The Investment Company Act of 1940: 77 Years Later

On this day in 1940, President Roosevelt signed the Investment Company Act of 1940.  Previously, both houses of congress had approved the ’40 Act unanimously. The ’40 Act, is the primary source of regulations for the multi-trillion dollar investment industry. The ’40 act defined and regulated investment companies, and provides investors with protections against conflicts of interest, misappropriation of funds, excessive fees, and undisclosed risks.

As he signed the bill, President Roosevelt declared:

We have come a long way since the bleak days of 1929…. I have great hopes that the act which I have signed today will enable the investment trust industry to fulfill its basic purpose as a vehicle to diversify the small investors risk.

What is a ’40 Act Fund?

The investment companies that the 1940 Act protections apply to are known as 1940 Act Funds, or ’40 Act Funds Broadly speaking, there are three types of  ’40 Act Funds: Closed End Funds, Open End Funds, and Unit Investment Trusts. Open end funds and closed end funds are the most common type of

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Interval Fund Service Providers

Interval funds rely on a variety of third party fund service providers in order to operate.  An administrator oversees the operational performance ensuring it complies with regulatory requirements. An independent accounting firm performs annual audits and certifies the fund’s financial statements. The interval fund transfer agent keeps ownership records, and handles transaction processing. A CSV file with information on service providers for all active interval funds is available at the bottom of this post.

Interval Fund Transfer Agent Market Share

Several users of this site have asked about interval fund transfer agents. DST Systems leads the market, and currently serves as transfer agent for 26% of active interval funds.  See this whitepaper that DST Systems recently produced on exploring new product structures. UMB Services serves as transfer agent for 21% of interval funds. UMB Services recently wrote about its turnkey interval fund solutions in HedgeWeek.

The following chart summarizes interval fund transfer agent market share, as of August 2017:

 

Interval Fund Transfer Agents

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Where PIMCO Sees Attractive Opportunities

PIMCO recently launched the Flexible Credit Income Fund(PFLEX). The fund has a a flexible mandate to capitalize on a variety of credit market opportunities. On the fund’s website, PIMCO describes the opportunities it is expecting to find:

Q: Where do you see attractive opportunities for the Flexible Credit Income Fund today and in the future?
A: While we believe valuations on many traditional credit sectors (investment grade, high yield and bank loans) are relatively fair at current levels, we are seeing several robust opportunities today.
First, despite strong performance in U.S. real estate markets since the financial crisis, we continue to find value in both public and private mortgage debt, especially on the residential side. These opportunities include traditional legacy non-agency mortgage-backed securities (MBS), legacy loans that Fannie Mae and Freddie Mac continue to dispose, and opportunities to purchase newer origination non-agency mortgage loans directly. (We see many loans being made at significantly high interest rates given the regulatory burden associated with making non-traditional loans.)

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Comparing Interval Funds to Open-End Mutual Funds

Interval Funds have several key similarities with open-end mutual funds, but they are not identical.   Mutual funds and interval funds both offer shares on a continuous basis at NAV.  Mutual funds and interval funds are both “40 Act Funds” that provide investor protections from the Investment Company Act of 1940.   Mutual funds by definition allow daily redemptions, but interval Funds provide limited liquidity at set intervals.  This diagram, from the recently launched Sierra Total Return Fund, compares and contrasts Open-End Mutual Funds, Closed-End Funds, and Interval Funds:

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Investors May Soon Be Hearing More About Interval Funds

Recent links:
What are Interval Funds? – Wall Street Journal

Some researchers think there will be both a need and a demand for exposure to such assets in the near future. Low returns from traditional investments by historical standards will lead to a “steady stream of assets moving into alternative investments,” says a 2016 report from consulting firm McKinsey & Co. “These flows will be redirected heavily toward illiquid private markets.”

Interval funds may also provide a boost for financial advisers in a world where passive investing in funds that track market indexes is the rage.

“What retail investors now hold is largely a portfolio of passive exchange-traded funds, so the alternative-assets domain is how the adviser will add value to the client,” says Kimberly Flynn, managing director of XA Investments LLC in Chicago.

Alts offer a new course- – Financial Advisor Magazine

Pioneer ILS Interval fund hits $305m, some loss impact in half-year -Artemis

Also, registration is still open for the Adisa Due Diligence Forum. This event is designed for industry professionals who are employed with a Broker-Dealer, RIA, Family Office, Due Diligence Firm, or select others, that offer alternative investments in their business.

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How Interval Funds Operate

A key defining feature of an interval fund is that they are regulated under the 1940 Act.  This provides critical protections for investors.  DLA Piper released a handbook discussing the 1940 Act and related statues and regulations that apply to and otherwise bear on the interval fund operations. The information covers the key regulatory framework for 40 Act Funds, as well as the impact of recent regulatory changes.
According to DLA Piper:

 ….an interval fund can be a suitable vehicle in which to run “alternative” strategies – i.e., strategies that are designed to produce returns that are not highly correlated to the broader stock and bond markets. Interval funds also mesh well with certain noteworthy regulatory initiatives – for example, FINRA’s new customer statement rule (RN 15-02), and the Department of Labor’s fiduciary rule and accompanying BIC exemption – making them attractive vehicles for use by independent broker dealers and other financial advisors that must operate within the complex regulatory environment.

Additionally, Griffin Capital, which operates the Institutional Access Credit Fund, and the Institutional Access Real Estate Fund…

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Why aren’t there more publicly traded interval funds?

