Board Oversight of Alternative Mutual Funds. Presentation to the Mutual Funds Directors Forum Benjamin J. Haskin May 21, 2013

Transcription

1 Board Oversight of Alternative Mutual Funds Presentation to the Mutual Funds Directors Forum Benjamin J. Haskin May 21, 2013

2 Overview of Alternative Funds What are Alternative Funds? Types of Alternative Funds Open-end fund Purchase and redemption of shares daily Value securities/price shares daily Fund must remain open to redemptions/no ability to impose gates Illiquid securities limited to 15% of net assets Unlimited potential fundraising as funds engage in continuous offering of securities No limit on the number of shareholders No accredited investor/qualified purchaser restrictions ETFs generally are open-end funds 2

3 Overview of Alternative Funds (continued) Types of Alternative Funds (continued) Closed-end fund Generally, exchange listed Publicly offered in underwriting Unlimited illiquid securities in portfolio No limit on number of shareholders Priced at least weekly Limited ability to sell additional shares after initial offering rights offering No accredited investor/qualified purchaser limits Commonly use leverage 3

4 Overview of Alternative Funds (continued) Types of Alternative Funds (continued) Hybrid Funds Closed-end fund 1940 Act Registered, but may rely on Regulation D under 1933 Act for Private Placements Can sell additional shares after initial offering; may engage in continuous offering (monthly or quarterly closings) Board can make periodic tender offers or rely on exemptive rule permitting periodic redemptions ( Interval Fund ) No limits on illiquid securities (unless Interval Fund) Restricted to accredited investors (including 1933 Act registered funds of hedge funds) 4

5 Overview of Alternative Funds (continued) Types of Alternative Funds (continued) Business Development Companies A form of publicly offered closed-end fund Can hold illiquid assets Must offer management assistance to portfolio companies Designed for private investments: mezzanine loans, senior loans, venture capital and private equity 70% of portfolio must be qualifying assets 5

6 Investment Program Derivatives (swaps, futures, forwards, etc.) Structured securities Other alternative asset classes (metals, real estate, etc.) Hedge funds and commodity pools 6

7 Investment Program (continued) Conflicts of interest Side-by-side management and trading Fair and equitable allocation Section 28(e) of the Securities Exchange Act of 1934 Board approved trading policies Board disclosure 7

8 Key Portfolio Management/Operational Issues Risk oversight framework Valuation Pricing sources and methodologies should be considered by the Board Pending Morgan Keegan case How Boards can carry out their valuation responsibilities Develop an understanding of the valuation process Understand role of third party pricing services Understand Adviser s resources for valuing securities Choose a reporting cycle for valuation determinations 8

9 Key Portfolio Management/Operational Issues (continued) Liquidity Illiquid assets includes (a) investments that cannot be sold within 7 days at approximately the amount at which the Fund has valued the security; (b) securities for which there is no readily available market quote; and (b) restricted securities. Open-End Funds: 15% illiquid limitation Closed-End Funds: no limitation Interval Funds: Liquid assets to meet each repurchase offer 9

10 Key Portfolio Management/Operational Issues (continued) Derivatives and transactional leverage Use of derivatives is deemed to create leverage that must be covered by way of offsetting positions or segregating liquid assets Segregating assets occurs by way of a notation on the custodian s records Segregating assets effectively limits the use of leverage Certain derivatives require segregation of the full notional value (e.g., physically settled) and others require segregation of the marked-to-market liability (e.g., cash settled). These positions are currently under review at the SEC. To the extent it is trading in commodities, the Fund must comply with coverage requirements separately within the offshore subsidiary used for commodity trading 10

11 Advisory Arrangements Use of one or more sub-advisers Prior experience managing a registered fund Compliance infrastructure 11

12 Advisory Arrangements (continued) Performance fees The Advisers Act generally prohibits a registered investment adviser from entering into an advisory contract that calls for performance-based fees except as provided in Section 205(b) of the Advisers Act. Section 205(b)(2) of the Advisers Act permits an investment adviser of a 1940 Act-RIC to charge a performance-based fee (commonly termed a fulcrum fee ) that: is based on the investment company s asset value averaged over a specified period, and increases or decreases proportionately with the investment performance of the RIC over a specified period in relation to the investment record of an appropriate index of securities prices or such other measure of investment performance as the SEC by rule, regulation, or order may specify. 12

