An Opportunity to Differentiate with Unlisted Closed-End Funds AUGUST 2017

Transcription

1 An Opportunity to Differentiate with Unlisted Closed-End Funds AUGUST 2017

2 Table of Contents Foreword from UMB Fund Services... 3 Introduction....4 Interval Funds...4 Tender Offer Funds... 5 Unlisted CEFs: By the Numbers Evolution of Unlisted CEFs....6 Product Features... 7 Investments Fees and Expenses Minimum Investments Investor Profile Market Overview Sizing....8 Drivers of Growth...8 Appeal to Financial Advisors....8 Strategies Used in Unlisted CEFs....9 Product and Pricing Structures Launching Unlisted CEFs Taxation Future Outlook Methodology About Us UMB Fund Services FUSE Research Network (FUSE)

3 Foreword from UMB Fund Services While interval funds and tender-offer funds, or unlisted closed-end funds (CEFs), are not a new concept in the registered marketplace, they have gained steady interest in recent years as a viable option to support the growing demand for non-correlated returns. At UMB Fund Services, we have partnered with our clients on their unlisted CEFs for nearly 20 years. During this time, and recognizing a need to streamline processing and product development for these funds, we have made significant investments in our servicing technology and a turnkey platform, Registered Fund Solutions. This unique platform was designed to lower overhead through shared expenses and eliminate barriers to entry such as the difficulty of selecting service providers and trustees. We are witnessing growing demand for these products, and we are excited to partner with FUSE to publish this in-depth report on interval funds and tender-offer funds. Given the quickly evolving interest and complexity of these structures, it has been difficult to gain insight into the market potential. We believe this report will be invaluable to not only our clients currently offering unlisted CEFs but also to managers considering product development in this space. UMB Fund Services partnered with FUSE Research Network to produce the following report. While UMB Fund Services believes this report to be accurate and comprehensive, the data presented, positions taken and forward-looking statements made herein are attributable to FUSE Research Network. An Opportunity to Differentiate with Unlisted Closed-End Funds 3

4 Introduction Interval funds and tender offer funds, collectively known as unlisted closed-end funds 1 (unlisted CEFs), are making headlines as the latest plays in opportunistic investment product development. Institutional managers seeking to broaden distribution are using unlisted CEFs to productize alternative and/or non-correlated asset strategies for the accredited investor and/or retail market. Meanwhile, traditional mutual fund managers are expanding their product offerings into alternative asset strategies using these vehicles to meet increased demand for non-correlated sources of alpha with less fee sensitivity. So what are these vehicles, and what is their appeal? Registered as investment companies with the Securities and Exchange Commission (SEC) under the Investment Company Act of 1940, as amended ( 40 Act), unlisted CEFs are closed-end funds that do not have to provide daily liquidity, and unlike listed CEFs, they do not trade on the secondary markets. While fund sponsors of listed CEFs sell shares of the fund in an initial public offering (IPO), unlisted CEF sponsors may elect to register shares according to Rule 415 under the Securities Act of 1933, as amended (Securities Act) and serve as the market maker. This allows sponsors to continuously offer shares and provide periodic redemption opportunities at the then calculated net asset value (NAV). From a 40 Act product sponsor standpoint, unlisted CEFs have the following appealing attributes: No requirement to hold annual shareholder meetings Permitted (with exemptive relief) to have multiple share classes for different investor constituencies, as well as master/feeder structures for portfolio management scalability Ability to invest in less liquid investments 1 Non-traded REITs and business develoopment companies (BDCs) are excluded from this analysis. Make them available to individual investors without the high minimum initial investments or investor accreditation of private funds While there are distinct legal differences between interval funds and tender offer funds, the terms are often (mistakenly) used interchangeably in the industry. Interval Funds Interval funds offer their shares continuously, generally calculate a daily NAV and periodically offer their shareholders a buy-back of a stated portion of their shares at NAV (e.g., monthly, quarterly, semi-annually, or annually). In order to qualify under Rule 23c-3 of the 40 Act, the buy-back terms must be incorporated in a fundamental policy stipulated in the fund s prospectus. Shareholders are not required to accept buy-back offers/sell their shares back to the fund; the buy-back is voluntary on the investor s part. Interval funds notify their shareholders of upcoming repurchase dates and the date by which the shareholder must accept the repurchase offer. The fund can only suspend or postpone the repurchase offer in limited circumstances. 2 The repurchase offer amount must be at least 5% and not more than 25% of the shares outstanding. Pro-rationing may apply when the redemption requests aggregate to a higher percentage than permitted. As a result, it may take an investor multiple repurchase periods to liquidate the investment. From a registration standpoint, interval funds rely on Rule 486(b) of the Securities Act to automatically update their Form N-2 registration statement and are exempt from the Financial Industry Regulatory Authority s (FINRA) filing and clearance requirements. In addition to the 40 Act, interval 2 For example, if the repurchase offer causes the fund to lose its RIC status, the NYSE is closed, there is restricted trading, or an emergency that renders the offer not reasonably practical. 4 An Opportunity to Differentiate with Unlisted Closed-End Funds

