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Ropes & Gray attorneys provide timely analysis on legal developments, court decisions and changes in legislation and regulations.
Catherine Skulan: Hello, and thank you for joining us today for this Ropes & Gray podcast where we’ll discuss considerations for private fund managers seeking to explore alternative retail products. I’m Catherine Skulan, and with me today is Chelsea Childs. We are both partners in the Ropes & Gray asset management practice group in San Francisco.
Our goal for today’s podcast discussion is to help private fund managers who are considering expanding their investor base by tapping into the retail market understand different fund products that may facilitate that expansion. First, we’ll go over some background on two types of alternative retail funds—interval funds and tender offer funds—that we think are interesting for private equity and private debt investment strategies. We will discuss the current market popularity and benefits to these two fund products and end with some considerations that private fund managers should keep in mind when thinking about expanding into these products. Retail offerings represent a new line of business for managers who, to date, have only managed private funds, and they come with new requirements, costs and compliance considerations. Running this business is more involved than just putting a registered wrapper on a current private product but is well worth considering as a potential way to diversify offerings to a different investor base. With that, Chelsea, would you like to kick off with some background on how interval and tender offer funds differ in key respects from private funds?
Chelsea Childs: Of course. To understand how alternative retail funds compare to other products, I find that it’s most helpful to think about the universe of possible fund products on a spectrum of liquidity from the perspective of an investor. For example, in the private funds space, at one end of the spectrum we have the “least liquid” types of funds, which are private closed-end funds such as venture and private equity funds. As our listeners likely know, these funds typically have limited terms, limited investment periods, and almost no liquidity for investors. Moving along the liquidity spectrum, we have private open-end funds, like hedge funds and other evergreen products, which are relatively more liquid from an investor’s perspective because they offer some form of periodic withdrawals, often subject to lockups and gates.
In the registered fund world, we also have closed- and open-end funds, but those terms mean different things in this context. Open-end registered funds—the most liquid fund type on our investor liquidity spectrum—are traditional mutual funds that offer daily subscriptions and redemptions at net asset value. Because mutual funds have to honor daily redemptions, they’re unable to make significant investments in less liquid private companies. Registered closed-end funds, on the other hand, have no limit on the amount of illiquid investments in which they can invest. Registered closed-end funds can be listed on a securities exchange or unlisted like interval funds and tender offer funds—those are the funds we’re focused on today.
Interval and tender offer funds are continuously open to new subscriptions (either on a daily or monthly basis) and provide limited liquidity through periodic repurchase offers or tender offers (most often conducted quarterly) for up to a certain percentage of the fund’s outstanding shares. This gives an investor liquidity that’s similar to that of certain evergreen private funds.
Catherine Skulan: That’s a really great way to visualize what we’re talking about today in the larger scope of the investment funds world. To focus on one of the key points you made—interval and tender offer funds are types of registered closed-end funds. That means that they’re subject to the provisions of the Investment Company Act and their shares are typically also registered under the Securities Act. Now, that means, for our purposes, that these alternative retail products must comply with SEC regulatory requirements to a much greater extent than private funds.
Chelsea Childs: That’s right. Managers should understand that launching these products essentially means launching a new line of business aimed at retail investors. For example, like all registered investment companies, interval and tender offer funds are required to have a board that is comprised substantially of directors who are independent from the fund’s adviser, and a chief compliance officer who is dedicated to the fund and reports to the board. These funds must also comply with public reporting requirements such as annually updating their offering documents and delivering annual and semi-annual reports to shareholders.
Current market popularity and benefits of tender offer/interval funds
Catherine Skulan: But although these products have more regulatory complexities than private funds, managers can find that the regulatory burdens are outweighed by the ability to tap into a larger investor base. Private funds that rely on the exemptions from the Investment Company Act registration in reliance on Sections 3(c)(1) or 3(c)(7) of the Act are constrained by the number of their investors or otherwise limited to investors who meet certain financial and sophistication standards, such as institutional or ultra high net worth investors. Now, in markets where institutional investment is soft and high net worth investors are feeling liquidity constraints, this can pose significant fundraising challenges. The ability to offer their investment strategies in a package that can be made available to retail investors can be particularly attractive to private fund managers in these markets.
Chelsea Childs: The current market for interval and tender offer funds is approximately $175 billion in total managed assets across well over 200 funds, with a number of funds having over $2 billion in managed assets. And funds with venture and private equity strategies make up a meaningful portion—over $35 billion—of that market.
Now, a particularly attractive thing about this market is that it allows these funds to be made available on large investment platforms like Schwab or Fidelity. Interval funds that calculate their net asset values daily are eligible to be on the traditional retail-facing platforms, while tender offer funds can be on the alternatives platforms used by registered investment advisers. Accessing this retail market opens up the potential to tap into a source that represents billions in assets.
