Leading business consultancy PwC has issued a regulatory brief offering its perspective on the upcoming SEC sweep of alternative mutual funds, also known as liquid alts funds. Back in April, the SEC announced that it planned a “coordinated review” of various liquid alts funds and managers. PwC’s brief provides a background in liquid alts, explores the SEC’s concerns, and makes suggestions about what liquid alts professionals can do to prepare for the coming sweep.
Background on Liquid Alts
The PwC brief explains how the investment strategies pursued by alternative mutual funds have traditionally been exclusive to high-net worth individuals and institutional investors. The Investment Act of 1940 was passed to regulate mutual funds and established requirements that effectively prohibited many alternative investment strategies from being managed in a mutual fund. As markets have evolved over the years however, liquid alts funds have emerged in significant numbers, and have done so in compliance with the Act of 1940 – at least in theory. The SEC’s investigation is aimed at confirming that theory.
The requirements made of mutual funds under the 1940 Act include providing daily liquidity and calculating a daily net-asset value. From the 1940s through the 1980s, these requirements inhibited the development of liquid alts funds, but with technological advancements and the growing financial sophistication of the public, liquid alts funds for individual investors began to emerge in greater numbers around a decade ago. But daily pricing features weren’t the only things that had kept some alternative strategies in the realm of hedge funds – there are many strategies practiced by private funds that are unavailable to public funds due to the leverage constraints and liquidity requirements of a daily valued mutual fund.
It’s in this area that PwC fears liquid alts fund managers may have a problem: Most alternative fund managers have limited experience with Act of 1940 regulations, and most fund managers with Act of 1940 regulation experience have limited experience with alternative investment strategies. These two facts combine to suggest the potential for regulatory misconduct that may be inadvertent but punishable nonetheless.
The SEC announced in April that the first round of its liquid alts sweep will begin this summer and continue for six months. Twenty-five firms that manage one or more liquid alts funds are expected to be targeted. PwC theorizes the SEC is moving proactively because the Federal Reserve’s ongoing policy of monetary stimulus is pushing interest rates lower, causing investors to shift from CDs and other low-risk vehicles to liquid alts, and that if there is any industry chicanery, it will be better to snuff it out prior to liquid alts funds gaining even more popularity. It should be noted that total investment in liquid alts funds approached $200 billion as of year-end, 2013.
In accordance with the Investment Act of 1940, the SEC will be examining the following areas of liquid alts fund management:
- Liquidity: PwC says this may be the most difficult regulatory constraint for liquid alts funds, so it’s almost certain it will be a primary focus of the SEC’s sweep. By law, liquid alts funds must hold no more than 15% of their assets in illiquid securities, in addition to meeting daily redemption requests and posting a daily net-asset value.
- Leverage: The Act of 1940 was intended to prevent funds from using “excessive” levels of leverage, and this bars many private alternative investment strategies from being available to individual investors. Borrowing cash for investment purposes has traditionally been prohibited under the Act, but regulators have been looser in their interpretations lately, allowing funds to “borrow” indirectly through leveraged investments such as futures, options, and short sales. This, however, creates regulatory compliance issues, as assets must be strictly segregated and additional rules must be followed.
- Investment Allocation: PwC warns that fund managers who manage private and public funds that replicate one another may be targeted for improper investment allocation practices. The concern is that managers may engage in tactics designed to enhance the performance of the private fund at the expense of the public fund.
- Governance: The SEC will likely be focused on situations in which board members may have breached fiduciary duties in failing to disclose conflicts of interest.
What Can Fund Managers Do About It?
PwC suggests that alternative mutual fund managers can begin preparing for the SEC’s sweep by doing the following:
- Have appropriate liquidity compliance controls in place that will ensure compliance even under distressed market conditions.
- Have controls and disclosures in place that are sufficient to manage the risks of added leverage.
- Review investment allocation policies and monitor public fund performance with respect to related private funds.
- Make sure board meeting minutes demonstrate the board’s understanding of the unique risks of liquid alts strategies.
In addition, PwC’s brief discusses issues related to sub-advisor oversight. For more information, download PwC’s briefing.