A primer on registered closed-end funds, specifically interval funds

Transcription

1 Straight to the point A primer on registered closed-end funds, specifically interval funds October 19, 2017 Cynthia M. Krus Partner Cynthia R. Beyea Partner Payam Siadatpour Counsel 2017 (US) LLP All Rights Reserved. This communication is for general informational purposes only and is not intended to constitute legal advice or a recommended course of action in any given situation. This communication is not intended to be, and should not be, relied upon by the recipient in making decisions of a legal nature with respect to the issues discussed herein. The recipient is encouraged to consult independent counsel before making any decisions or taking any action concerning the matters in this communication. This communication does not create an attorney-client relationship between (US) LLP and the recipient. (US) LLP is part of a global legal practice, operating through various separate and distinct legal entities, under. For a full description of the structure and a list of offices, please visit

2 Non-traded closed-end funds

3 Traditional, non-traded closed-end funds Overview Historically, registered closed-end funds have been listed and traded on stock exchanges The traditional non-traded closed-end fund model emerged within the past decade, following after non-traded REITs and then non-traded BDCs Certain market conditions and the regulatory environment have sparked an interest in non-traded registered closed-end funds, and specifically interval funds because of certain advantages that we will discuss 3

4 Traditional, non-traded closed-end funds General regulatory framework Non-traded closed-end funds are investment companies registered under the Investment Company Act (the 1940 Act ) and include several features that are advantageous, including: Securities of closed-end funds are not redeemable and cannot be sold back to the fund upon the shareholder s request. Public offerings are exemptfrom state blue sky requirements and the shares issued are covered securities. A Registration Statement allows for three years and extends for an additional 180 days by filing a subsequent Registration Statement. (Of course, subsequent registration statements are subject to a SEC and FINRA review/comment process) Semi-annual reports contain less disclosure than are required for operating companies, plus no Form 8-Ks are required. 4

5 Traditional, non-traded closed-end funds General regulatory framework (cont.) Leverage Limitations -300% asset coverage ratio requirement Incentive fees generally permitted only on investment income. Incentive fees on capital gains are permitted to the extent all of the fund s investors are qualified clients. Ability to sell shares below NAV: Exception for rights offering. No ability to seek annual blanket approval. Approval required from majority of shareholders. 5

6 Traditional, non-traded closed-end funds General regulatory framework (cont.) Leverage Limitations -300% asset coverage ratio requirement Incentive fees generally permitted only on investment income. Incentive fees on capital gains are permitted to the extent all of the fund s investors are qualified clients. Ability to sell shares below NAV: Exception for rights offering. No ability to seek annual blanket approval. Approval required from majority of shareholders. 6

7 Traditional, non-traded closed-end funds General regulatory framework (cont.) FORM N-PORT As information is viewed as more free flowing, the SEC rescinded semiannual portfolio reporting in favor of a new monthly portfolio reporting form, requiring information about portfolio holdings to be filed 30 days after the end of each month. This information is not made public monthly, but only quarterly, and even then not for 60 days after the quarter s end. The SEC adopted a tiered compliance dates for Form N-PORT: June 1, 2018, for larger entities (i.e., funds that together with other investment companies in the same group of related investment companies have net assets of $1 billion or more as of the end of the most recent fiscal year). June 1, 2019, for smaller entities (i.e., funds that together with other investment companies in the same group of related investment companies have net assets of less than $1 billion as of the end of the most recent fiscal year). 7

8 Traditional, non-traded closed-end funds General regulatory framework (cont.) At least 40% of a registered investment company s board of directors must be independent, unless using an affiliated principal underwriter, in which case must have a majority of independent directors In order to rely on certain exemptive rules under the 1940 Act a registered closed-end fund must satisfy the requirements of Rule 0-1(a)(7)(iii)-(vii): Any person who acts as outside legal counsel for the disinterested directors must be independent legal counsel as defined by 1940 Act Rule 0-1(6);Registered closed-end funds generally must place and maintain their securities and similar investments in the custody of a bank or a broker dealer. The board of directors must evaluate at least once annually the performance of the board of directors and its committees, including the effectiveness of the committee structure and number of companies on whose board each director serves; The disinterested directors meet at least once quarterly without the interested directors present (i.e., hold an executive session); and The disinterested directors have been authorized to hire employees, and retain advisers and experts necessary to carry out their duties. Exemptive rules under the 1940 Act which may be relevant include the following: Rule 12b-1 relating to asset based distribution fees Rule 15a-4 relating to interim investment advisory contracts for the Company; Rule 17a-7 relating to purchases and sales of securities between Company and certain of its affiliates; Rule 17a-8 relating to mergers with affiliates companies; Rules under Rule 17d-1 relating to joint arrangements and profit-sharing plans between Company and its principal underwriter or affiliates thereof; Rule 17e-1 relating to certain brokerage fees and commissions; Rule 17g-1 relating to the bonding of officers and employees; and Rule 23c-3 relating repurchase offers of securities issued. 8

