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Podcast: COVID-19: European Regulatory Update for Asset Managers: 22 June 2020

Welcome to the fourth installment of Ropes & Gray’s European regulatory podcast for asset managers. These fortnightly podcasts and accompanying speaker notes are intended to provide an overview of updates relevant to GCs, CCOs and other compliance professionals to help you navigate both COVID-19 and other developments relevant to your business. The speakers on today’s podcast are Eve Ellis, a partner in Ropes & Gray’s asset management group specialising in fund regulation, and Rosemarie Paul, a partner in the firm’s litigation & enforcement group specialising in regulatory enforcement matters.

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Podcast: The Intersection of Private and Registered Funds: Interval Fund Investments in Private Open-End Real Estate Funds


Time to Listen: 26:41 Practices: Asset Management, Private Funds, Investment Management, Real Estate Investments & Transactions, Tax, Mutual Funds, ETFs & Closed-End Funds, Hedge Funds

In this Ropes & Gray podcast, asset management partners Matthew Posthuma and George Raine are joined by tax partner Pamela Glazier to discuss the legal, tax and operational issues involved when 1940 Act registered interval funds invest in unregistered open-end real estate funds, as private fund managers look for new sources of capital, and registered fund managers look for alternative investments for their retail investor base.

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Matt PosthumaMatt Posthuma: Hello, and thank you for joining us today on this Ropes & Gray podcast. I'm Matt Posthuma, a private funds partner in the asset management practice, and joining me today are George Raine, a registered funds partner in the asset management practice, and Pam Glazier, a tax partner who specializes in both registered funds and private funds. Today, we're going to talk about one of the areas where private funds and registered funds intersect, namely the investment of registered funds into private real estate funds. Just to give you a little bit of the market background: As defined benefit pension plans are going away, private managers of open-end real estate funds are looking for other sources of capital, including access to retail investors. George, what's the background from the registered fund perspective? 

George RaineGeorge Raine: Thanks, Matt, and thanks for everyone for coming along. From the public fund manager perspective, there are a number of different factors leading to the tendency for managers to look for investments into alternative types of vehicles. First off, there's been a fair amount of decompression in the industry where funds are not able to charge high fees or pay high fees to their managers, whereas if they're investing into more sophisticated investment strategies, they can maintain a higher fee for the manager. There's also been a rise of passive investing in the public market, so index funds, ETFs that have passive strategies are squeezing traditional fund managers outside of their bread and butter, which has been public markets. But these are areas where you can't have real passive investing – it's a place where active managers can have a real foothold. Lastly, there's been definitely a movement in the types of investments that public funds can make to try to diversify across different asset types. 

Matt Posthuma: Thanks, George. You and I have seen a few different structures for registered interval funds investing into private real estate funds. The first one is a registered fund of funds that invests in a variety of unaffiliated private funds, and I've seen these interval funds invest in a lot of my private real estate open-end fund clients. Another structure is where a private fund manager is looking for a way to access retail investors and wants to set up, in essence, its own public fund structure that can invest in one or more private real estate funds managed by that manager. George and I have worked on those kinds of structures as well for clients. Kind of a hybrid of either one of those structures is a structure in which the registered fund is investing both in privately managed funds as well as public securities, such as listed REITs and CMBS, which can provide more liquidity for the registered fund. George, can you touch on some of the regulatory regime surrounding public interval funds and how they might be relevant to private real estate fund investing? 

George Raine: The overall regulatory regime really focuses around the 1940 Act, which specifically regulates interval funds. There's a particular rule on interval funds, which is Rule 23c-3, and that lays out a number of the required characteristics for those funds. These feature elements such as periodic redemptions, namely that the fund will put out a redemption offer to allow its investors to take out somewhere between five percent and twenty-five percent of the outstanding shares of the fund on a periodic basis, such as quarterly, which has been publicly disclosed. Also, there is a tendency for these funds in trying to raise investment that they are allowed to conduct an ongoing offer, so that on a daily basis, they can take in subscriptions based on net asset value. While these are technically closed-ended funds for purposes of the 1940 Act, that gives them a little bit more of the attribute of being like an open-ended fund given that they’re selling daily. One requirement for the redemptions and the subscriptions as well is that the funds strike a net asset value, which is certainly subject to extensive regulatory scrutiny. 