5 funds are also subject to the Securities Act and the Securities Exchange Act of 1934, as amended (Exchange Act). Tender Offer Funds Tender offer funds are different from interval funds in that they are not required to establish a fundamental repurchase policy, but rather must commit to the marketplace to buy back shares on some defined schedule and at some defined amount (most commonly quarterly tenders of up to 25% of outstanding shares). This liquidity process is governed under Rule 13e-4 of the Exchange Act. Similar to an interval fund, tender offer funds notify their shareholders of upcoming repurchase dates, but do so by filing an offer to repurchase letter with the SEC, indicating the date by which the shareholder must accept the repurchase offer. Different from the interval fund repurchase offer, the tender offer must remain open for at least 20 business days, but the offering/repurchase period can be suspended or postponed at the discretion of the fund s sponsor. While the tender for many of these funds is usually up to 25%, the historical trend has typically averaged much lower than 20%. Another difference from interval funds is that tender offer funds typically calculate monthly NAVs instead of daily. With respect to registration, tender offer funds have an initial offering filed and cleared by FINRA, and must file an annual Form N-2 registration statement if registered as a Securities Act and 40 Act fund, in order for the SEC to declare the filing effective. Unlisted CEFs: By the Numbers As of first quarter 2017, there were 109 unlisted CEFs available for purchase by investors regardless of accreditation status, with total assets under management (AUM) of approximately $41.7 billion. Regarding assets, 46 funds have accumulated assets greater than $100 million. Of these funds, 59% were launched prior to The five largest funds, listed below, dominate the market with more than 40% market share. Interestingly, there is no one prevalent investment strategy; rather, there is a diverse mix of alpha-generating or yield strategies that typically are not available in daily liquidity vehicles. Top Unlisted CEFs by Assets Firm Portfolio Name Inception Date Fund Type Category SkyBridge Capital II Stone Ridge Asset Management Partners Group Skybridge Multi Adviser Hedge Fund Portfolios LLC Stone Ridge Reinsurance Risk Premium Interval Fund Partners Group Private Equity Fund, LLC 8/16/02 Tender Offer Multi-alternative $25K/ N/A 12/9/13 Interval Insurance Linked Securities/ Catastrophe Bonds Minimum Invest/ Suitability $15M/ Inst 7/1/2009 Tender Offer Private Equity $50K/ Qualified Client AUM as of 1Q17 ($B) $5.4 $4.3 $2.3 Stone Ridge Asset Management SilverBay Capital Management Stone Ridge Alternative Lending Risk Premium Fund 5/23/16 Interval Marketplace Loans $15M/ Inst ACAP Strategic Fund 3/1/10 Interval Equity Long/Short $100K/ Qualified Client $2.0 $1.8 Source: FUSE Research Network, July 2017 An Opportunity to Differentiate with Unlisted Closed-End Funds 5