9 Traditional, non-traded closed-end funds General regulatory framework (cont.) Closed-end funds can elect to be treated and to qualify each year for taxation as a Regulated Investment Company ( RIC ) under Subchapter M of the of the Internal Revenue Code of 1986, as amended (the Code ).At least 40% of a registered investment company s board of directors must be independent, unless using an affiliated principal underwriter, in which case must have a majority of independent directors In order for a closed-end fund to qualify as a RIC, it must meet certain source-of-income, asset diversification and annual distribution requirements. RICs are not be subject to federal income tax to the extent they distribute investment company taxable income and net capital gains. The Code imposes a 4% nondeductible excise tax on RICs to the extent they do not meet certain distribution requirements by the end of each calendar year. 9

10 Traditional, non-traded closed-end funds Shareholder liquidity May institute share repurchase program and periodically offer to repurchase shares from stockholders via tender offers subject to Rule 13e- 4 of the 1934 Act. Amount and frequency of repurchase offers are at the sole discretion of the Fund s Board of Directors (e.g., repurchase amounts can be limited to amount of cash retained from dividend reinvestment program). The Fund s Board of Directors has the sole power to amend or suspend the share repurchase program. 10

11 Traditional, non-traded closed-end funds Underwriting compensation limits (cont.) Registered closed-end funds are subject to substantive FINRA review. Certain information, including offering documents, must be submitted to FINRA. Must receive FINRA no objection letter before commencing sales, which can take anywhere from 3 to 6 months. Subject to FINRA Rule 5110, which limits underwriting compensation under a fair and reasonable standard. 11

12 Traditional, non-traded closed-end funds Underwriting compensation limits (cont.) Underwriting compensation for non-traded closed-end funds usually consists of: a sales load deducted from offering proceeds, generally at around 4.5%, plus fees paid to underwriters, underwriter expenses covered by fund advisers, and total underwriting compensation in an amount generally up to 8% of offering proceeds. There is no explicit cap on total underwriting compensation under the fair and reasonable standard, as each offering is evaluated on its merits, risks, etc., and relative to other similar offerings. 12

13 Interval Funds

14 Market overview As of June 30, 2017, there were approximately 56 active interval funds that have collectively raised approximately $3.9 billion. Interval funds can have a wide range of investment strategies, including listed, non-listed, public and private investments. Investment strategies include real estate focused funds, commercial real estate loans, small-and-middle market loans, institutional funds, and private funds. Interval fund capital raising broken down by investment focus as of June 30, 2017 is as follows: Insurance/Reinsurance Focused: $1.54 billion Real Estate Focused: $1.5 billion Debt/Fixed-Income: $914.1 million Derivatives/Hedge Funds/Exotics: $188.0 million Equities: $129.2 million Hybrid: (Equities & Debt): $21.3 million 14

15 General regulatory framework Interval Funds are closed-end investment companies registered under the 1940 Act, and are generally similar to Traditional, Non-Traded Closed-End Funds. Leverage Limitations -300% asset coverage ratio requirement. Incentive fees are generally permitted only on investment income. Incentive fees on capital gains are permitted to the extent all of the fund s investors are qualified clients. Ability to sell shares below NAV: Interval fund capital raising broken down by investment focus as of June 30, 2017 is as follows: Exception for rights offering. No ability to seek annual blanket approval. Approval required from majority of shareholders. 15

16 General regulatory framework (cont.) Public offerings are exempt from state blue sky as covered securities. Registration statements extend indefinitely, and there is an SEC process for automatic effectiveness of subsequent registration statements and post-effective amendments. Interval Funds are not subject to substantive FINRA review. 16