Matt Posthuma: George, it's interesting to hear you talk about some of those requirements. Based on those, I can see why the open-end real estate funds are more attractive for the interval funds than other types of alternative investments. Open-end real estate funds have quarterly deposits and redemptions, and they strike a quarterly NAV based on appraisals. As you might suspect, appraisals of real estate are a much more robust form of valuation than other valuations of private equity. Pam, I understand that registered investment funds also have their own special tax regime. Can you talk about that? 

Pam GlazierEPam Glazier: Sure, Matt. Thanks. Most or nearly all registered funds seek to qualify as regulated investment companies for tax purposes. A fund that qualifies as a RIC is not subject to a fund level tax, so long as it distributes all of its income and it can pass through the character of that income, for example capital gains. In this way, RICs and REITs are similar. There are a number of qualification requirements for these purposes. One is a diversification requirement. So a fund can't have more than twenty-five percent of its assets in a single issuer, and at least half of the fund's assets must be in securities of issuers that represent no more than five percent of the fund's assets. In this bucket, for example, you'd need at least ten issuers that represent no more than five percent of the fund's total assets. As we'll discuss, that can be a limitation for some of these interval funds. In addition, there's a qualifying income requirement. At least ninety percent of the fund's income has to be from things like interest, dividends, and income and gains from securities. And notably, for this purpose, rents and other income from real estate investments do not qualify. 

Matt Posthuma: Pam, a lot of the open-end real estate funds that I see make all of their investments through REITs. Is that a good or a bad thing, from your perspective? 

Pam Glazier: The fact that open-end real estate funds typically invest through REITs is a very helpful fact. REIT dividends are qualifying income for the RIC purposes, so it's a good way to make sure that the interval fund is receiving qualifying income to qualify as a RIC. Finally, there are distribution requirements for RICs, again similar to REITs, which can be a liquidity consideration, which we will discuss later as well. 

Matt Posthuma: So George, if I'm a private fund manager who wants to set up my own registered fund structure or wants to get investments from registered funds, how does that work? What do I need to be thinking about? 

George Raine: First off, if you're trying to set it up so that you can get investments into a wide selection of your existing funds and trying to, essentially, retailize a group of private funds, you're going to run into some real issues under the 1940 Act’s affiliation requirements. Effectively, when a registered fund takes on an investment adviser, whether as the principal manager or as a subadviser – that advisory firm automatically becomes an affiliate. Then if that fund is then trying to invest into private funds, which in turn are managed by the same investment adviser, those underlying funds are also treated as affiliates. You run straight into prohibitions on being able to invest in those affiliated funds below. One of the issues of trying to deal with the affiliation problem is, if you can find a third party that is unaffiliated and is selecting the underlying funds and you, the underlying manager aren’t in turn acting as an investment adviser to the registered funds, then those private funds can come into the portfolio. Generally, the way affiliation works is that you technically become an affiliate – namely, the mutual fund technically becomes an affiliate of any private fund when it goes over five percent of the outstanding voting interest. There's a lot of hair on what that means, but certainly, also there are levels of affiliation when the mutual fund controls an underlying fund, and that also raises questions as to large positions for registered funds coming into private funds. 

Matt Posthuma: So that would come into play too, George, with a fund of funds as well? They wouldn't want to have five percent or more of the voting stock of any underlying private fund, even if the underlying private fund was unaffiliated with the registered fund? 