6 Evolution of Unlisted CEFs Higher-yielding or less liquid alpha-generating asset classes such as hedge funds, private equity and real estate are generally characterized by (longer) lock-up periods, illiquidity and limited transparency, which ultimately confine their suitability to higher-net-worth investors. Mutual fund portfolio managers continue to be prohibited from making significant allocations to illiquid securities, and liquidity requirements are becoming even tougher. 3 Creative minds of the financial industry began designing unlisted CEFs in 1992, in response to the SEC s landmark study, Protecting Investors: A Half Century of Investment Company Regulation. In its study, the SEC concluded that the industry was limited in its ability to offer innovative investment products due to the inflexible separation between the daily liquidity of open-end funds and the limited liquidity of closed end funds and that it would now be appropriate to chart new territory between the two extremes [...] consistent with investor protection. Thinking how CEFs could be structured as perpetual trusts, term trusts or interval funds product innovators then started looking for ways to capitalize on this new opportunity. The tender offer fund was designed to offer liquidity to investors by conducting tender offers according to Section 23(c)(2) of the 40 Act, which states that closedend funds may not purchase any of their own securities except pursuant to tender offers, after providing all shareholders a reasonable opportunity to participate in the tender offer. In 1993, the SEC adopted the Interval Fund Rule Rule 23c-3 under the 40 Act allowing for repurchase offers by closed-end companies. 3 While the new SEC Liquidity regulations are applicable to only open-end funds and ETFs, we understand that closed-end funds may also plan to observe these same rules. 6 An Opportunity to Differentiate with Unlisted Closed-End Funds

7 Product Features Investments Generally, unlisted CEFs seek to provide access to securities not easily accessible by mutual funds and may provide higher returns compared with mutual funds by allowing portfolio managers greater flexibility in their investment strategies, holdings and risk appetite. In addition to the ability to invest in less liquid investments than traditional open-end mutual funds, managers are likely to have greater access to institutional investment opportunities. Investment strategies embedded in unlisted CEFs provide additional portfolio diversification and returns that generally do not correlate with the broad markets. Fees and Expenses Higher yielding investment opportunities tend to be associated with higher costs and therefore higher fees to the unlisted CEF shareholder often 200 bps or more. Compare this range in expenses with a 1.21% median for equity mutual funds, or 0.35% for index equity mutual funds. 41 Unlisted CEFs may charge performance fees, as long as all fund shareholders are qualified clients. Given that the target market for interval funds is more retail, performance fees are not generally part of the fee structure, while they are commonly seen in tender offer products. For interval funds, Rule 23c-3 under the 40 Act permits the deduction of a redemption fee from repurchase proceeds, which represents compensation to the fund for repurchase expenses. Under Rule 23-3 under the 40 Act, the redemption fee may not exceed 2% of the proceeds. Investor Profile The eventual target audience for interval funds and some tender funds is the broadest market retail. The appeal of these vehicles is that they provide a means for investors to participate in sophisticated, high-yielding and alternative investment strategies without the hurdles typically associated with private placement funds, such as K-1s, even more diminished liquidity and tougher initial investor qualifications. Yet, to date, the majority of asset growth is from funds that have an accredited investor requirement. Generally speaking, however, interval funds are geared to the retail market, while tender offer funds are more likely to qualify their target market with the accredited investor standard. Over time, funds with minimum investments of as low as $500 may open up another retail distribution channel. While the mass retail market presents a growth opportunity, today roughly two-thirds of unlisted CEF assets are held within products that feature accredited investor, qualified client or institutional level investment minimum. We believe the key to successfully selling these funds to accredited and retail investors lies in the education and training of investment advisors. Suitability and risk tolerances play important roles in the sale of these types of investments. Minimum Investments For interval funds that are active or in registration with the SEC, 71% have an investment minimum of $10,000 or less. For tender offer funds, that percentage drops to 14% of funds that are active or in registration. More than half of tender offer funds have minimums of $50,000 or above compared to only 25% of interval funds Investment Company Fact Book An Opportunity to Differentiate with Unlisted Closed-End Funds 7

