SEC Updates Framework for Fund of Funds Arrangements

SEC Updates Framework for Fund of Funds Arrangements

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The Securities and Exchange Commission (“SEC”) voted on Oct. 7, 2020, to adopt a new rule, as well as related amendments, to provide a streamlined regulatory framework for “fund of funds” investments.

Rule 12d1-4 will allow a registered investment company or business development company, or BDCs (referred to as “acquiring funds”) to acquire the securities of any other registered investment company or BDC (“acquired funds”) beyond the limits laid out in section 12(d)(1) of the Investment Company Act of 1940, should it meet several conditions.

The rule will simplify the existing framework, which currently is based on SEC exemptive orders and varies based on acquiring fund type, by creating a consistent framework for all funds of funds, whether they’re BDCs or other closed-end funds (CEFs), open-end funds, unit investment trusts (UITs), exchange-traded funds (ETFs) or exchange-traded managed funds.

However, while the rule is designed to provide funds with the flexibility they need to meet their investment objectives, it also provides enhanced investor protections.

Rule 12d1-4 Conditions

Control

Rule 12d1-4 will prohibit an acquiring fund and its advisory group from controlling, either individually or in the aggregate, and acquired fund, with some exceptions. “Control” is defined by the Investment Company Act of 1940 as “the power to exercise a controlling influence over the management or policies of a company, unless such power is solely the result of an official position with such company,” and it also establishes a rebuttable resumption that anyone who owns more than 25% of a company’s voting securities controls that company; any person who doesn’t own that amount doesn’t have control. That said, control isn’t based solely on ownership of voting securities, but other factors, too.

Thus, Rule 12d1-4 allows for acquiring funds to own up to 25% of the voting securities of an acquired fund, but would prohibit an acquiring fund and its advisory group from controlling an acquired fund, with certain exceptions.

Voting

Rule 12d1-4 will require mirror voting in some situations in which acquiring funds and its advisory groups hold more than particular thresholds that are dependent on the type of fund they hold.

For instance, an acquiring fund and its advisory group must use mirror voting if they hold more than 25% of the outstanding voting securities of an open-end fund or UIT as a result of a decrease in the outstanding securities of the acquired fund. However, it also will require the use of mirror voting if they own more than 10% of the outstanding voting securities of a CEF.

Required Findings

Rule 12d1-4 will require investment advisers to acquiring and acquired funds that are management companies to make certain findings about the fund of funds arrangement.

Acquired funds’ investment advisers must make findings addressing any undue influence concerns associated with the acquiring fund’s investment, after considering four factors:

  • The scale of contemplated investments by the acquiring fund and any maximum investment limits.
  • The anticipated timing of redemption requests by the acquiring fund.
  • Whether, and under what circumstances, the acquiring fund will provide advance notification of investment and redemptions.
  • The circumstances under which the acquired fund may elect to satisfy redemption requests in kind rather than in cash and the terms of any redemptions in kind.

The acquiring fund’s adviser, principal underwriter or depositor also must evaluate the complexity of the fund of funds structure, as well as its fees and expenses, and find that those fees and expenses are not duplicative.

These findings must be made before the acquiring fund invests in the acquired fund.

Fund of Funds Investment Agreement

Rule 12d1-4 will require funds with different investment advisers to enter into a fund of funds investment agreement before the acquiring fund obtains securities of the acquired fund in excess of section 12(d)(1)’s limits. This agreement should cover material terms necessary for each adviser to make the appropriate finding under the rule, a termination provision, and a requirement that the acquired fund provide fee and expense information to the acquiring fund.

This condition is meant to prevent overreaching and undue influence by the acquiring fund and its affiliates.

Complex Structures

Rule 12d1-4 will generally prohibit three-tier arrangements to cut down on complexity, with some exceptions.

One such exception is that acquired funds may invest up to 10% of total assets in other funds – referred to as a “10% bucket” –  without regard to the purpose of the investment or types of underlying funds. This bucket is meant to provide flexibility for these arrangements to evolve, while permitting structures that could benefit investors via greater flexibility.

Rescission of Rule 12d1-2 and Certain Exemptive Relief

As part of this action, the SEC is rescinding rule 12d1-2 to make the regulatory framework for fund of funds arrangements more consistent and efficient. Section 12(d)(1)(G) permits registered open-ended funds or UITs that primarily invest in funds within the same group to invest in unaffiliated funds and non-fund assets. With the rule rescinded, however, those funds reliant on 12(d)(1)(G) will be limited from acquiring funds from outside their same “group of investment companies.”

The SEC also rescinded its exemptive orders permitting fund of funds arrangements, with some exceptions.

That said, the SEC has amended rule 12d1-1 to allow funds that rely on section 12(d)(1)(G) to invest in money market funds that aren’t part of the same group of investment companies.

Amendments to Form N-CEN

The SEC also amended Form N-CEN, a structured form that requires registered funds to provide census-type information to the Commission every year, to report their reliance on 12d1-4 or the statutory exception in section 12(d)(1)(G) of the Investment Company Act during the reporting period.

Timing

Rule 12d1-4 will be effective 60 days after publication in the Federal Register. That said, the SEC will create a transition period by setting a compliance date for Form N-CEN’s amendments of 425 days after publication in the Federal Register. The rescission of rule 12d1-2 and the SEC’s exemptive orders will take effect one year from the rule’s effective date.

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Darren Mooney

Partner and Co-Head of Business Development

Darren Mooney is a Partner and the Co-Head of Business Development at Greyline. Before joining Greyline, Darren served as deputy chief compliance officer of Partner Fund Management where he held primary responsibility for the compliance program of the second-largest hedge fund in the Bay Area. Prior to that, Darren spent five years providing compliance consulting services at Cordium and then ACA Compliance Group, where he led the company’s San Francisco office and west coast operations. In addition to providing ongoing consulting services to a variety of investment managers, including hedge fund, private equity, venture capital, real estate, quantitative and other wealth managers, Darren also regularly guided clients through the SEC registration process, implemented tailored compliance programs, supported clients’ live SEC exams, and served as an SEC-mandated independent compliance consultant following an SEC enforcement action. Darren’s other experience includes serving as deputy chief compliance officer and associate counsel at F-Squared Investments where he directly supported the compliance program during the investigation and subsequent enforcement regarding historical advertising practices. Darren has a B.S. in Economics from the University of Delaware and a J.D. from Suffolk University Law School. He is a member of the Massachusetts bar.

Annie Kong

Partner and Head of Venture Capital
Annie Kong is a Partner and Head of the Venture Capital Division at Greyline. She provides ongoing compliance consulting to investment advisers and manages client relationships. Prior to joining Greyline, Annie was part of compliance and operations at a long-only manager-of-managers that advised pension fund clients. While there, she conducted compliance and operational due diligence on SEC-registered investment advisers on the platform. She also oversaw and counseled on various legal matters across the firm. Annie has a B.A. in Economics from the University of California, San Diego, and a J.D. from the University of San Diego School of Law. She is an active member of the State Bar of California.
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