13 Advisory Arrangements (continued) Performance fees (continued) Rule under the Advisers Act requires the calculation of the fulcrum fee to be based on the change in the net asset value of the shares in question. Unlike Rule 205-1, Section 205 of the Advisers Act and Rule thereunder do not distinguish between gross asset value and net asset value and contemplate calculation of a fulcrum fee based on the asset value of the company or fund under management. Rule under the Advisers Act permits an adviser to a 1940 Act-registered investment company to charge a performance-based fee that is not a fulcrum fee, if each equity owner of the registered investment company (except for the investment adviser entering into the contract and any other equity owners not charged a performance fee) is a qualified client with whom the adviser could otherwise enter into a performance fee contract under the Rule. A mutual fund offered to the general public would not be eligible to rely on this Rule. 13

14 Advisory Arrangements (continued) Persons Who Provide Advice Solely Regarding Matters Not Concerning Securities [SEC Division of Investment Management - Issues of Interest March 27, 2012] Persons who provide advice solely regarding matters that do not concern securities (collectively, "Non-Securities Matters," and such persons, "Non- Securities Advisers"), including commodities, diamonds, precious metals, coins, and stamps. A Non-Securities Adviser therefore is not an investment adviser as defined in Section 202(a)(11) and would not be required to register under the Advisers Act, even if the Non-Securities Adviser provides advice on Non-Securities Matters to a RIC or a BDC. A Non-Securities Adviser to a RIC or a BDC that meets the definition in Section 2(a)(20) of the 1940 Act is subject to the provisions of the 1940 Act that apply to an investment adviser including, among others, Section 15 of the 1940 Act governing the investment adviser's contract and Section 17 of the 1940 Act prohibiting certain affiliated transactions. 14

15 CFTC Compliance In order to rely on amended Rule 4.5, a RIC must qualify for exemption under a Trading Test and a Marketing Test. Trading Test Alternative 1: The RIC may not trade commodity futures, options and swaps in an amount such that initial margin payments exceed 5% of the liquidation value of the RIC. Alternative 2: The RIC may limit use of commodity futures, options and swaps to meet a net notional test. Bona fide hedging transactions are excluded from both trading alternatives. Marketing Test A RIC also must not market itself as a commodity pool or as a vehicle for trading in the commodity futures, commodity options, or swaps markets. 15

16 CFTC Compliance (continued) Commodity futures defined broadly: includes broad-based stock index futures (e.g., S&P 500 futures), security futures generally and financial futures contracts as a whole. The CFTC takes the position that Section 2 of the Commodity Exchange Act grants the CFTC authority over all futures. Dodd-Frank includes swaps as commodity interests : The Dodd-Frank Act amended the statutory definition of the terms commodity pool operator and commodity pool to include those entities that trade many types of swaps. CPOs of certain RICs that invest in swaps based on similar reference assets may also not be able to rely on amended Rule

17 Tax Issues Diversification Requirements under Subchapter M of the Internal Revenue Code If a fund qualifies under Subchapter M, a fund s distributed net income and longterm capital gains generally can be passed through to shareholders without the fund incurring federal income taxes. In order to qualify under Subchapter M, a fund must satisfy the following diversification requirements: At least 50% of the value of the fund s total assets are invested in cash, cash items, government securities, securities of other regulated investment companies (RICs), and investments in other securities. The fund may not count securities of a single issuer that account for more than 5% of the fund s total assets or that constitute more than 10% of the issuer s voting securities. No more than 25% of the value of the fund s total assets is invested in the securities, other than U.S. Government securities or securities of other RICs, of any one issuer. 17

18 Tax Issues (continued) Partnership for tax purposes Some alternative funds may choose to be a partnership for tax purposes A partnership is a pass-through entity; all income, gain, loss and deduction treated as received by partners in the year received by partnership 18

19 Questions and Answers 19