By Rodney F. Tonkovic, J.D.
A comment letter by the Managed Funds Association asks the SEC to include private funds in the scope of its proposed "fund of funds" rules. While the MFA supports the updating of the regulation of fund of fund arrangements, it believes that the proposed rule should also include private funds in the scope of Investment Company Act rule 12d1-4 so they may invest in the same manner and subject to the same conditions as registered funds.
Funds of funds. On December 19, 2018, the Commission proposed a new rule and related amendments designed to streamline and enhance the regulatory framework for fund of funds arrangements. "Funds of funds" are created when a mutual fund or other type of fund invests in shares of another fund. The proposal, which would rescind Investment Company Act Rule 12d1-2 as well as a series of exemptive orders issued since the 1990s, would allow, under proposed Rule 12d1-4, a fund to acquire the shares of another fund in excess of the limits of the Investment Company Act without obtaining an individual exemptive order from the Commission, subject to certain conditions.
In its proposal, the Commission acknowledged that expanding the scope of the proposed rule to private funds would level the playing field for those funds. But, the proposal continues, there are risks associated with expanding the scope to private funds including that private funds are not registered with the SEC and are not subject to the same reporting and recordkeeping requirements as registered entities. Accordingly, the Commission did not propose to include private funds as acquiring funds under the scope of the rule.
Market benefits. In its letter, the MFA argued that including private funds would benefit investors and capital markets. With more options, private funds could incorporate ETFs into their investment strategies for the benefit of their investors. ETFs offer an attractive range of opportunities across sectors, the letter says, and restricting private funds from the full range of investments would tilt the playing field in favor of investors in registered funds. Plus, the current restrictions limit hedging through ETFs and could distort price discovery.
Policy concerns. Next, if the proposal is expanded to include private funds, those funds would be required to comply with the investor protection conditions in a substantially similar manner as registered funds. These conditions, the letter adds, would mitigate policy concerns of undue influence and control of acquired funds, layering of fees, and the formation of overly complex structures that could confuse investors.
Along these lines, the MFA recommends amendments to the rule that would provide additional flexibility for private funds to benefit their investors while continuing to protect investors generally. For example, the proposal contains a prohibition against an acquiring fund from controlling the acquired fund. The MFA recommends that the Commission apply the existing requirement in Section 12(d)(1)(A), which prohibits an acquiring fund and companies it controls from acquiring in the aggregate more than 3 percent of an acquired fund’s shares, to Rule 12d1-4.
Compliance. Next, responding to the Commission's explanation that private funds are not subject to the same reporting and recordkeeping requirements as registered funds, the MFA suggested that the extensive regulatory and reporting requirements already applicable to registered private fund managers would provide the sufficient oversight to ensure compliance with the rule. Forms ADV and PF, for example require advisers to private funds to provide extensive information.
Investments in ETFs. Finally, if the Commission declines to include private funds from Rule 12d1-4, the MFA recommends that it allow additional investments by private funds in ETFs, subject to appropriate conditions. The Commission could also opt to treat ETFs separately from other registered funds based on their different characteristics, the letter suggests.