Most publicly traded interval funds do not trade on an exchange. Many people in the industry speak of interval funds as if they are always non-traded. However it is possible for an interval fund to be publicly traded. Currently, of the ~40 active or and recently launched interval funds, the Blackrock Enhanced Government Fund (EGF) is the only one that is publicly traded. Or put differently, of the >500 publicly traded closed end funds, EGF is the only one that is structured as an interval fund. It offers to repurchase 5-25% of its shares annually, and charges a repurchase fee of 2%. Since it is an interval fund, the repurchase plan can be suspended only with shareholder approval.

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Comparing The New Credit Funds

With a whole slew of credit interval funds hitting the market this year, its time to compare the basic structures and fee arrangements.  The chart below consists of funds that have been declared effective within the past year, all from familiar sponsors.  Within the broader category of credit, there are a lot of substrategies, but its no coincidence, that all of the Sponsors for these funds have marketed BDCs to retail investors in the past.

Interval Funds- Credit              
Fund FS Energy Total Return Fund- A FS Energy Total Return Fund -I Griffin Institutional Access Credit Fund- A Griffin Institutional Access Credit Fund- C Griffin Institutional Access Credit Fund- I Sierra Total Return Fund Cion Ares Diversified Credit Fund
Ticker XFEAX XFEYX CRDTX CGCCX CRDIX SRNTX CADEX
Advisor FS Energy Advisor LLC FS Energy Advisor LLC Griffin Capital Credit Advisor, LLC Griffin Capital Credit Advisor, LLC Griffin Capital Credit Advisor, LLC STRF Advisors, LLC (Medley Management) Cion Ares Management, LLC
Sub-Advisor Magnetar Asset Management LLC Magnetar Asset Management LLC BCSF Advisors, LP BCSF Advisors, LP BCSF Advisors, LP NA Ares Capital
Minimum Initial Investment $2,500 $1,000,000 $2,500 $2,500 $1,000,000 $2,500 $2,500
Strategy Equity and Debt securities of natural resource companies. Equity and Debt securities of natural resource companies. High yield debt securities High yield debt securities High yield debt securities Debt and Equity Diversified Credit
Targeted Capital Raise Up to $2 billion Up to $2 billion Up to $1 billion Up to $1 billion Up to $1 billion Up to $1 billion Up to $1 billion
Redemption Program 5% per quarter 5% per quarter 5% per quarter 5% per quarter 5% per quarter 5% per quarter 5% per quarter
Offering Costs              
Maximum Total Sales Load 5.75% None 5.75% None None 2.00% 5.75%
Maximum Commission 5.00% None 5.00% None None 0.75% 5.00%
Dealer Manager Fee 0.75% None 0.75% None None 1.25% 0.75%
Distribution Fee None None None 0.75% None 0.75% of average daily net assets until cap is reached None
Shareholder servicing expenses 0.25% average daily net assets None 0.25% average daily net assets 0.25% average daily net assets None 0.25% of average daily net assets 0.25% of average daily net assets
Operating Fees/Costs              
Management Fee 1.75% of total assets 1.75% of total assets 1.85% of net assets 1.85% of net assets 1.85% of net assets 1.5% of total assets 1.5% of total assets
Contingent Deferred Sales Charge None None None 1.0% during first year None 1.0% during first year 1.0% during first 18 months
Incentive Fee None None None None None 15.0% of net investment income over 6.0% hurdle, with catch up provision 20% of net investment income over 6% hurdle, with catch up provision
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The Interval Fund Rule: Charting New Territory

Interval funds may seem like a new concept, but they were originally created as a result of a SEC recommendations in its landmark 1992 study : “Protecting Investors: A Half Century of Investment Company Regulation.”  This study concluded that the rigid delineation between “open end” funds, providing daily liquidity, and “closed end funds” , which do not offer daily liquidity, limited the ability of sponsors to offer innovative investment products to investors:

The Division has  concluded it would be appropriate to provide the opportunity for investment  companies to chart new territory between the two extremes of the open-end and  closed-end forms, consistent with investor protection. >

As a result of this recommendation, the Rule 23c-3 under the 1940 Act, known as interval fund rule was adopted in 1993.   Under the interval fund rule, closed end interval funds are required to offer to repurchase between 5% and 25% of shares at NAV at predetermined intervals(quarterly, semi-annually, or annually). The Fund is required to provide advanced notice to shareholders between 21 and 42 days in advance of repurchase offer .  Interval Funds also file N-23c-3 with the SEC within 3 days of sending shareholder notification of a tender offer. 

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Visualizing The Secular Shift in Retail Alternative Investments

As non-traded REITs and BDCs have shrunk, registrations of new interval funds have grown rapidly. Launches of interval funds have overtaken non-traded REITS and BDCs  (Source: SEC Filings)

The market for retail alternative investments is in the midst of a dramatic secular shift.   High commission  non-traded REITs and BDCs were a core revenue source for many smaller broker-dealers.  However  sales have collapsed.     Lightstone recently laid off most of its sales staff and closed its non-traded REITs. Lightstone will likely be launching Reg D and Reg A+ offerings. Inland has struggled to raise capital for its REIT although it continues to dominate the 1031 Exchange space, and is in the process of launching a private closed end fund.  FS Investments and Griffin Capital have both diversified their product suites away from traditional retail alternative investments, into newer product structures designed to achieve the similar objectives.

Non-traded REITs and  BDCs peaked right before the  ARCP accounting scandal which ultimately led to the collapse of the Nick Schorsch empire.  This led to many broker-dealers suspending sales from anything affiliated with then largest non-traded product Sponsor. Finra 15-02, which increased the transparency on client statements, made it harder for advisors to get away with charging the traditional 10% sales load.  The looming fiduciary standard, which required broker-dealers to act in the best interest of clients, also led many broker-dealers to suspend or slow down the sales of high commission products.

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