George Raine: There's enough gray area in this that the question of, "What is voting stock?" does actually receive attention. The LP interests in private funds often can be structured so as to not qualify as voting securities for purposes of a five percent test. If the registered fund goes over five percent, the problem you do end up with is that it creates restrictions on things such as joint transactions and a number of restrictions on transactions with affiliates that can get quite complicated, so it's going to be tricky. Certainly, if you stay below five percent of the outstanding units of an underlying private fund, there's no way there can be an affiliation. But there are ways to structure it, certainly depending on the facts and circumstances, and how you're setting up the whole vehicle structure so as to not treat the interests of private funds as being voting securities. 

Matt Posthuma: How does a registered fund manager decide which underlying private funds to invest in? Is that something that they do themselves? Do they hire a third-party manager or consultant? 

George Raine: Oftentimes, the managers of interval funds may not have quite the same expertise in being able to select among different private fund options. I'm certainly seeing with some clients that they’ll hire consultants who can be helpful in allocating among private fund investments – you can certainly engage a subadviser as well. In the end, the key question is, "What constitutes an investment adviser of the registered fund?" So there's going to be a real question of what information can go flow up and down from the private fund manager so that you're falling outside of the definition of being deemed to be an investment adviser to the registered interval fund. 

Matt Posthuma: Pam, you had talked about tax diversification requirements. How does that come into play when a registered fund is investing in a variety of private funds below? 

Pam Glazier: It's an issue that often comes up when the private fund adviser has a limited number of private funds and the goal is to invest only in those private funds. For example, if there's only five or six, or anything under 12 private funds to invest in and those are the only investments, the interval funds won't be able to meet the RIC diversification test. But one common question is, "Well, my private funds are partnerships. Each private fund owns a number of investments. Can we look through the private fund partnership and look at the underlying investments?" Unfortunately, unlike REITs, there is no rule that says you can look through private funds in that manner. For RIC diversification purposes, you're looking at each private fund. If you don't have a large enough offering of private funds, the interval funds will have to look to obtain exposure through other means as well to meet the test diversification rules. 

George Raine: Pamela, unlike the 1940 Act, which has its own separate diversification requirements on an ongoing basis, I believe the tax diversification requirements are measured at the end of each quarter. How is that measured? 

Pam Glazier: It's measured at the end of each fiscal quarter, so it's a quarter end test. There are some cure periods – for example, you have 30 days after quarter end to get into compliance with the test if you weren't at quarter end. What's difficult with private funds is the way you would cure noncompliance is to shift your asset mix and sell some investments and invest in other things, which often doesn't work well with these private fund structures and the business desires there. It's important upfront when you're contemplating setting up a fund to have an idea of what investments you'll be able to use to be able to meet the test. 

Matt Posthuma: Pam, what kinds of due diligence would you do from a tax perspective when a registered fund is looking at a private real estate fund and trying to decide whether it's a good investment? 

Pam Glazier: As we discussed before, one of the important RIC qualification requirements is a qualifying income requirement, so one question is, "What is the private fund investing in?" Like we discussed, the open-end real estate funds largely invest through REITs, so you would confirm that they invest only through REITs, and thus you have qualifying income. If they invest directly in real estate or through other structures, you need to dig down more to make sure the fund would meet the qualifying income requirements. There's also distribution requirements, so another question is if you have income allocated to the interval fund from a private fund but no cash distribution, making sure there's a method to be able to make the necessary distributions for RIC purposes?" Again, investing through REITs is a helpful point there because REITs also make regular dividends. 

Matt Posthuma: Thanks, Pam. I want to touch on some of the operational issues that come up with registered funds investing in private funds. First, I want to touch on valuations. As I mentioned earlier, the private open-end real estate funds do appraisals on a quarterly basis. Usually, those appraisals are sometime during the quarter, obviously not right at the end of the quarter. Then those appraisals are used to report a quarterly value for the fund, which is reported to investors at some point after the end of the quarter. But George, I remember you saying that interval funds have daily values. How do we reconcile the delayed quarterly values of the real estate funds based on these appraisals with the daily valuation requirement that the registered funds have? 

