to be local; and (iii) for LPFs, its general partner needs to be a natural person at least 18 years old, a Hong Kong private limited company, a registered non-Hong Kong company, another LPF or a limited partnership established outside of Hong Kong (but for the latter two categories, a local authorized representative is required).
Additional requirements may be required for retail AIFs.
What rules apply to foreign managers or advisers wishing to manage, advise, or otherwise operate funds domiciled in your jurisdiction?
Regardless of whether based in Hong Kong or abroad: (i) managers and advisers of all funds domiciled in Hong Kong are bound by the SFO; (ii) managers and advisers of authorized retail unit trusts domiciled in Hong Kong are bound by the UT Code; (iii) managers and trustees of REITs domiciled in Hong Kong are bound by the REIT Code; and (iv) managers of OFCs are bound by the OFC Code.
If they are conducting a regulated activity in Hong Kong (see question 12 above), or actively marketing a fund to the public of Hong Kong (see question 27 below), they will also need to be licensed by the SFC. In the event that a licence is granted, the foreign manager will be required to comply with the Code of Conduct for Persons Licensed by or Registered with the SFC (“Code of Conduct”) and the FMCC.
What are common enforcement risks that managers face with respect to the management of their Alternative Investment Funds?
The SFC is the regulator in Hong Kong which exercises enforcement powers under the SFO. Each year the SFC conducts random audits of licensed entities to ensure its compliance with the SFO and the relevant codes issued by the SFC, including the Code of Conduct. In its 2020-2021 annual report, it was noted that the SFC had conducted 304 on-site inspections during the year and had issued 231 compliance advice letter to address areas of regulator concern, raise standards of conduct and promote compliance. If serious breaches are found, the SFC will also take disciplinary actions, which range from monetary fines, criminal proceedings, disqualification orders and bans from re-entering the industry. In 2020-2021, the SFC had taken disciplinary action against 31 persons and 18 corporations on issues including AML-related breaches, deficient selling practices, regulatory breaches of short selling and internal control deficiencies.
What is the typical level of management fee paid? Does it vary by asset type?
Management fee is typically between 1.5% and 2.0% and does range by asset type (e.g. funds investing in real estate will be at the lower end). Other varying factors include investment strategy (e.g. blind pool investments will also be at the lower end) and the fund size (e.g. funds over US$1 billion will usually have less than 2.0%).
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.
Yes, due to different tax implications, it is can also appear in the form of “performance allocation”, “incentive fee”, “incentive allocation” or “carried interest”. Usually, the performance-related bonus is around 20%, payable to the manager or its affiliate. Such bonus is usually only payable if the “hurdle rate” (usually around 6-8%), with reference to the fund’s annual rate of return, is exceeded. Hedge funds also commonly include a “high water mark”, a concept which only entitles the manager to the performance bonus if the fund exceeds the highest NAV it previously achieved.
The distribution of a PE fund’s capital gains commonly appears as a “waterfall”, being distributed in several levels. Generally speaking, the first level involves a return of the investors’ capital contributions, the second level is distributed to investors until they receive the “preferred return” (usually also around 6-8%) on their investment, the third level is distributed to the sponsor for it to catch-up until it receives the full amount of its performance bonus, and the last level is distributed in accordance with the carried interest rate split between the sponsor and the investors.
Are fee discounts / fee rebates or other economic benefits for initial investors typical in raising assets for new fund launches?
Yes, this is a commercial decision between the fund and the investor. In hedge funds, this is usually reflected in a separate share class or side letters, but whilst there may be a reduced fee structure, this is often coupled with a higher minimum investment amount. In PE funds, this usually appears in the form of the sponsor committing capital into the fund as an investor and reflected in the side letters.
Are management fee “break-points” offered based on investment size?
Yes, this is a commercial decision between the fund and the investor. Reduced management fee may be also given on the profile of the investor (e.g. strategic alliances) and to early-bird investors.
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)?
Yes, in hedge funds. Often, an affiliate of the manager will contribute capital as an investor in a separate share class or in side letters. However, whilst the manager’s share class will absorb the fund’s losses first, the return of the investors’ share class is also usually capped.
What is the typical terms of a seeding / acceleration program?
Typically, investors in seeding and acceleration programs will offer a budget (e.g. interest-free loan) to small or new companies (“Seeders”) to finance their working capital needs in return for certain equity ownership in the Seeders (or its management entity). The investors will be given investor protection rights and may also be offered additional rights to participate in the management or material decision-making of the Seeders. The program usually runs for at least 3-4 years. At certain intervals during the program and/or at the end of the program, investors will have the option to withdraw their equity ownership (or alternatively, the Seeder may have a call option to call back the stake from the investors) and/or have capacity rights to make additional investments.
