EXECUTIVE INSIGHTS: WHAT WE LEARNED BY HELPING MANAGERS MAKE THE MOVE INTO MUTUAL FUNDS

ABOUT THE AUTHOR Q&A with Matthew Kerfoot of Dechert LLP Matthew K. Kerfoot is a nationally recognized authority in the Why would a hedge fund manager want to launch a mutual fund? alternative management Aren’t the two completely different? and financial services industries. He Many hedge fund managers are looking to expand their product offerings and advises many of the world’s largest diversify their revenue streams. In the past, we would typically see a asset managers and financial manager focus on just hedge funds or just mutual funds or just institutions on the structuring and funds. Over the past few years, however, many managers have begun to see development of their alternative the benefits of offering a wide array of funds to various groups. Given mutual funds, the explosive growth in the liquid alternative space, for most hedge fund development , exchange- managers, it’s usually now a question of when they will launch a mutual fund, traded funds and structured not if they will. products. Mr. Kerfoot has particular expertise in providing derivatives- Adding one or more mutual funds to an existing suite of private funds is a focused solutions to address relatively streamlined process these days. One of the big hurdles in the regulatory, tax and financing needs past—registering the advisor with the SEC—is obviously now required for for mutual funds, ETFs, BDCs and most managers. From that point, launching a mutual fund is really a matter of corporates. He is also the author of understanding how to run a strategy within the confines of the mutual fund the well-known “Liquid Alternatives” rules. The other important piece is how to manage the distribution of the periodic newsletter. fund, either through self-distribution, third-party distribution or, what we’re Matthew Kerfoot can be reached seeing more often now, partnering with an established mutual fund manager at 212 641 5694 or and its distribution team. [email protected]. Should managers worry about mutual funds cannibalizing their ABOUT THIS SERIES hedge fund business? I can understand the worry that liquid alternatives such as mutual funds The Executive Insights series was developed to help educate could cannibalize the core business. But as we’ve seen, hedge fund assets fund managers and other industry appear to be stickier than you might think. Hedge fund like being participants by highlighting subject hedge fund investors and tend to enjoy the full service model. Some investors matter experts who have vast may also have less of a need for the more liquid end of the alternative experience and knowledge about investment spectrum. the convergence movement. What is the first step to starting a registered fund? First, you need to choose the type of fund structure you wish to launch. Should you create an open-end or closed-end fund? Exchange-traded, onshore or offshore? Series trust or standalone trust? We walk our clients through the complete menu of registered fund options, helping them select products for their lineup and decide which fund structure is appropriate for each strategy. The decision making process starts with two questions: 1.) How liquid is your strategy? 2.) How much liquidity do you want to provide to investors? By definition, all liquid alternatives involve greater liquidity than hedge funds. However, there is still a broad spectrum of liquidity available. At one end, mutual funds provide daily liquidity and also invest in liquid assets. However, if more than 15% of your portfolio is illiquid, then your product will not fit into a mutual fund framework. Instead, you might select a closed-end fund format, which gives you more options such as monthly, quarterly, semi-annual or annual liquidity.

What fund structures are the most popular with managers right now? While administrator-sponsored series trusts have been popular, we are seeing a resurgence of interest in standalone mutual funds. Standalone mutual funds offer more control, allowing managers to have more input in the selection of service providers, including the administrator, auditor, legal counsel and custodian. They also can negotiate service provider fees. A standalone mutual fund also allows the manager to have the ability to propose an affiliate to serve on the board (usually a principal of the manager) and have a greater voice in the operations of the fund. In the beginning, a standalone mutual fund can take a bit longer and cost more to launch because of service provider agreement negotiations and a longer SEC review period. However, down the road, standalone mutual funds make it much easier to switch providers if you need to. With a series trust, you might have to go through a costly proxy solicitation to reorganize the fund into a standalone mutual fund. This is a particular concern for smaller managers looking to be acquired at some point.

Are certain structures better suited for larger managers? One of the most attractive structures today is an exchange-listed closed-end fund. These ‘40 Act funds raise capital through an IPO process with a lead underwriter, much like an operating . They offer managers permanent capital and can attract hundreds of millions or even billions of dollars in assets—with no need to employ any wholesaling boots on the ground. However, these structures are really available only to marquee managers with high name recognition. Lead underwriters have limited availability on their calendars, so managers face very heavy competition for those slots.