George Raine: You're absolutely right – if the fund is being sold daily, it needs to be sold at a net asset value. There are operating procedures for share valuation that a mutual fund board will adopt, which will have to find ways to adjust the NAV in order to come up with a fair price to sell the shares at on a daily basis. There's obviously a fair amount of conjecture over the course of a quarter, so there’s a bit of a concern that could be second guessed if the markets are moving around too much and your NAV is not moving with them. You can certainly solve that to some degree by disclosure, but in the end, there has to be a fair value process. You don't want to be creating any dilution of the interests of existing investors or charging too much for new investors coming in. One really critical time to be right on target with the NAV is for the periodic redemption because that’s going to be a significant outflow and the fund is going to have to be striking a NAV to base that outflow off of. Typically, you do have flexibility to set the period and the timing for your periodic redemptions so you can go out with an offer or redemption, coming up with the period of notice and then a date on which you can actually pay out the redemption. Typically, you would try to coordinate all of those pieces so that you’re as close as you can to get the most recent information for purposes of valuation. There might be a small lag when you're not going to have all of your periodic valuations come in on the same day for real estate that’s in the portfolio, but you do want to work out a process that gets you as close as you can, so at least on the date when you have a particularly large amount of the fund going out for the periodic redemption, you're coming up with as firm a calculation of the current value of the overall portfolio as you possibly can. 

Matt Posthuma: Another mechanical issue I wanted to touch on was contributions or investments. With the open-end real estate funds, that's done on a quarterly basis, but sometimes, depending on the new investments that the open-end private fund is going to make, there might be a deposit queue or a line to get into the open-end funds. There are times where an investor may have to wait for a couple of quarters before it’s able to deploy its capital. Now, I remember you saying, George, that interval funds are raising capital on a constant basis. I'm assuming that when they're looking for investments in private funds that they want to find funds that are going to be able to invest their capital as quickly as possible, rather than ones where the interval fund is going to have to wait in a deposit queue for a few months. 

George Raine: Absolutely, Matt. There's a real disconnect between trying to raise money on a daily basis and put it to work with then having to show your performance on a blended basis where you have a bunch of cash and a bunch of private vehicles. This really brings us back to the dichotomy of having interval funds where you have a mixture of private funds and public securities. I think that's a critical element to structuring an interval fund that works, is namely having some way to put cash to work in an appropriate manner both to hold onto that cash and make it move with the markets over time while you're waiting to get your investments into private funds that might have a queue, but also allows you to be able to have liquidity on hand to meet your redemptions because you really do have to free up a fair chunk of the portfolio in order to meet one of those periodic redemption offers. You also need to be able to have cash on hand for those in advance of paying them out. Both on the way in and on the way out, having a mix of types of investments is probably one of the ways I see clients trying to manage this disconnect between the retail product and the private or institutional product. 

Matt Posthuma: Let's talk a little bit more about redemptions, which you just alluded to there, and then in the context of valuations. In normal times, a private open-end fund will be accepting new contributions and processing redemptions in the ordinary course, but in times where a fund is liquidity constrained, they may set up a redemption queue. As I'm seeing with many of my open-end fund clients, that's what's happening right now as many of those funds are setting up redemption queues for the second quarter. Usually, the funds are not obligated to sell assets or to borrow funds in order to process redemptions. How does that interplay with the redemption requirements of the interval funds? 

George Raine: It's certainly a structural challenge, Matt. Interval funds are required to set their periodic redemptions and have at least five percent of the fund going out or available to go out with each periodic redemption offer. In putting together a vehicle that you'd want to put in this type of structure, you've got to think that there are going to be periods where you need to have more liquidity on hand than you might be able to get from the private fund side of the house entirely. The board of the funds does have the ability on the quarterly basis to change the amount of the fund that's being redeemed from between five up to twenty-five percent. You do need to deal with the fact that the investor base may want to get some liquidity from the fund, simply going out and saying you can only get five percent of the fund or only five percent of the shareholders can get out in any one quarter, might cause some investors to panic a bit and maybe over submit their redemption requests in efforts not to get prorated. So you can actually have a bit of a run on the bank if you try to restrain those percentages too much on the quarterly redemption periods. 