17 General regulatory framework (cont.) Determination of NAV Interval funds are required to determine NAV weekly. If engaging in a continuous daily offering, an interval fund must determine NAV on a daily basis. All sales are made at a price equal to the Fund s NAV per share. 17

18 General regulatory framework (cont.) Semi-annual reports contain less disclosure than are required for operating companies, plus no Forms 8-K are required. The new forms noted earlier also apply to interval funds: FORM N-PORT FORM N-CEN The SEC adopted the same tiered compliance dates for these forms. 18

19 General regulatory framework (cont.) Interval funds can elect to be treated and to qualify each year for taxation as a Regulated Investment Company ( RIC ) under Subchapter M of the of the Internal Revenue Code of 1986, as amended (the Code ). In order for an interval fund to qualify as a RIC, it must meet certain source-of-income, asset diversification and annual distribution requirements. RICs are not be subject to federal income tax to the extent they distribute investment company taxable income and net capital gains. The Code imposes a 4% nondeductible excise tax on RICs to the extent they do not meet certain distribution requirements by the end of each calendar year. 19

20 Shareholder liquidity Like all closed-end funds, the securities issued by Interval Funds are not redeemable by shareholders. The securities cannot be sold back to the Interval Fund upon the shareholder s demand. Interval Funds typically do not trade on a securities exchange or other secondary Interval Funds are required to adopt a fundamental policy to repurchase their shares: at a price equal to NAV, from shareholders at periodic, pre-determined intervals. 20

21 Shareholder liquidity (cont.) Rule 23c-3 requires Interval Funds to establish a periodic, pre-determined interval in offering to repurchase shares every 3, 6, or 12 months (i.e., quarterly, semi-annually or annually). Rule 23c-3 also requires each such repurchase offer to be for an amount that is equal to between 5% and 25% of outstanding shares. Repurchase offers are made pursuant to a notice filing on Form N-23c-3 under the 1940 Act. Significantly less burdensome than filing tender offer materials under Rule 13e-4 of the 1934 Act. 21

22 Shareholder liquidity (cont.) This fundamental policy can be changed only by the vote of a majority of the Interval Fund s shareholders. There are certain limited circumstances where the Board of Directors, by a vote of the majority of the independent directors, can suspend or postpone a repurchase offer. Under Rule 23c-3, additional liquidity may be provided outside of the fundamental policy only once every two years. 22

23 Shareholder liquidity (cont.) Liquidity Considerations: Required to maintain liquid assets, equal to 100% of the repurchase offering amount, from the date of the notification of the repurchase offer, through the repurchase pricing date. The actual repurchase must be within 7 days of this date. Liquid assets refer to assets that: can be sold or disposed of in the ordinary course of business, and at approximately the price at which the company has valued the investment. 23

24 Shareholder liquidity (cont.) Liquidity Considerations: Interval Funds can invest in illiquid assets: real estate, equity investments in private companies, and directly originated loans, as long as the portfolio manager maintains a sufficient level of liquidity 24

25 Shareholder liquidity (cont.) Combining 1940 Act and 1934 Act Repurchase Offers. Fundamental policy to conduct one or two repurchase offers annually under Rule 23c-3 of the 1940 Act, supplemented with discretionary repurchase offers under the 1934 Act. Creates a more flexible Interval Fund. Greater ability to effectuate investment strategy. Maintains all the regulatory benefits of being an Interval Fund. 25

26 Underwriting compensation limits Interval Funds are not subject to substantive FINRA review. Interval Funds are subject to FINRA s Sales Charge Rule for mutual funds. FINRA has issued guidance that specifically exempts Interval Funds from FINRA Rule An offering subject to FINRA review cannot proceed until the underwriting terms have been approved by FINRA. Interval Fund offerings do not require a FINRA filing or FINRA determination. The fact that Internal Funds are not subject to the Corporate Financing Rule results in considerable cost and time savings. 26

