Launching a private fund is a fairly streamlined process compared to launching a registered fund, in part because there’s no need to wait for the Securities Exchange Commission (SEC) to complete its review and for its approval to become effective. That speed differential is prompting some investment managers to launch a strategy privately with a plan—from the beginning—to convert their private fund to a 1940 Act registered fund.
Managers have described the process to us as using the private-fund stage as “training wheels” on their way to launching what is typically their first registered product.
This type of anticipated private-to-registered fund conversion is growing in popularity, based on our observations, for two reasons. First, competition. A manager lining up a promising strategy is keenly aware that others are likely doing so also. Second, available capital. If a manager has seed money available to go to work right away, both the manager and the seed investors may wish to go after investment opportunities sooner than later.
Three paths for private fund managers getting started with registered funds
Behind all of this is investors’ increasing comfort buying alternative products in registered-fund wrappers. We are in about year six or seven of an explosion of investment vehicles inside tender-offer and interval-fund wrappers. These registered-fund structures make investments available that investors could previously access only through private funds. The upshot is a wider distribution base for managers and greater portfolio diversification opportunities for investors in the mass-affluent category.
Our team has been intimately involved in the rise of interval and tender-offer funds. That work has led us to a 30% market share for administration of unlisted closed-end funds, according to a FUSE Research report late last year. Along the way, we’ve helped guide managers with significant assets in the private space get their feet wet in the registered space. Here are three typical paths.
Often, we see a manager launch its first registered fund featuring a strategy that largely mirrors one they operate already as a private fund. If time permits, the manager may simply continue operating that private strategy as it goes through the setup and regulatory demands necessary for ’40 Act registration.
Sometimes, to speed the process, a manager may choose to launch as a ’40 Act fund before also completing ’33 Act registration. (It is the ’33 Act registration that enables a public offering of a registered fund.) This approach can work well when there’s just one investor—say, the manager putting its own seed capital to work. The risk of this approach is that the SEC might, as part of the ’33 Act process, unexpectedly make a substantial comment that requires the manager to go back to investors, offering the opportunity for recission. If the manager itself is the only investor, it can of course be confident it won’t rescind. Paperwork changes can be made, the ’33 Act registration can be completed, and then the fund can be offered publicly.
But what if there’s a need for even greater speed? In this case, it may make sense to launch a strategy as a private fund while already anticipating a later conversion to a registered fund. What follows are suggestions, based on our experience, for managers contemplating this path.
Suggestions for managers with plans for a private fund conversion
Operating in the registered-fund space is an eye-opening experience for most managers who have previously worked only in the private-fund arena.
Understand the regulatory requirements
The rules emanating from the Investment Company Act of 1940 and the Securities Act of 1933 are simply unavoidable. Managers need to develop a significant infrastructure that isn’t required for private funds. They have to meet specific deadlines, treat all shareholders equally, carefully consider tax consequences, and engage a qualified custodian.
Even apart from the demands of SEC review, getting going takes time and effort. This is why the “training wheels” concept is so apt. Managers may launch a private fund—a process they already know—with a plan to actively learn and prepare for an anticipated conversion. All the while, they can track performance with an eye to eventually move into the retail space, with a broader fund distribution strategy.
Be strategic with distribution
Distribution strategy is key. It sounds obvious, but it’s worth saying that converting a successful strategy to a registered fund by no means assures success with a public offering. In this model of starting private, be sure to use the initial, private period to refine your approach to fund distribution. Have a basic distribution plan in place even before you launch the private version of a fund you plan to later convert.
Prepare your team for conversion
To help ensure a smooth conversion later, have conversations with your service team from the outset. That includes your legal counsel, auditors and fund administrator. Knowing you want to later convert, everyone involved will focus on eliminating, as much as possible, the element of surprise. For example, your auditor will advise on whether you’re likely to need a tax opinion to support an anticipated tax-free conversion.
Consider the future paperwork
Another example is the need to understand the concept of “good income” with respect to interval or tender-offer funds. If you plan to issue your investors 1099 tax forms (as opposed to the K-1s typical for private investments), you need to make sure you invest in holdings that generate income that qualifies for simpler, more investor-friendly 1099 reporting.
Understand valuation and investor communication
Yet another area for “training wheels” focus is your valuation policy. Use the private-fund phase to ensure you fully understand the valuation exercise, including how you communicate with your business partners through those recurring cycles.
You’ll also want to be sure your attorneys have considered, early on, how a plan of reorganization will be drafted, and how the investor approval process will work.
As much as possible, avoid the element of surprise. Avoid assumptions—such as that you’ll be able to make use of a private-fund performance history when making a public offering. Morningstar won’t present that history; whether you’ll be able to in your own communications is a matter for exploration.
There are many paths to success. Launching a private fund with an anticipation of converting to registered is likely a natural one for many managers with innovative strategies and capital available to put to work.
Learn more about UMB Fund Services and how we can support your firm’s registered and alternative investment fund servicing needs, or contact us to be connected with a fund services team member.