This three-part series covers not only what it takes to launch a fund, but what it takes to launch a potentially successful fund. If you missed the first two installments, they can be accessed here:
In this final post, the compliance and regulatory types of questions regarding a fund launch are answered.
What are the general limitations in a ’40 Act fund?
Internal Revenue Code Qualifications: For any mutual fund to be able to pass through its income to shareholders, the fund must meet certain qualifying tests under Internal Revenue Code. One of the regulated investment company (RIC) tests requires that the fund meet quarter-end diversification limits. At least 50% of the fund’s total assets needs to be represented by cash, cash equivalents, U.S. government securities, other regulated investment companies (such as mutual funds or ETFs), or security holdings from the same issuer worth 5% or less of total assets. For example: 10 security holdings of 4% each, 8% in another mutual fund and 10% in cash would meet the 50% diversification requirement. Except for its first tax quarter-end, security holdings that appreciate over 5% of total assets remain as qualifying assets, unless the fund has added to the position over the quarter. A fund cannot own more than 25% of its total assets in a single issuer (excluding U.S. government securities or the securities of other RICs) at tax quarter-end. To qualify as a RIC, a fund must derive at least 90% of its gross income for the tax year from investment related activities, such as dividends, interest and gain on sale of securities. Finally, a RIC needs to distribute to shareholders at least 90% of its investment company taxable income, which includes net investment income and net capital gains.
Diversification: If a fund holds itself out to be a “diversified” fund, at least 75% of the fund’s total assets needs to be represented by cash, cash equivalents, U.S. government securities, other regulated investment companies (such as mutual funds or ETFs), or security holdings from the same issuer worth 5% or less of total assets.
Liquidity: A mutual fund is limited to a maximum of 15% in illiquid investments (generally, investments that cannot be sold for the fund’s carrying value within 5 business days). Many funds that hold illiquid investments have lower internal limits, to avoid inadvertently violating the regulatory limit. However, liquidity has been a major topic of discussion and liquidity classifications will be evolving with the recently adopted SEC Rule 22e-4. The rule will require funds to create a documented liquidity risk management program intended to measure, manage, and regularly evaluate liquidity risk. The new regulations will require advisers to regularly monitor and report the liquidity classifications of each investment in the portfolio.
Leverage: The ‘40 Act rules regarding leverage apply to borrowed money. Generally, a fund can borrow only up to 33% of the overall investable portfolio. The borrowings are subject to a 300% asset coverage requirement, meaning that a fund may borrow amounts that do not exceed 50% of its assets, excluding the amount of borrowings. For example, if the fund has $50m in assets, it could borrow $25m from a bank. $25m is 33% of the total $75m of investable assets. Inherent leverage in derivative investments do not currently fall under the ‘40 Act leverage rules above; however, they are subject to various collateral requirements and senior security issuance rules, and the SEC has proposed more rules for derivatives in funds.
Can a performance fee be charged by the adviser?
Traditional performance-based fees are not allowed in a ’40 Act mutual fund. A management fee assessed against total fund assets (subject to any stated fee caps) is the typical adviser fee arrangement for ’40 Act mutual funds. There is, however, a performance-based fee structure, called a Fulcrum Fee, that can be used in a ‘40 Act mutual fund.
What is a Fulcrum fee and how does it work?
A fulcrum fee is a performance fee applied based on the managers performance against a set benchmark (must be an appropriate/rational benchmark). The management fee is increased or decreased based on the managers performance against the benchmark and as stated in the prospectus. For example, let’s say the base management fee is set at 0.75% (75 basis points). The prospectus states that a performance-based fee of 0.01% (1 basis point) will be added or deducted to the management fee for every 0.10% (10 basis points) of absolute performance against the benchmark; with a cap of 50 basis points (the maximum allowable rate is equal to the stated base management fee). That means the management fee could range from 1.25% (125 basis points) down to 0.25% (25 basis points) in this example. Put simply, the management fee pivots higher or lower based on the outperformance or underperformance, respectively, against the benchmark over a stated, rolling period of time.
Can the track record from Separately Managed Accounts (SMAs) be used to market the fund?
No – FINRA rules only allow the use of the fund’s track record to market the fund. The prospectus can include a section regarding manager experience in running a similar strategy and show that performance in the initial prospectus, eventually to be replaced by the fund performance. However, that performance information still cannot be used in any marketing materials.
Can a hedge fund be converted into a mutual fund?
If the hedge fund strategy meets the ’40 Act constraints and can be run substantially similar in a mutual fund, conversion is often possible. Investors in the hedge fund on the conversion date would be converted to mutual fund shareholders and the hedge fund would cease operation. In this case, the applicable track record of the hedge fund would be carried over to the mutual fund and could be used in fund marketing materials. Please note, the rating agencies generally do not recognize the hedge fund track records for ratings purposes.
As with any undertaking of this magnitude, there can be lots of questions and many variables to consider. If you are contemplating launching a mutual fund, whether it be open-end, closed-end or another type, and are interested in a more in-depth conversation about your specific details, please contact us.
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