I. After the Dust Settles: Acting on Identifying Matters of Value
After yielding constant information about COVID-19 the ability to secure certainty about the matters of value became increasingly obscure. How ironic. Nevertheless, the pressure to manage assets during unprecedented market uncertainty, maintain adviser-client relationships, and preserve the safety and engagement of employees never seemed to waver.
It has been said that when everything is uncertain, what is important becomes clear; and although a portion of our ability to respond to uncertainty is instinctive, a greater portion is learned. Collectively, the industry learned that we were all in this together. However, 2020's uncertainty may also prompt independent reactions from the lessons learned about what truly matters at the core of each firm. One of which may be to pivot away from the perception of stability from an all in-house organizational structure, and rather, favor agility to confront the external environments ability to rock a firm's foundation in an instant.
Re-framing a once reliable approach is surely no easy feat. However, the asset managers that decide to embrace turning such uncertainty into possibility may very well uncover a refreshed approach that will magnify the focus on core services and innovation, deepen the cultural roots of the business, and strengthen the client base along the way.
All of which sound wonderful, but how, one might ask?
Magnifying the focus starts by identifying what makes an asset manager unique - where value is added that cannot be duplicated by competitors. Does anything fall out of scope that may be essential, but less of a competitive strength? If the answer is yes, then outsource it. Something that, conveniently enough, segues into how PINE can be that missing puzzle piece as a strategic extension of staff who takes pride in supporting such newly agile firm structures.
Not only can PINE be trusted to manage essential functions and allow for this magnified focus on value, but in turn, it may help stimulate employee engagement as well. Tasking PINE with the essential, yet competitive functionalities, will ultimately reduce internal levels of management and mitigate unnecessary complex governance structures to allow for more concentrated employee opportunities in a nimbler and more innovative environment. The accumulation of which are imperative for a firm's competitive success, but more importantly; each helps support what truly matters - the core strengths and the employees of the business.
Ultimately, the firms that endured the height of COVID-19's uncertainty during the first half of 2020 should be proud of simply accomplishing any level of success during unprecedented times. However, those that leverage the experience of turning uncertainty into possibility may find themselves light years ahead of their competitors once the dust from the pandemic has officially settled, if not sooner.
II. Observations from Examinations of Private Fund Advisers
The Office of Compliance Inspection and Examinations ("OCIE") released a risk alert on June 23, 2020 regarding certain compliance issues observed during examinations of registered investment advisers that manage hedge funds or private equity funds ("private fund advisers"). The risk alert outlined three general areas of deficiencies that OCIE concluded during these examinations: 1) conflicts of interest; 2) fees and expenses; and 3) policies and procedures related to material-non-public information ("MNPI").
Conflicts of Interest
OCIE staff observed several conflicts of interest that were not adequately disclosed to investors, a few of which are summarized below.
Conflicts related to allocation of investments: The staff identified private fund advisers that did not provide adequate disclosure about conflicts relating to allocations of investments among clients, including the adviser's flagship funds, co-investment vehicles and SMAs. The staff identified several private fund advisers that preferentially allocated limited investment opportunities without adequate disclosure.
Conflicts related to preferential liquidity rights: The staff observed private fund advisers that entered into side letters with certain investors that established preferential terms including preferential liquidity rights, but didn't not properly disclose the side letters to investors. Failure to provide disclosure resulted in certain investors not being aware of the potential harm that could be caused by selected investors redeeming interests in the fund ahead of other investors.
Conflicts related to cross-transactions: The staff observed private fund advisers that did not properly disclose conflicts related to buys and sells between clients (i.e. cross trades). Advisers were establishing transaction prices that would disadvantage either the buying or selling client without providing proper disclosure.
Fees and Expenses
Allocation of fees and expenses: The staff observed private fund advisers that allocated shared expenses, such as broken-deal costs, due diligence, insurance, etc. among the adviser and its clients in a manner that was inconsistent with disclosures to investors or policies and procedures. In addition, advisers charged private fund clients for expenses that were not permitted by the relevant fund operating agreements. In both instances, these mis-allocations caused investors to overpay expenses.
Valuation: The staff observed private fund advisers that did not value client assets in accordance with their valuation policies and procedures or in accordance with disclosures to clients. The failure to value a private fund's securities in accordance with the policies and procedures led to overcharging of management fees and carried interest.