27 Underwriting compensation limits (cont.) Fee structures for Interval Funds range from the high end of 8.5% of the offering price to the low end of 6.25% of total gross sales. Interval Funds may charge investors a front-end sales charge and/or a continuing asset-based fee that generally takes the form of a distribution fee and/or a service fee. Interval Funds are not subject to substantive FINRA review. Distribution Fee: A distribution fee is an asset-based sales charge that compensates broker-dealers for effecting sales for the fund, and Any distribution-related asset-based sales charge may not exceed 0.75% of the average annual net assets of the fund.interval Funds are subject to FINRA s Sales Charge Rule for mutual funds. Service Fee: A service fee is a payment for personal services and/or the maintenance of shareholder accounts, and May not exceed 25 basis points of the average annual NAV of the shares.finra has issued guidance that specifically exempts Interval Funds from FINRA Rule

28 Offering process Interval Funds typically offer their shares for sale to the public on a continuous basis at a price based on the NAV of their shares. Once the SEC review and comment process has been completed and the registration statement has been declared effective by the SEC Staff, the Interval Fund may commence sales of its shares. Interval Funds are permitted to update their registration statements by filing post-effective amendments that, in certain circumstances, become automatically (60 days after filing) or immediately effective. These automatically effective amendments are not available to other non-traded vehicles, including other registered closed-end funds, BDCs and REITs, affording significant benefits to Interval Funds with respect to complying with the updating requirements and providing more certainty. 28

29 Offering related matters Easier and More Efficient Distribution Methods. Stemming from the view that Interval Funds are similar to open-end funds, the manner in which Interval Funds are distributed is considerably more efficient than the manner in which more traditional non-traded closed-end funds are typically sold. Interval Funds can be sold through an electronic platform, referred to as point and click, without the use of a written subscription agreement. Many large brokerage firms have demonstrated a greater willingness to place Interval Funds on their selling platforms as compared to other nontraded closed-end funds, largely because of the predictable liquidity that Interval Funds offer to shareholders and more flexibility in distribution. 29

30 Key operational considerations Rule 23c-3 of the 1940 Act requires Interval Funds to determine the current NAV of their shares no less frequently than weekly. Interval Funds must determine the current NAV of their shares on a daily basis during the five business days preceding a repurchase request deadline. This is the designated date by which Interval Funds must receive a repurchase request by a shareholder in response to their repurchase offers. Virtually all Interval Funds that are currently in existence determine NAV on a daily basis because they are offering and selling their securities on a daily basis. The necessity to determine the fund s NAV on a daily basis means that it must maintain the appropriate policies and procedures that provides for an accurate valuation of the Interval Fund s assets. 30

31 Key operational considerations (cont.) Liquidity Though Interval Funds are not specifically limited to a particular investment strategy, an investment strategy that includes a meaningful component of liquid securities is most appropriate. This the practical result of the requirements to conduct regular repurchase offers and the necessity to determine NAV on a daily basis in connection with selling activities. Interval Funds can invest in illiquid assets like real estate, equity investments in private companies and directly originated loans, as long as the portfolio manager maintains a sufficient level of liquidity. 31

32 Key operational considerations (cont.) Liquidity Rule 23c-3 of the 1940 Act requires an Interval Fund to maintain assets that: can be sold or disposed of in the ordinary course of business, at approximately the price at which the company has valued the investment, in an amount that is equal to the total repurchase offer amount, and to generally do so for the period of time beginning on the date that the company first sends the repurchase request offer through the actual payment date.though Interval Funds are not specifically limited to a particular investment strategy, an investment strategy that includes a meaningful component of liquid securities is most appropriate. 32

33 Exemptive relief to offer multiple share classes An Interval Fund may apply for exemptive relief from the SEC to issue multiple classes of shares. This provides investors with broader choices depending on how much they intend to invest, how long they expect to own shares, and the total costs and expenses associated with a particular class. As a condition of receiving multi-class relief, Interval Funds must comply with Rule 12b-1 under the 1940 Act, governing the use of fund assets for distribution of related expenses and other mutual fund rules. 33

34 Conclusion Interval funds could be a positive addition to an asset management firm s platform Key considerations in determining if an interval fund is a good fit:how much they intend to invest, Investment Strategy Shareholder Liquidity Distribution Model Operational/Administrative 34

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36 Cynthia M. Krus Executive Partner Cynthia R. Beyea Partner Payam Siadatpour Counsel Sixth Street NW, Suite 700 Washington, DC 2000 eversheds-sutherland.com 2017 (US) LLP All rights reserved. This communication cannot be used for the purpose of avoiding any penalties that may be imposed under federal, state or local tax law.