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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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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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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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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Non-Traded REIT and BDC Sponsors Launching Interval Funds

Non-traded REIT and BDC sponsors are entering the interval fund space en masse. This was a key trend in 2016 and it is continuing in 2017. Here is a partial list of Non-traded REIT and BDC Sponsors with interval funds in various stages of launch.

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