MNPI / Code of Ethics
Section 204A of the Advisers Act requires investment advisers to establish, maintain, and enforce written policies and procedures reasonably designed to prevent the misuse of MNPI by the adviser or any of its associated persons. During the examinations, the staff identified deficiencies under Section 204A or the Advisers Act Rule 204-1 ("Code of Ethics Rule").
Section 204A: Advisers did not address risks posed by their employees that conduct business with insiders of public companies, expert network firms and others in order to determine if MNPI would have been exchanged.
Code of Ethics Rule: The staff identified firms that failed to have adequate Code of Ethics designed to prevent the misuse of MNPI. Advisers did not enforce trading restrictions on securities placed on the restricted list. In addition, private fund advisers failed to enforce their Code of Ethics requirements related to employees' receipt of gifts and entertainment. In addition, certain advisers had poor controls and procedures relating to employee supervision, including personal trading, pre-clearance and submission of holdings and transactions reports.
III. Emergence of Interval Funds
One area where we are seeing growing interest in the industry is in interval funds. Interval Funds are Security and Exchange Commission ("SEC") registered funds, which are a hybrid between open-end mutual funds and closed-end funds. While closed-end funds list their shares on a stock exchange, interval funds accept fund subscriptions more similarly to open-end mutual funds, by making a continuous offering of shares at its current net asset value. However, unlike open-end mutual funds, interval funds limit redemption of their shares to certain time periods through periodic repurchase offers. Through these repurchase offers, the interval fund will offer to buy back a percentage of its outstanding shares at its net asset value. These repurchase offers can vary in frequency, but are generally offered on a quarterly basis.
Interval funds may invest in many different security types, including direct security investments, other funds (open, closed, private), or pooled investment vehicles (LLCs, partnerships, joint ventures). They must calculate a NAV at least weekly, and more frequently in the days surrounding their repurchase offers.
Through the repurchase offer process, investment managers of interval funds are able to predict when the fund might have an outflow of assets. This unique characteristic may make interval funds favorable options for investment managers who want to manage an alternative investment strategy focusing on less liquid assets.
PINE's experience working with investment managers on interval funds continues to enhance. If you would like to learn more about their structure, feel free to reach out to us.
IV. Cayman Islands Private Funds Law 2020
The value of a good compliance officer has recently increased, for investment managers who do business in the Cayman Islands, and with the enactment of the Cayman Island Private Fund Law 2020, more private funds will have to register with CIMA.
A vehicle will be considered a "private fund" under the Law if the following applies 1) its principal business is offering and issuing investment interests; 2) its investment interests carry an entitlement to participate in the profits or gains of the vehicle and are not redeemable or re-purchasable at the option of the investor(i.e. it is a close-ended fund); 3) its purpose or effect is the pooling of investor funds with the aim of spreading investment risks and enabling investors to receive profits or gains from such vehicle investments; 4) the investors do not have day-to-day control over the investment; 5) its investments are managed as a whole by or on behalf of the operator, directly or indirectly, for reward based on the assets, profits or gains on the vehicle; and 6) it does not constitute a "non-fund arrangement" and the law provides a list of non-fund arrangements which include pension funds, contracts of insurance, join ventures, holding vehicles, and individual investment management arrangements. The law also states that it does not apply to regulated mutual funds or EU connected funds.
Apart from the requirement to register, the law also includes several ongoing reporting requirements:
These new requirements make it clear that private funds will need a dedicated compliance officer to keep up with files, changes, and continued clarification as the new law is implemented by CIMA. Additionally, the past few years have seen an increase in regulatory requirements that private funds must comply with, and thus the need for a good compliance officer continues to increase.
- Any change to the fund may have to be submitted to CIMA within 21 days of making the change or becoming aware of the change;
- The annual return of the fund must be in a prescribed form. However, the Law does not specify how the return should be presented;
- Identification of securities held by the fund shall be made available to CIMA upon request, including international securities identification numbers or other identification codes; and
- CIMA may request a private fund provide such documents, statements, or other information reasonably required in connection with CIMA functions.
