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If you manage a private fund or commingled pool and find yourself wondering where to go from here, you may want to consider converting your fund to an open-end mutual fund. Converting from an unregistered fund to a mutual fund provides immediate scale and positions your fund to take advantage of the broad distribution opportunities available to registered funds. Furthermore, the converted mutual fund may be structured as a tax-free reorganization, which enhances your fund’s appeal to existing investors. Conversion to a mutual fund also offers an advantage that a newly launched fund cannot match: under certain circumstances, the performance of the private fund may be carried over, or ported, to the new mutual fund, thus giving your fund a historical track record that a newly launched fund will not have.
SUITABLE FOR A MUTUAL FUND
Before getting started, determine if your current private product is suitable for a mutual fund. Registered mutual funds must comply with IRS and SEC requirements governing the fund’s investments, income, distributions, liquidity and leverage. You will need to consider the following: Is your current strategy suitable for a mutual fund? Are you comfortable with the level of required transparency and oversight? And — not to be overlooked — do the economics work? Mutual funds typically have higher operational expenses than private funds and existing investors will not want to pay more for the product, nor will the mutual fund’s board want you to charge more, so plan on a lower profit margin until you garner new assets.
Once you have decided that a mutual fund is right for you and your strategy, the product launch begins. The process to convert a private fund into a mutual fund is similar to starting a fund that will be seeded with cash — but with some key additional steps.
In legal terms, the conversion is a reorganization of the private fund (the “acquired fund”) into a mutual fund shell (the “acquiring fund”). The assets are transferred to the acquiring fund from the acquired fund, which will cease to exist after the reorganization.
An Agreement and Plan of Transfer or Reorganization (the “Plan”) defines the terms of the transaction and provides, among other things, that the investors in the acquired fund approve the transaction, that they have an opportunity to exit the acquired fund prior to the transfer, and that the boards of directors of the acquired fund and the acquiring fund believe the transaction is in the best interests of the shareholders. The Plan details the assets to be transferred, the liabilities to be assumed and the method for valuing the investors’ interests that transfer to the acquiring fund. Legal counsel will provide guidance regarding the legality, conditions and requirements of the boards of directors being asked to approve the Plan.
The acquired fund’s investments typically transfer to the mutual fund in-kind, thus avoiding trading costs and adverse tax consequences for the acquired fund’s investors who will be making the transition to the acquiring fund. Legal counsel may be asked to provide a tax opinion letter regarding the tax-free nature of the transaction. It is important to note that an investor’s holding period in the private fund will not carry over to the mutual fund; if the investor sells shares in the mutual fund within a year of the conversion, a portion of the gain/loss may be considered short term.
Conversion is just one step along the way to a successful launch of a mutual fund — a process that typically takes about four months, and begins with a due diligence review before the initial filing with the SEC.
As for the opportunity to retain, or port, the performance record of the private fund as the mutual fund’s own performance, the SEC considers each request on a case by case basis. Certain factors must be met — for example, the private fund cannot have been created in order to establish a performance record and the investment strategy and management of the mutual fund must be consistent with that of the private fund. The private fund’s performance may be cited in the fund’s prospectus, shareholder reports, and marketing materials — followed by disclosure that the private fund was not registered and therefore not subject to certain mutual fund requirements and that the private fund’s performance may have been adversely affected if it had been registered.
It’s important to understand at the outset that although the fund’s marketing materials may refer to prior performance, Morningstar will use the launch date of the mutual fund (not the private fund) when rating the fund.
KEY TO A SUCCESSFUL CONVERSION
The key to a successful conversion is choosing the right service providers. A fund administrator with practical experience can help you analyze the product to make sure critical considerations and requirements are addressed before moving forward. Not only will an experienced administrator manage the conversion and fund launch, but will also provide valuable legal and regulatory support such as drafting the Plan and addressing conversion related requirements prior to engaging outside counsel. This can help you save money and ensure a smooth conversion.
Jessica Chase is the Director of Business Development at Atlantic Fund Services. For over thirty years Atlantic has provided fund start-up and ongoing services to mutual funds and other pooled investments.