Despite the challenging outlook for equity markets, many investment managers are organizing and managing collective investment products, such as mutual funds or private investment limited partnerships. This article will discuss some of the practical and legal issues affecting those products. At the outset, you should note that the discussions here are general in nature and not intended as legal advice. You should consult with an experienced investment management attorney if you are considering this kind of undertaking.
Mutual funds (which are open-end investment companies) and private investment limited partnerships (often referred to as hedge funds, regardless of their investment strategy, but referred to as “private funds” here) allow an investment manager to pool the assets of many clients into one product.
By creating such a pool, all investors can be treated equally and the assets may be managed more efficiently than in numerous separate accounts. But there are substantial differences between a mutual fund and a private fund. You must recognize and understand these differences to determine which of these, if any, is right for you and your clients.
When considering the differences between the two products, most people immediately focus on the different levels of legal and regulatory oversight. Mutual funds must be registered under both the Securities Act of 1933 and the Investment Company Act of 1940. A mutual fund’s investment manager must also be registered under the Investment Advisers Act of 1940 (i.e., as an RIA). Virtually every aspect of a mutual fund’s operations is governed by laws or regulations.
A private fund, if structured and offered correctly, is subject to very little regulation. It is not registered either under the Securities Act or the Investment Company Act, nor is it necessary for its investment manager to be registered with the Securities & Exchange Commission. Nonetheless, a private fund cannot operate in a regulatory and compliance vacuum, especially if the manager is an RIA. In that case, some of the requirements of the Investment Advisers Act of 1940 may apply to the fund and its operations. In addition, even if the investment manager is not registered, a private fund and its manager are subject to the anti-fraud provisions of the Advisers Act and other federal securities laws, which can be surprisingly far-reaching.
Who, What, and How Much
You must also consider the profile of your target investors, the products’ growth potential, and the costs of the products. While mutual funds are offered to the general investing public through public offerings and may have an unlimited number of investors, a private fund is offered to fewer than 100 high-net-worth investors, and cannot be offered publicly. There is also a great deal of difference in the complexity, time, and expense to organize and operate a mutual fund and a private fund.
The SEC registration process for a mutual fund is lengthy, detailed, and costly. In addition, a mutual fund is subject to a number of structural and operational requirements, which make it much more costly than a private fund. Those requirements include, but are not limited to, securities custody arrangements, portfolio composition requirements, transfer agency arrangements, board of directors requirements, and requirements relating to operations, bonding, insurance, and pricing.
Investment strategies must also be considered. A mutual fund’s investments must meet certain diversification and liquidity requirements, as well as certain other restrictions imposed by the Investment Company Act. As a result, investment strategies that may be appropriate for a private fund may not even be legally permissible or practically possible for a mutual fund. All of these matters, along with the legal process for starting both kinds of funds, are discussed more thoroughly below.
Starting a Mutual Fund
A mutual fund must have at least $100,000 in seed capital and be registered with the SEC (see Create, File, and Wait sidebar at right) before it can be offered to the public. It is usually created as a business trust under state law. This form of organization may be more favorable, for a number of reasons, than a corporation, which is another way in which a mutual fund can be organized. For example, as a business trust, a mutual fund is not required to hold annual shareholder meetings, unless an extraordinary event is being considered or one is required by the Investment Company Act. Other benefits include the ability to offer an unlimited number of shares and to incorporate the utmost flexibility into its governing documents. Some state laws are now providing some of the same benefits for mutual funds organized as corporations. For example, mutual funds organized as Maryland corporations now have many of the same benefits provided by business trust laws.
A mutual fund’s management must be overseen by a board of directors, which, for all practical purposes, must be composed of a majority of independent directors. To be considered independent, directors cannot be affiliated with the investment manager now nor have had a material business relationship with the investment manager in the last two years. Other guidelines and restrictions also apply. Those affiliated with the investment manager can serve on the board, but should not comprise the majority of the directors. Such affiliates are typically named as officers of the fund, responsible for carrying out all day-to-day activities. The board members must adopt a code of ethics to govern trading and other conflicts, and should appoint an audit committee to oversee the fund’s finances. They should also consider seeking the advice of independent counsel to ensure that they and the fund comply with the myriad laws and regulations that apply to mutual funds.
Despite the capital and energy spent in organizing and operating a fund, an investment manager never owns the fund; it is owned by its shareholders. The investment manager only has an advisory agreement with the fund, which may be canceled by the board or the shareholders at any time without penalty. And since the fund’s board of directors is typically composed of a majority of disinterested directors, who are legally required to act exclusively in the best interest of the mutual fund and its shareholders, the investment manager does not have legal control. This is one of the reasons why an investment manager must take some protective measures, such as ensuring that its name is legally protected and can only be used by the fund while the investment manager is managing the fund.
A mutual fund has many ongoing requirements. A mutual fund’s registration statement must be updated annually through amended N1-A filings with the SEC. It must also prepare and mail annual and semiannual shareholder reports. It must calculate and publish daily the net asset value of its holdings. It must be audited annually by an independent accountant, and should have comprehensive written procedural controls to ensure that it does not violate any of the applicable laws or regulations.
To insure that investors can redeem their investments at will, a mutual fund must also comply with certain liquidity standards. No more than 15% of the fund’s total portfolio may be invested in illiquid securities. The figure is 10% for money market funds. An illiquid investment is generally defined as one that cannot be sold within seven days for approximately the price at which it is valued on the fund’s books. For equity funds, all securities that are not traded on a major exchange or the Nasdaq stock market should be carefully monitored for liquidity purposes.
Similarly, to be considered diversified from an SEC perspective and receive favorable tax treatment from the Internal Revenue Service, a mutual fund’s investments must meet certain requirements. The SEC and the IRS each have separate but similar standards. As a general rule, a mutual fund company should try to insure that the securities of no one issuer represent 5% or more of the assets of the mutual fund. That is why you do not typically see mutual funds holding securities in fewer than 20 companies. Even if a mutual fund is classified as “non-diversified” for SEC purposes, it must meet the IRS’s diversification requirements to obtain favorable “pass-through” tax treatment. The IRS standards require at least 50% of the fund’s assets to consist of cash or securities; no more than 5% of those assets may be invested in one issuer; the fund cannot own more than 10% of the outstanding voting securities of one issuer; and with respect to the other 50% of the fund’s assets, no more than 25% may be invested in the securities of any one issuer.