What are the options for smaller players? A small to midsize fund with modest name recognition can access more distribution options with mutual funds. If you don’t want to worry about creating a new product and attempting to raise capital for it, you may be able to reorganize an existing hedge fund into a registered fund. This approach offers an opportunity to start off on ‘day one’ in the retail space with assets already in the fund. Subadvisory opportunities can also be compelling for small and midsize managers. Today there are many types of multi-manager funds on the market. You can enter into a subadvisory agreement, manage a sleeve of the fund and then eventually—when you have a more established record—look into managing your own fund. Because this arrangement is very attractive, competition has increased significantly, and subadvisory opportunities are becoming harder to find. A third alternative is to manage an underlying hedge fund in a fund-of-funds structure. When private funds of funds managers launch new registered funds, or convert private funds into registered funds, managing one of their underlying funds can be an attractive opportunity.

How do all of these fund structures compare in terms of cost and time to market? Timelines and budgets are specific to each situation, so there is no single right answer to this question. Due diligence of service providers is a major variable that drives time and expenses, although many hedge fund managers should be able to leverage existing service providers and contacts. The overall process can be completed in a few months, or it can stretch to last a year or more. Once a manager has settled on a fund structure, what is the next step? Establishing distribution is critical. The two primary distribution channels for a registered fund are RIAs and wirehouses. The trick is bringing that network to the table and getting the story out. A manager has to decide whether to build an internal wholesaling team or rely on external wholesalers. As I mentioned above, one of the most compelling opportunities is for a hedge fund manager to be the “product” and partner with an established mutual fund company that will be the “distribution.” There have been several of these highly successful joint ventures and many more in development.

What is the most important caution you can offer to a manager starting a mutual fund? Do not underestimate the importance of distribution. Be certain that you have a partner or a well-thought out plan for self-distribution or through third-party distributors. Self-distribution can certainly work. We have a hedge fund client that spent substantial time and energy on distribution prior to exploring a liquid alternatives product and, when the time came to launch the mutual fund, it successfully leveraged its distribution network and raised several hundred million dollars in less than a year. Also, spend the time to conduct thorough due diligence of your service providers. Many people don’t realize that mutual funds have no employees. In a mutual fund, everything is outsourced, and your providers can make or break your business. Too many managers focus on launch costs alone, forgetting that a fund may have much lower expense ratios three to five years out.

What new trends are you seeing in the alternative mutual fund space? Recently there has been a trend toward reorganizing funds out of series trusts, although that can be difficult. Right after Dodd-Frank, hedge fund managers found it very costly to comply with all the new regulations. At the same time, barriers to entry in the registered fund business dropped, creating an unprecedented opportunity to scale up and raise assets through mutual funds. At that point, many high-quality managers wanted to outsource as much as possible so they could enter the market as quickly as possible. Now, however, some find they have outgrown the bundled services model of the series trust, and they are currently reorganizing their products into standalone mutual funds. Another new trend is offering alternative strategies through variable insurance products. Their structure is similar to a mutual fund; if you have a product suitable for the mutual fund format, you can probably offer a similar product through an insurance product. The benefit is that you no longer need to attract multiple platforms; one insurance company can provide all the distribution you need. Right now, insurance companies are actively looking for managers with an established record of managing money through periods of market volatility and protecting against downside risk.

Where will this trend toward convergence lead? Who will be the ultimate winners and losers? At this point, it looks like larger, global managers are well on their way to becoming product- diversified, general asset management companies. We see private equity funds launching mutual funds. We see hedge funds launching closed-end funds. We see business development companies launching closed-end funds. Ultimately, we’ll likely see a handful of global asset managers with a wide array of product offerings across the liquidity spectrum, made available to all classes of investors. We’ll also likely see a much larger group of managers that has a more limited shelf of inventory—perhaps with illiquid strategies in hedge funds or closed-end funds and liquid strategies in mutual funds. We can already see how the hedge fund and retail spaces are competing with each other and making each other better. There are now alternative mutual funds that are designed to access 401(k) and 529 plans, as well as target date funds that offer alternative sleeves. In the end, though, our experience with hedge fund managers is that they are very creative and entrepreneurial. They can sense that there is a huge opportunity, and they are keen on introducing innovative product offerings to the mutual fund space. Given the amount of activity we are seeing and the investor inflows and interest over the past couple of years, I think we’re just in the first or second inning of a fascinating game. As the New Model Prime , Pershing Prime Services offers a consultative approach to both hedge fund managers and mutual fund managers looking to launch products with complimentary business strategies. A key part of this consultative approach is to produce thought leadership that can offer guidance and insights for fund managers who are interested in learning more about the origins of the convergence movement, considerations and best practices. To learn more contact Pershing Prime Services at [email protected].

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