8 Market Overview Sizing The size of the unlisted CEF market has grown steadily since Assets have grown at a 6% CAGR from approximately $36.6 billion in 2014 to $41.7 billion as of 1Q As of first quarter 2017, there were 33 interval funds with a total of $15.9 billion AUM, and an additional 25 interval funds in registration with the SEC. Looking at tender offer funds, there were 76 funds, representing $25.8 billion in AUM, with an additional 12 tender offer funds in registration during the same time period. Of these, 5 of the 12 tenders represent new advisors to the space. Drivers of Growth As investment products, unlisted CEFs are opportunistic given they were conceived by both institutional and traditional portfolio managers looking to capture a broader market share for their investment opportunities. At the same time, investors of all levels sought higher returns with mitigated risk in response to the gradual recovery from the financial crisis of Helping non-accredited investors access institutional-like products that are typically limited to accredited investors will widen the distribution net. By offering lower investment minimums, both institutional and traditional fund providers have the opportunity to expand their potential audience. Some issues to contend with include institutional managers ramping up their ability to distribute into certain channels and advisors lacking experience with this product. With the number of unlisted CEFs growing from 80 in 2014 to 109 in 2017 there is positive momentum with no current sign of slowdown. The increasing number of funds in registration with the SEC demonstrates a clear interest on behalf of investment managers to tap into this growing opportunity. Unlisted CEFs are still a niche product, however. While they are increasing in popularity, they are only recently being tracked by Morningstar and others. Appeal to Financial Advisors Financial advisors are increasingly learning about the benefits of unlisted CEFs. With public oversight and transparency similar to mutual funds and non-correlated Unlisted CEF Assets, Q17 ($ Millions) $45,000 $40,000 $35,000 $30,000 $25,000 $20,000 $15,000 $10,000 $5,000 $0 $25,867 $25,793 $29,782 $29,463 $14,191 $15,940 $6,823 $7, Q 2017 Tender offer Interval Source: FUSE Research Network, July An Opportunity to Differentiate with Unlisted Closed-End Funds

9 performance, it appears financial advisors are more comfortable recommending these funds and are beginning to recognize where unlisted CEFs may best be deployed in their clients portfolios. Product manufacturers are actively ramping up their marketing and training efforts to broaden their distribution through intermediaries. By definition, unlisted CEF assets are stickier than traditional mutual funds due to their less frequent redemptions, which keeps investors from making rapid withdrawals during market volatility. We believe the illiquidity of unlisted CEF assets supports the longer-term organic AUM growth of these types of funds. Strategies Used in Unlisted CEFs Given their investment goals, strategies wrapped in unlisted CEF wrappers are diverse, often complex, and typically are not run-of-the-mill. With more than 30 different investment strategies, some unique investment strategies include: Direct Loans Marketplace Loans Risk Transfer ILS/Catastrophe Bonds Trade Finance Related Securities Non-traditional restricted stocks Private Equity The earliest unlisted CEFs invested mostly in real estate and syndicated leveraged loans, but this landscape is fast changing. Today s unlisted CEFs are looking to much broader investment opportunities in hedge funds and private equity, as well as public and private corporate debt. Number of Unique Funds CURRENTLY OFFERED IN REGISTRATION Interval (33) Tender (12) Tender (76) Interval (25) Source: FUSE Research Network, July 2017 An Opportunity to Differentiate with Unlisted Closed-End Funds 9

10 While we think of the most complex strategies in these controlled-redemption vehicles, there are opportunities in somewhat more traditional strategies, such as frontier markets and municipal bonds, that are able to extend their investment reach into less liquid opportunities. This will allow asset managers to execute on their investment strategies rather than liquidating their positions sooner than they like. Unlisted CEF AUM by Broad Objective, Q17 ($ Millions) $45,000 $40,000 $35,000 $30,000 $25,000 $20,000 $15,000 $10,000 $5,000 $ Q 2017 International Equity Allocation Sector Fixed Income Alternative Source: FUSE Research Network, July An Opportunity to Differentiate with Unlisted Closed-End Funds

