Launching a private fund is far quicker than launching a registered fund. The big difference is not waiting on SEC comments. That speed differential is prompting some managers to launch a strategy privately with a plan, from the beginning, of converting to a registered fund. Managers have described the process to us as using the private-fund stage as “training wheels” on their way to launching what is typically their first registered product.
This type of anticipated conversion is growing in popularity, based on our observations, for two reasons. First, competition. A manager lining up a promising strategy is keenly aware that others are likely doing so also. Second, available capital. When a manager has seed money available to go to work right away, both the manager and the seed investors may wish to go after investment opportunities sooner than later.
Three paths for private equity managers getting started with registered funds
Behind all of this is investors’ increasing comfort buying private equity-type products in registered-fund wrappers. By our observation, we’re in about year six or seven of an explosion of investment vehicles inside tender-offer and (especially) interval-fund wrappers. These registered-fund structures make available investments that investors could previously access only through private funds. The upshot a wider distribution base for managers and greater portfolio diversification opportunities for investors in the mass-affluent category.
Our team at UMB has been intimately involved in the rise of interval and tender-offer funds. That work has led us to a 30% market share for administration of non-listed closed-end funds, according to a FUSE Research report late last year. Along the way, we’ve helped guide managers with significant assets in the private space get their feet wet in the registered space. Here are three typical paths.
- Managers’ first registered fund typically features a strategy that largely mirrors one they operate already as a private fund. If time permits, they can simply continue operating that private strategy as they go through the setup and regulatory demands necessary for ’40 Act registration.
- Sometimes, to speed the process, a manager chooses to launch as a ’40 Act fund before also completing ’33 Act registration. (It’s the ’33 Act registration that enables a public offering of a registered fund.) This approach can work well when there’s just one investor—say, the manager putting its own seed capital to work. The risk of this approach is that the SEC might, as part of the ’33 Act process, unexpectedly make a substantial comment that requires the manager to go back to investors, offering the opportunity for recission. If the manager itself is the only investor, it can of course be confident it won’t rescind. Paperwork changes can be made, the ’33 Act registration can be completed, and then the fund can be offered publicly.
- But what if there’s a need for even greater speed? That’s when it may make sense to go ahead and launch a strategy as a private fund while already anticipating a later conversion to a registered fund. What follows are suggestions, based on our experience, for managers contemplating this path.
Suggestions for managers launching private but intending to convert to registered
Operating in the registered-fund space is an eye-opening experience for most managers who have previously worked only in the private-fund arena.
The rules emanating from the Investment Company Act of 1940 and the Securities Act of 1933 are simply unavoidable. Managers need to develop a significant infrastructure that isn’t required for private funds. They have to meet specific deadlines, treat all shareholders equally, carefully consider tax consequences, and engage a qualified custodian.
So, even apart from the demands of SEC review, getting going takes time and effort. This is why the “training wheels” concept is so apt. Managers can launch a private fund—a process they already know—with a plan to actively learn and prepare for an anticipated conversion. All the while, they can track performance with an eye to eventually move into the retail space, with a broader distribution strategy.
That distribution strategy is key. It sounds obvious, but it’s worth saying that converting a successful strategy to a registered fund by no means assures success with a public offering. In this model of starting private, be sure to use the initial, private period to refine your approach to distribution. Have a basic distribution plan in place even before you launch the private version of a fund you plan to later convert.
To help ensure a smooth conversion later, have conversations with your service team from the outset. That includes your legal counsel, auditors and fund administrator. Knowing you want to later convert, everyone involved will focus on eliminating, as much as possible, the element of surprise. For example, your auditor will advise on whether you’re likely to need a tax opinion to support an anticipated tax-free conversion.
Another example is the need to understand the concept of “good income” with respect to interval or tender-offer funds. If you plan to issue your investors 1099 tax forms (as opposed to the K-1s typical for private investments), you need to make sure you invest in holdings that generate income that qualifies for reporting in the simpler, more investor-friendly 1099 reporting.
Yet another area for “training wheels” focus is your valuation policy. Use the private-fund phase to ensure you fully understand the valuation exercise, including how you communicate with your business partners through those recurring cycles.
You’ll also want to be sure your attorneys have considered, early on, how a plan of reorganization will be drafted, and how the investor approval process will work.
I’ll end by echoing the suggestion to seek to avoid, as much as possible, the element of surprise. Avoid assumptions—such as that you’ll be able to make use of a private-fund performance history when making a public offering. (Morningstar won’t present that history; whether you’ll be able to in your own communications is a matter for exploration.)
There are many paths to success. Launching a private fund with an anticipation of shifting to registered is likely a natural one for many managers with innovative strategies and capital available to put to work. Explore early, ask questions, and don’t try to fight the ’40 Act!
About Ann Maurer
Ann Maurer serves as product manager and secretary for the Registered Fund Solutions platform, UMB Fund Services’ turnkey solution for starting and servicing unlisted closed-end funds, such as interval and tender-offer funds.
Ann brings in-depth product and systems knowledge to her role. She has worked with a variety of investment companies, including open-end funds, closed-end funds, registered funds of funds, hedge funds and REITs. Since joining UMB in 1996, Ann has worked in several capacities in client services, product management and the transfer agency. Before joining UMB, she spent two years with a national broker-dealer clearing corporation.
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