V. Fund Valuation Practices - SEC Proposes New Framework
The SEC took steps during the quarter to revamp fund valuation practices under the Investment Advisors Act of 1940 for the first time in 50 years. The asset management industry has evolved greatly over the years regarding the types of asset classes funds may hold; therefore the SEC is looking to streamline the responsibilities of those involved in determining fair value to better reflect the market. The proposed Rule, 2a-5, specifically addresses the roles and responsibilities of the fund's board of directors in determining fair value and their ability to leverage the investment adviser in situations where their expertise is needed. This has the potential to directly impact both fees and returns so it is important to understand the ramifications these proposed changes can have on your business.
Proposed Rule changes:
The fund's board of directors must continue to play an active role in the oversight of the valuation processes as required by the SEC even though they may not be involved in the day-to-day operations of the fund. To ensure proper compliance the board must ensure the act of detailed record keeping, the avoidance of conflicts of interest, and timely reporting is provided on a frequent basis. The market continues to change, and this newly proposed rule looks to align valuation practices with the current asset management industry.
- Define requirements for determining fair value
- Allow the fund's board of directors to delegate the responsibilities of fair value determination to the investment adviser of the fund, subject to the conditions and oversight requirements outlined in the proposed rule, which include:
- Assessing and managing material risks associated with fair value determinations
- Selecting, applying, and testing fair value methodologies
- Overseeing and evaluating pricing services, including third parties
- Adopting and implementing policies and procedures
- Maintaining certain records; and
- Define when the market quotations are readily available
"The way a fund values its investments is critical to our Main Street investors." said SEC Chairman Jay Clayton. "It affects the fees they pay, the returns they receive, and the value of the fund shares they hold. Today's proposal would improve valuation practices, including oversight, thereby protecting investors and improving market efficiency, integrity and fairness.
VI. Get to Know PINE
PINE is excited to provide the audience of our Quarterly Newsletter with some insight into what our team and corporate culture, both in and outside our work environment is like. To do so, we have asked each team member the following question to hopefully accomplish just that!
Q2 Newsletter Question:
If PINE was a rock-band, who would be the lead singer?
Stephanie Pokuta: Chris would be the lead singer, J.B. would be on the drums, Derek would be the band manager, and the rest of us would be impeccable backup dancers/vocals.
Derek Mullins: I would choose Xavier to be our lead singer. As the youngest member of the PINE team, he has the energy to jump around stage like Mick Jagger in his prime.
Chris Jones: Our lead singer would be Xavier! Not sure if he has any musical talent, but if I were to guess any of us did, it would definitely be him. Regardless, he is the youngest so he will lead us to the Rock and Roll Hall of Fame!
Xavier Chavez: Chris would definitely be our lead singer. He constantly has a positive attitude and is always able to captivate any audience he comes in contact with. This alone would land us a spot in the top 20 of the Billboard Hot 100 list, not to mention he probably has some musical talent to push us even higher.
Marcie McVeigh: Chris would be our lead singer because he keeps us all entertained and coins cool catch phrases that we all end up using.
J.B. Blue: I would have to go with Derek because of his skills on the dance floor. Although he may need to lip sync.
Tom Merrill: I would say Stephanie is the lead singer of our little rock band.
Brain Teaser Answer
You have a 3-gallon bucket and a 5-gallon bucket. How do you measure out EXACTLY 4-gallons?
1) Fill the 3-gallon bucket
2) Pour the 3-gallon bucket into the 5-gallon bucket
3) Fill the 3-gallon bucket again
4) Fill the 5-gallon bucket with the 3-gallon bucket until full, leaving 1-gallon left in the 3-gallon bucket
5) Empty the 5-gallon bucket
6) Pour the one remaining gallon from the 3-gallon bucket into the 5-gallon bucket
7) Fill the 3-gallon bucket and dump into the 5-gallon bucket for a total of 4 exact gallons
1) Fill the 5-gallon bucket
2) Pour the 5-gallon bucket into the 3-gallon bucket until full leaving 2-gallons left over
3) Empty the 3-gallon bucket
4) Pour the 2-gallons left over from the 5-gallon bucket into the 3-gallon bucket
5) Fill the 5-gallon bucket
6) Pour the 5-gallon bucket into the 3-gallon bucket until the 3-gallon bucket is full. Leaving 4-gallons exactly in the 5-gallon bucket.