11 Product and Pricing Structures Launching Unlisted CEFs Product manufacturers looking to launch unlisted CEFs should anticipate a longer time horizon compared with the launch of traditional mutual funds. Timeline. Generally, the N-2 registration statement filing process is the same as for other closed-end investment companies. In contrast with a three-month standard timeline for launching CEFs, however, today s new unlisted CEF launches are taking 10 months or longer to complete. There is a relatively long N-2 registration statement review period with the SEC. While the standard timeline is 120 days to issue comments and 120 days to respond, new product filers are sharing that the SEC staff is taking more time to turn around their comments. Changes in administration in the SEC and the newness of these types of products, layered with a potentially less sophisticated target market, are some of the factors that help explain the more protracted approval process. Reporting. To satisfy the SEC s and (as applicable) FINRA s regulatory requirements for unlisted CEFs, the fund sponsor must deliver a prospectus before or at the time of sale, a Statement of Additional Information (SAI) upon request and ongoing shareholder reports post-investment. The filings required by the SEC include: Form N-2 (registration statement); Form N-CSR (annual and semi-annual reports to shareholders); Form N-SAR (annual and semi-annual financial information); Form N-Q (portfolio holdings); and Form N-PX (proxy voting record). Also, a copy of the tender offer letter(s) issued during the filing period is required to be filed for tender offer funds including results. Marketing and Promotion. The marketing and promotion of unlisted CEFs is subject to compliance with SEC and FINRA rules on advertising and marketing. Since unlisted CEFs are publicly offered products, there are a number of benefits compared with the marketing and promotion of private funds. Namely, unlisted CEFs without accredited investor hurdles may be broadly advertised and marketed (without requiring a pre-existing relationship as with private funds). This expands the ability of the fund manager to reach a general audience. Since there is no requirement for investors to satisfy net worth or knowledgeable investor standards, many of these funds, especially interval funds, target a retail audience with lower minimum investment requirements. Lastly, there are no limits to the number of investors in each fund, as would be the case for private placement funds. Brokers who sell private fund shares through offering and subscription documents appreciate that there is a simplified sales process for unlisted CEFs. Investors may either buy directly into the fund using an application or purchase through a broker s mutual fund platforms or a streamlined subscription agreement through the broker s alternative investment platform or other electronic transaction networks. Organizational Structure and Service Providers. Unlisted CEFs are managed by a Board of Trustees, who annually approve a registered Investment Advisor (portfolio management firm) for daily management and investment responsibilities. The suite of service providers is relatively similar to those engaged by mutual funds. These funds require a fund administrator whose responsibilities include, among other agreed-upon tasks, fund accounting, NAV calculation, and preparation of financial statements. These funds also contract with a registered transfer agent that is responsible for recording fund share ownership, processing any dividends and mailing An Opportunity to Differentiate with Unlisted Closed-End Funds 11

12 shareholder statements and tax forms. A qualified custodian maintains the assets of the fund, and an independent accounting firm is engaged to audit the fund and the financial statements. Service providers also include SEC and FINRA-registered distributors and underwriters. Taxation Generally, the taxation of unlisted CEFs is the same as that of a U.S. mutual fund, as a regulated investment company (RIC) under Subchapter M of the Internal Revenue Code of 1986, as amended. This tax treatment is less complicated than private placement investment funds and may serve as an attractive benefit for investing in unlisted CEFs. Shareholders in RICs are generally taxed on their fund distributions (unless shares are held in a retirement account or the holder is exempt from U.S. federal income tax) and receive IRS Form 1099, instead of Form K-1 issued by private investment funds. K-1 reporting can be complicated and delayed so that investors must file for additional time to prepare or amend their returns, resulting in additional tax return preparation costs. 12 An Opportunity to Differentiate with Unlisted Closed-End Funds

