Brian McCabe is a partner and Ed Baer is counsel at Ropes & Gray.

The Securities and Exchange Commission proposed a new rule in December that would harmonize the regulation of funds of funds, vehicles currently regulated through a combination of statutory exemptions, commission rules and exemptive orders that are subject to varying, sometimes inconsistent, conditions.

Brian McCabe

Ed Baer

The new rule would replace the existing regime with a more consistent regulatory framework and would permit sponsors to develop new and innovative products that invest in a broader array of funds, including non-listed closed-end funds and business development companies, or BDCs.

It would also create opportunities and challenges for fund boards. Because acquired fund investments under the rule are subject to redemption limits, boards and sponsors would need to be mindful of liquidity considerations in connection with both product design and ongoing compliance.

Here are some tips for directors and what they could face if the new rule is adopted as proposed.

Background

The '40 Act limits how much registered funds can invest in other funds. Funds are generally prohibited from acquiring more than 3% of another fund's outstanding voting securities and investing more than 5% of their total assets in any one fund. In addition, registered funds can't invest more than 10% of total assets in other funds. A statutory exception applies to certain funds of affiliated funds.

Under the new proposal, all funds of funds would be able to acquire the securities of other registered investment companies or BDCs, and an acquired fund would be able to redeem or repurchase its securities that are issued to another fund, subject to a single set of conditions. Importantly, however, the proposal would rescind certain existing rules, as well as most related exemptive orders permitting funds of funds.

It would also alter the existing fund-of-funds landscape and eliminate some of the existing flexibility that funds of funds have under the '40 Act and SEC exemptions. This means sponsors must choose between operating these products based on the new rule or on the existing – but now more restrictive – statutory exemption. Each structure offers advantages and disadvantages.

While the recent rule proposal provides additional investment flexibility, it also places additional conditions on fund advisers and boards.

More Innovation

The proposal would expand the types of investments permitted in fund-of-funds arrangements, creating opportunities for exposure to closed-end funds, interval funds and BDCs, as well as to individual securities and derivatives. For example, a fund could invest a portion of its assets in BDCs to gain exposure to smaller companies that do not yet have significant public equity. However, investments in closed-end funds, interval funds and BDCs often provide limited liquidity.

Directors will want to understand how their advisers weigh the benefits of greater flexibility to invest in less-liquid funds against the challenges of managing portfolio liquidity. When deciding how much to invest in each fund, advisers will have to consider the proposal's redemption limits of 3% of an acquired fund's assets in any 30-day period.

If an open-end fund that relies on the proposal invests in another fund, the board may want to understand how these redemption limits will figure into the adviser's assessment of the fund's liquidity risk and how investments in other funds will be classified under the fund's liquidity risk management program.

Evaluating 'Best Interest'

Under the proposed rule, advisers would have to establish new procedures for making and documenting findings that it's in a fund's "best interest" to acquire shares of another fund. These findings, and the basis for them, must be presented to fund directors before any investment is made and, then, at least annually.

Those findings will likely discuss the nature and characteristics of the fund that's being acquired as well as the complexity of the fund-of-funds structure and the aggregate fees associated with the fund's investment in the acquired fund. Boards will want to understand the liquidity differences between redeeming shares of a mutual fund, for which there is no established secondary market, and selling shares of an ETF or closed-end fund on an exchange.

And while fund boards are not required to approve each fund investment, directors may wish to consider these arrangements and any conflicts of interest they may present. Boards should work closely with advisers to ensure there is alignment on which investments are in the acquiring fund's best interest and how the adviser came to that conclusion.

If the proposed rule is adopted in its current form, it will significantly alter the existing fund-of-funds landscape. In some situations, these vehicles will gain flexibility. For example, they will be able to invest in a broader range of underlying funds. However, funds of funds relying on the rule will also be subject to new limitations, such as new redemption restrictions.

Boards will want to work closely with advisers to understand how the proposed rule will affect product design – both of existing funds impacted by the elimination of current rules and SEC exemptions and of new products that would need to weigh increased investment flexibility against potential liquidity constraints.

What to Know About SEC Fund-of-Funds Proposal

or

Quick links:

Most Popular