Hedge Fund Managers Starting RICs
For the past several years it has been difficult to raise capital for many fund managers. It has become just as hard to keep investors as it was to get them to invest with you in the first place. This has been the fund manager’s problem for years, even before the financial crisis.Many managers have shared their frustration over managing the investor relationship.More recently, many have inquired about becoming a Regulated Investment Company (“RIC”) so they can have permanent capital and not have to worry about investors withdrawing.Sounds great, but as they say “if it sounds too good to be true, it probably is.”
So what is a RIC exactly? The simple answer is that it’s an Investment Company that is registered under the Investment Company Act of 1940 (the “40 Act”).As a result of the stock market crash of 1929, the US Congress created the 40 Act. The 40 Act defines the responsibilities and limitations placed on open-end mutual funds, unit investments trusts and closed-end funds that offer investment products to the public. The 40 Act provides an exemption for registration for private investment companies (i.e. hedge funds or private equity funds) under Sections 3(c)1 and 3(c)7. However, these sections limit the type and number of investors a private investment company can have, whereas a RIC does not have these restrictions.Furthermore, RICs can be offered to the general public. Investors need not be sophisticated, accredited or qualified.
So, if you manage a private investment fund and you are thinking of starting a registered fund and becoming a RIC, you should be aware of some big differences between private funds verses public investment companies.
Registration and other requirements include:
- The investment advisor of a RIC is required to be registered under the Advisers Act. There are no exemptions for small advisors.
- The RIC must be registered under the 40 Act, which will subject the RIC to reviews and comments on disclosure by the Securities and Exchange Commission (the “SEC”) as well a various annual, semi-annual and quarterly public filings.
- Most 40 Act registered funds must also be registered under the Securities Act of 1933 (the “33 Act”), which will make them subject to Sarbanes-Oxley certifications, amongst other requirements.
- Along with the increased regulation you will have increased costs. RICs are required to have a board of directors, with independent directors. In addition, registered funds must have an audit committee with a financial expert on such committee.
- Audited financial statements are due sixty days (60) after the end of the fiscal year vs. one hundred and twenty (120) for a private investment company.
- There are restrictions on types of investments, affiliated transactions and use of leverage.
- In order to maintain pass-through taxation status, RICs must pass various diversification tests and distribute at least 90% of their taxable income each year.
There are three basic types of RICs (1) Open-End Funds, (2) Closed-End Funds, and (3) Business Development Companies (“BDC”):
An Open-End Fund – must issue and redeem shares at net asset value, which needs to be calculated daily.They also have restrictions on what types of investments they can hold. The majority of the investments (85%) must be liquid investments.In addition, they cannot charge incentive fees, but they can charge a fulcrum fee, which is a performance fee over a stated benchmark.
A Closed-End Fund – Typically, they have a one-time offering (you can also have a continuing offering closed-end fund) and they issue a set amount of shares which are generally exchange-traded, and they do not have to offer redemption rights to investors.Another advantage of a Closed-End Fund is that they are much more flexible with the type of illiquid investments they can invest in. If a Closed-End Fund is exchange traded or is sold to non-qualified people, it also cannot charge incentive fees.
A BDC is a type of Closed-End Fund set up with the intention to provide capital to small and middle market companies. As such, it has eased restrictions for transactions with affiliates and may co-invest with affiliates. In addition, there are significant restrictions on what can be invested in. BDCs generally use credit strategies such as investments in mezzanine loans and senior and secured debt. Unlike typical open ended RICS, a BDC can charge an incentive fee up to 20% appreciation to qualified investors.
Accounting Rules and Auditor Independence
Along with all the other rules that you will need to follow, there are some very important accounting and auditor independence rules that must be adhered to.A RIC needs to have a financial statement audit at least once a year (a BDC needs to file quarterly 10Qs and Annual 10K) depending on what type of RIC you are.An audit firm registered with the Public Company Accounting Oversight Board (the “PCAOB”) is required to perform the audit of a RIC.The PCAOB was formed as a result of the Sarbanes-Oxley Act. Besides performing inspection of member audit firms, the PCAOB also issues accounting regulation and have their own auditor independence rules.
Private funds are subject to accounting and auditor independence rules established by the American Institute of CPAs, which are less restrictive than the PCAOB.Here are some of the services that an Audit Firm CANNOT perform for a RIC:
- Draft Financial Statements for the fund. Recent interpretation includes word processing and binding of the financial statements.
- The fund must reasonably evaluate it owns accounting policies and procedures.
- The audit firm cannot prepare the tax returns of employees or management of the fund.
- The audit firm cannot be an advocate for the fund.
This may not seem too severe, but if you manage a private fund there will be adjustments to make in your relationship with your auditors and the services they provide. You will need to coordinate with your administrator to confirm that they cannot only handle the preparation of the financial statements, but also the revisions and publishing of those statements, and are capable of filing the required forms with the SEC. And don’t forget, administrators will need to turn around those financial statements quicker than for private funds, to comply with the 60 day annual filing requirement.
If you are considering starting a RIC, you should discuss the operational, legal and accounting considerations with your attorney and audit firm.Remember, you will have another layer of costs by becoming a RIC and your fund will need to be large enough to absorb those costs.There is a limit to the amount of expenses that can be charged to a RIC, so you may have to absorb any excess costs. Becoming a RIC can give you a tremendous business advantage and open you up to a whole new world of investors, but you need to know what the unintended consequences are BEFORE you file to become a RIC.