13 Future Outlook There are three constituencies that are likely to drive future growth in unlisted CEFs. 1. Investors Investors are presently seeking non-correlated assets in their portfolios, new sources of alpha and/or higher yields. Given the market highs in the US equity markets and (until recently) rock-bottom yields on fixed-income offerings, the options have been limited for portfolio diversification and income pick-ups for a typical investor. Unless the investor is extremely affluent (e.g., qualified purchaser), they have been precluded from investing in diverse sources of alpha, such as hedge funds, private equity or real estate, to cite just a few examples. An unlisted CEF allows the investor to accomplish any of these investment objectives with one trade-off a sacrifice in investment liquidity. If the investor understands that the investments typically held within these vehicles are inherently more of a niche investment and should represent only a small portfolio allocation, the trade-off in liquidity is less critical. As long as these investments are purchased through a knowledgeable financial advisor as a part of a holistic investment plan, interest in these offerings should continue to build. There is another additional benefit of these structures for investors: unlisted CEFs force investors to take a disciplined investment approach by holding fast to their investment strategy rather than prompting an immediate liquidate the portfolio reaction to a market dip. Active managers have been faced with eroding AUM as investors move to low cost, passive investment options. Assuming that the manager has the expertise to implement these particular alpha-generating investment strategies, they are not faced with the same fee compression as open-end funds. In addition, they are able to distinguish their investment acumen and have a new investment offering that will resonate with financial advisors. Additionally, institutional investment managers that have not found their strategies conducive for similar performance in traditional packaged offerings now have an entrée into a broader market. 3. Intermediaries Intermediaries are encouraging the migration of their financial advisors books to fee-based arrangements. In this scenario, the advisor is able to oversee the client s entire financial worth, or a substantial portion of it. While intermediaries are contracting the number of mutual fund products on their platforms, they need to offer a more diverse alpha-generating product suite to meet the typical client s holistic portfolio needs. Fee-based arrangements are stickier, and by their very structure, assets in unlisted CEFs will be even more adhering. In short, we foresee a win-win-win for the investor, investment manager, and intermediary. 2. Active Investment Managers Active investment managers are looking to diversify their product lineup and for new revenue sources that are not subject to the fee compression associated with passive management. An Opportunity to Differentiate with Unlisted Closed-End Funds 13

14 Methodology Underlying asset data and general vehicle attributes (e.g., strategy type, inception date, minimum investment, etc.) are collected by FUSE from audited annual report filings as well as unaudited semi-annual reports and quarterly schedule of portfolio holdings (Forms N-CSR/N- CSRS/N-Q). FUSE searched through all of the N-2 filings over the past four years in the SEC s Edgar database to identify funds for this paper. In addition, tender offer filings were searched for the past 12 months to identify tender offer funds that were launched more than four years ago. Non-traded REITs and BDCs are excluded from this analysis. Assets presented are net assets (i.e., do not reflect total Managed Assets for leveraged products). The periodic display of assets presented reflects a combination of AUM for the exact period where available as well as a proxy representing the closest historical period available (no more than one quarter ago). For example, if a fund has a fiscal year end in October, the October 2016 actual net assets would be used for the displayed aggregation of 2016 AUM. Term trust funds are included in the tender offer category. 14 An Opportunity to Differentiate with Unlisted Closed-End Funds

15 About Us UMB Fund Services UMB Fund Services offers a broad array of services for mutual funds and alternative investments, including turnkey solutions, to help our clients not only bring new products to market, but also to position themselves for future growth. Key services include fund accounting and administration, investor accounting and reporting, tax preparation, transfer agency, distribution, custody* and cash management.* At UMB, we excel at adapting in an ever-changing market environment. This agility positions our operation to meet client needs now and in the future. For more information, visit umbfs.com. FUSE Research Network FUSE was launched in 2008 with the view that research and consulting support for asset managers has failed to evolve with the changing needs of the client. The future competitive environment will demand that clients make important business decisions within shorter and shorter timeframes. In order to support clients in this setting, FUSE provides a dynamic research platform that covers our clients current and future decision areas (strategic and tactical). Our goal is to become an invaluable business partner through the delivery of highly informed and forward-looking recommendations that are among the critical inputs our clients need to optimize results. * Services provided by UMB Bank, n.a. An Opportunity to Differentiate with Unlisted Closed-End Funds 15

16 2017 fuse research network UMB Fund Services