You Can’t Manage the ’40 Act: Five Pointers for Private Managers Considering a Registered Fund
Private fund managers considering the launch of a registered fund are entering a different world. For those stepping into the closed-end interval or tender-offer fund arena, here are some things to know as you orient yourself to the public fund arena.
When one of my sons was in high school, he would transition right from football season to basketball season. He’d still have a football mindset on the basketball court and would rack up three fouls in the first quarter. His coach would say, “Don’t get in the way of your own success.” That meant reorienting himself to the new world he just stepped into. Private fund managers have similar reorienting to do when launching a registered fund.
To shift mindsets from private to registered investment funds means accepting the rules of the new game. Rules and regulations evolve, but the basic framework governing registered funds has existed for more than eight decades. The Investment Company Act of 1940 and the Securities Act of 1933 and the rules adopted for these acts, among others, must be understood and followed.
That sounds obvious, but in practice it isn’t. Private fund managers interested in launching a registered product like an interval fund or tender-offer fund often do so because they have achieved significant investment and business success managing unregistered funds. They thrive in the context they know. It’s no surprise some hope to put a new, registered fund wrapper around a strategy that has worked well.
The quicker that managers begin to focus resources on developing a structure to understand and comply with the rules, the quicker they can work to further develop their business strategy. I suggest they channel energy into doing what’s necessary to make a registered product successful. This approach can save money and time and lead to success. No one wants to delay a fund launch or spend more on legal review and outside counsel. But I see this happen regularly.
To avoid delays, dollars and frustration, keep in mind these five facts about the registered fund world.
- Managers have to develop a significant infrastructure to comply with certain rules that is not required for private funds.
This takes time and money to set up. You need to retain outside counsel for the fund. Not only that, you need to listen to and rely on them. You need experienced, independent auditors and a qualified chief compliance officer—and to leverage them. You need a qualified board. Your board members have fiduciary responsibility to shareholders of the fund. The board hires the advisor, which means they are your boss. This is a major shift in mindset for many private managers to grapple with. You manage the assets, but the board oversees the fund.
- You have to meet fixed deadlines.
There’s a whole array of tasks—audits and filings are an example—that must occur by specified dates. You must provide notification to the board on a timely basis. You must wait for the board to approve certain documents or actions. You simply do not have full control of the pace and you must not fail to meet the deadlines that apply to a registered fund.
- All shareholders must be treated equally.
In a private fund, there is more flexibility to create side-pocket special arrangements or other arrangements that provide for different treatment of holdings. However, in a registered product, differing rights must be done within the framework of established rules, typically by creating different share classes.
- Be aware of the tax consequences of the fund’s investments.
This sounds obvious, but the topic comes up in practice most commonly with respect to “bad income.” You have to meet “good income” tests set forth in the Internal Revenue Code if you want to issue 1099s, which most managers do if they are seeking to play in this market. Be aware that the fund may have more tax work than you are used to. Essentially, K-1s enable funds (whether public or private) to delegate work to the investor’s accountant.
But with 1099s, you’ll need to go through an annual distribution review and have everything buttoned up early in the calendar year to send forms. For more detail on tax topics, see my colleague Terry Gallagher’s article, Nuances that trip up investment managers forming tender-offer and interval funds.
- You’ll need a qualified custodian.
In the private fund world, “custody” may be a function provided by your prime broker as part of a spread. In the public fund world, the custodian function is quite different and there are specific types of entities that are allowed to safekeep investor assets, such as a bank that is a “qualified custodian.” Typically bank custodians also process transactions and corporate actions.
Expense—but also an opportunity
Nothing I’ve covered here suggests that moving into the registered fund world is uneconomical. It may in fact be highly attractive. We’ve had the honor of assisting many managers with interval funds, tender-offer funds and other registered fund structures that suit their target markets.
Still, it’s helpful to start out with a presumption that meeting regulatory requirements is likely to cost more than you think it will. Depending upon the structure and strategy or a registered fund, compliance costs can be significant. You can keep costs and frustration down by putting your energy into working within the rules rather than fighting against them, and by following the advice of your service provider partners, rather than questioning regulations or exploring potential exceptions to rules to which there really aren’t exceptions.
Just remember: you can’t manage the ’40 Act. It’s going to manage you. Listen to your coach, and don’t get in the way of your own success.
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