Catherine Skulan: Now, we certainly aren’t saying that raising a $2 billion fund is the experience of every manager, nor should it be. The appropriate size of any fund is going to be influenced by a number of factors—an important one being the ability to source deals. This is an area in which managers focused on venture capital funds, for example, may have a leg up on a larger, more diversified manager who doesn’t have that organic access to deals. In any case, it’s important to keep things in perspective. For managers looking to get into this business line and unlock this market, let’s understand a bit more about the difference between interval and tender offer funds.
Chelsea Childs: Sure. Interval and tender offer funds can offer similar investor experiences, but they have some key differences that managers should be aware of. Interval funds are regulated by Rule 23c-3 under the Investment Company Act. Once a fund opts into the rule’s regime, it can’t cease being an interval fund without the approval of shareholders. Rule 23c-3 is a fairly prescriptive rule which outlines requirements for the amount (which must be between 5-25% of the fund’s outstanding shares), timing (every three, six or 12 months) and process of a fund’s periodic repurchase offers. The fund’s board approves the repurchase offers and can skip or postpone an offer only under extremely limited circumstances.
Importantly, while closed-end funds don’t have a limit on the amount of illiquid assets they can hold, Rule 23c-3 does have a liquidity requirement in that an interval fund must maintain sufficiently liquid assets equal to 100% of the repurchase offer amount during the fund’s repurchase period. Under the rule’s timing requirements, this equates to a period of between 21 and 42 days. There are ways to manage these liquidity requirements, including through the use of credit facilities, but these considerations can be nuanced, so we won’t discuss those in detail today.
Catherine Skulan: Great. Now, the liquidity requirement is an important difference between these products and their private fund counterparts. Managers used to running illiquid investment strategies will need to incorporate some more liquid investments into their strategy in order to make these periodic repurchase offers possible. This can be done by investing in publicly traded securities, including, potentially, portfolio companies that have IPOed, or other investments such as derivatives, exchange-traded funds and other pooled investment vehicles. If a manager doesn’t have those investment capabilities in house, it is possible to hire a sub-adviser to manage this more liquid sleeve of the portfolio.
Chelsea Childs: Yes, that’s important to understand, particularly for managers investing primarily in private equity. And while both interval funds and tender offer funds must have enough liquidity to meet their repurchase requests, it is worth noting that tender offer funds have more flexibility with their repurchase process.
Now, tender offer funds are subject to a different rule—Rule 13e-4 under the Exchange Act, which prescribes the timing and manner of a fund’s tender offers, but this rule is less limiting than Rule 23c-3 in a few key respects:
i. it doesn’t require periodic tenders, meaning that a board can skip a tender offer (although commercial considerations may often limit this ability in practice),
ii. the amount of the tender offer is not prescribed,
iii. the deadline by which shareholders must receive the proceeds from their tendered shares is also not prescribed, although for funds primarily investing in equity of private companies and private funds, current SEC staff policy is that tender offers must be paid within 65 days after the end of the tender period, and
iv. finally, and perhaps most significantly, it does not prescribe the amount of liquid assets required to be held by funds in connection with their tender offers.
The flip side to this additional flexibility, however, is that the regulatory filings for tender offers require significantly more disclosure than filings required for interval funds’ repurchase offers.
Challenges and considerations of tender offer/interval funds
Catherine Skulan: Now, in addition to some of the key regulatory requirements you noted earlier, what are some other important considerations that a manager should be mindful of in considering these products?
Chelsea Childs: Perhaps most importantly, there are limitations on managers’ compensation arrangements. Registered funds are prohibited from charging differential management fees, which means that a manager can’t offer management fee breaks to founders or other significant investors in the fund, which is common in private funds. Additionally, managers may charge registered funds performance or incentive fees only if such fees are based on income (not capital gains or appreciation), unless the fund limits its investors to those who meet the “qualified client” standard in the Investment Advisers Act.
Another important consideration, which we don’t have time to dig into today, is the prohibition on affiliated transactions and the restrictions on joint transactions among a registered fund and its affiliates, which includes private funds with the same manager. We’ll get into details on some of these topics in a future podcast, so stay tuned.
Catherine Skulan: Yes, there is a lot more to explore on those topics. But to close out today’s discussion, can you speak to any considerations on the time to launch an interval or tender offer fund?
Chelsea Childs: Launching a registered closed-end fund is generally a lengthier process than launching a private fund, and this is primarily due to the nature of the SEC staff’s review of the fund’s registration statement, so managers should factor this into their timelines. Depending on the complexity of the fund, we generally expect a minimum of four to six months to launch an interval or tender offer fund, but our Ropes & Gray team here has timelines and checklists to make this process as smooth as possible.
Catherine Skulan: There was lots to consider here, but hopefully, this has given some initial food for thought to listeners who are private fund managers looking to get into a new business line that may open access to a broader investor base. For more information, please visit our website at www.ropesgray.com/assetmanagement and don’t hesitate to reach out to Chelsea or me if you would like to learn more about private funds or alternative retail funds. You can subscribe and listen to any Ropes & Gray podcast wherever you regularly listen to podcasts, including on Apple and Spotify. Thank you again for listening.