What industry trends have recently developed regarding management fees and incentive fees?
In the more recent times, we have seen a downward pressure from 2.0% in management fees, particularly as the size of funds are getting larger. In some cases, coupled with lower fees, we have also seen a rise in “super carry”, which is a higher performance fee or carried interest paid (up to 30% or more) if the returns of the fund exceeds certain benchmarks.
In general, we have also seen that secondary funds (or commonly known as “funds-of-funds”) charge lower management fees than primary funds, and may also set lower benchmarks for to earning carry or performance based returns.
What restrictions are there on marketing Alternative Investment Funds?
Marketing of AIFs is considered to fall within the scope of Type 1 regulated activity (dealing in securities) under the SFO, hence any entity engaged in Hong Kong to conduct marketing activities must hold a Type 1 licence issued by the SFC. If the marketing activities are conducted from outside of Hong Kong, a licence would be required if a person “actively markets” to the public of Hong Kong.
Apart from the conduct of marketing, the marketing materials may also need SFC authorization, unless an exemption applies. One of the exemptions is offering to professional investors in Hong Kong, and as this is the typical case for AIFs, authorization is not normally required.
Is the concept of “pre-marketing” (or equivalent) recognised in your jurisdiction? If so, how has it been defined (by law and/or practice)?
“Pre-marketing” is not defined or recognised as a concept under Hong Kong law. However, for unlicensed persons or entities, to err on the side of caution, such marketing efforts should be based on general investment strategies only, with no references to any specific “securities” or the services that will be provided.
Can Alternative Investment Funds be marketed to retail investors?
Yes, if it is authorized by the SFC.
Does your jurisdiction have a particular form of Alternative Investment Fund be that can be marketed to retail investors (e.g. a Long-Term Investment Fund or Non-UCITS Retail Scheme)?
In Hong Kong, private AIFs are typically offered only to professional investors. Offerings to retail investors would require approval from the SFC, unless otherwise exempted (see question 31 below).
What are the minimum investor qualification requirements?
Generally, private AIFs are distributed in Hong Kong on the basis that they are exempted from authorization from the SFC. The exemptions that are commonly relied upon (which depends on the legal structure of the AIF, and does not vary by asset class) include:
offerings to “professional investors” only, which is defined in the SFO to include recognized exchange companies and clearing houses, regulated investment business professionals, regulated banks, regulated insurers, authorized collective investment schemes, pension schemes, governments (other than municipal government authorities), central banks and multilateral agencies, substantial trusts meeting a HK$40 million minimum asset requirement and high net worth individuals or businesses meeting a HK$8 million minimum investment portfolio or a HK$40 million minimum asset requirement;
offerings to 50 persons or less, whereby two or more offers in relation to the same class of shares or debentures may be taken as one if (i) the offers were made by the same person and (ii) the offers were made within a 12-month period;
offerings of a minimum consideration, of which the total consideration payable for the shares concerned must not exceed HK$500,000; and
small offerings, of which the maximum subscription amount must be less than HK$500,000 or that the total maximum offering must be less than HK$5 million.
Are there additional restrictions on marketing to government entities or pensions?
Governments and institutions which performs functions of a central bank, sovereign wealth funds, mandatory provident funds, occupational retirement schemes and insurers all fall within the definition of “professional investor” under the SFO. There are no additional restrictions on marketing to such entities but unless an exemption applies, the marketing conduct should be carried out by a licensed person.
Are there any restrictions on the use of intermediaries to assist in the fundraising process?
There are no restrictions on the use of intermediaries to assist in the fundraising process but the intermediary should be licensed to conduct Type 1 regulated activities if it intends to conduct the activities in Hong Kong or “actively market” to the public of Hong Kong (see question 27 above).
Is the use of “side letters” restricted?
Are there any disclosure requirements with respect to side letters?
It is good practice to disclose in the fund’s offering documents that side letters may be entered into which result in preferential treatment for certain investors over others. The SFC also encourages disclosure of material terms to all existing and potential investors and highlight (where applicable) that side letters have been entered into only with investors with significant shareholding or interest.
In the FMCC, there is also a note emphasising that where a fund manager has granted preferential treatment (e.g. side letters) to certain investors, it should disclose such fact and the material terms in relation to redemption in the side letters to all relevant potential and existing fund investors.
What are the most common side letter terms? What industry trends have recently developed regarding side letter terms?
The most common side letter terms we have seen include:
confidentiality provisions for fund-of-funds;
Most Favoured Nation provisions;
preferential redemption rights (for hedge funds); and
excuse rights (for PE funds).
Estimated word count: 3719
Privacy & Cookies Policy