Matt Posthuma: We started out this discussion by talking about how private funds liked the idea of getting capital from registered funds because it was a way for them to access the retail investor market. George, are these products really retail, the ones that are able to invest in these private real estate funds? 

George Raine: It's a great question and one that's developing as we speak under current Chair Clayton of the SEC, who has certainly made an effort to give more access for retail investors into slightly more private type investments. As we currently stand, there is and has been for some time an informal SEC staff position that prohibits any registered fund from investing more than fifteen percent of its assets into private funds, unless that registered fund, and the interval fund in this case, restricts its investor base to accredited investors, which is the same standard that applies to private 3(c)(1)  funds. So it's essentially a high-net worth individual type of test. While they can make public offerings out of this kind of an interval fund, it isn't going to be available to every person on the street who wants to buy a mutual fund, so there is a limitation on just how retail this type of retail product actually can be. Importantly, the term “private fund” has certainly been interpreted by a number of practitioners as meaning only 3(c)(1) or 3(c)(7) funds. If you're buying, say, a bunch of close-ended private funds that are relying on a different exemption, such as the one that applies only to real estate-type investments, that might be workable. But even still, for the standard private open-end real estate funds, there’s going to be a limit to the types of investors that can actually buy the interval fund. Again, we will have to see once rulemaking starts emerging out of Chair Clayton’s initiatives and what comes out of recent SEC requests for comment, and to see what the industry does and how the SEC is willing to open things up going forward. 

Matt Posthuma: What's the advantage then of accessing these interval funds as a source of capital? George, is there better distribution? Is it really the distribution channels that the registered fund manager may offer to the private fund manager? 

George Raine: I think from the perspective of the private fund manager, pretty clearly a great advantage is the distribution channel – that those funds can be marketed on a very similar basis to an open-end registered public fund, that if you're setting up a structure where you, the private fund manager, are getting a number of your funds essentially funneled through an interval fund structure created by a third party, you're going to benefit from whatever distribution channels  that third-party sponsor has set up to sell its own funds. As we've seen in the markets developing, there are a number of relatively retail-themed platforms out there that still restrict investors to accredited investors. The fact that you're not limited by the private fund offering requirements is simply the limitation on the qualification of people coming in really does give you a much broader exposure on the distribution side that starts to approximate retail, but you just need to keep in mind it's not a panacea that gives you the ability to get the 401(k) plans or the everyday investor into your vehicles. 

Matt Posthuma: Pam, is there any difference from a tax perspective between an accredited investor investing directly investing in a private fund or a private feeder versus investing in a registered fund? 

Pam Glazier: There is a helpful tax difference. Private feeders that are partnerships for tax purposes give K1s to their investors. RICs, again like REITs, give 1099s, which the retail investor, including accredited investors that one might consider retail investors, would prefer 1099s. They're simpler. They come early into the year. It makes tax reporting easier for the investors. 

Matt Posthuma: This has all been very, very helpful. Obviously, while there are some issues, I think that interval funds are a good way for retail investors or at least some retail investors to get exposure to private real estate, and on the other side, for private real estate managers to gain access to another growing source of capital. This concludes our discussion regarding interval funds and private real estate funds. Thank you very much to George and Pam for joining me today, and thank you to you, our listeners. If you'd like more information on the topics we discussed or there are other topics of interest to you in the asset management field, please feel free to visit our website at www.ropesgray.com. And of course, feel free to reach out to any of us if you have any questions about these topics. You can also subscribe and listen to the series wherever you regularly listen to podcasts, including on Apple, Google and Spotify. Thanks again for listening, and have a great day.

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