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Should I Go With the Flow Into Liquid Alts? (Emerging Managers Part Two)

By Frank Attalla, CPA, and Marc J. Wolf, CPA, Rothstein Kass | Thursday, April 10th, 2014

The following article is part of our Emerging Managers Insight Article Series and was contributed by Rothstein Kass. Read more articles from the Series HERE.

Emerging Managers Articles Series

In Part One of Rothstein Kass’ Should I Go With the Flow Into Liquid Alts? Critical Questions for Alternative Managers Weighing a Move Into the Retail Space, we examined five key questions and critical considerations to help guide alternative investment managers through the decision-making process when weighing a move into the growing liquid alternatives market, including:

  • Will a registered product cannibalize my existing private fund business?

  • Will my strategy fit inside a mutual fund?

  • Do I understand the distribution landscape?

  • Should I use a stand-alone trust or a series trust? If a series trust, how do I choose the right one?

  • Is a registered fund too expensive? 

In Part Two, we conclude our examination of several other key questions and considerations.
6. Do I understand all my product options?
All registered funds are not created equal. There are many different varieties of mutual funds and closed-end funds, each with different:

  • Tax considerations,

  • Reporting requirement, and

  • Fee structures.

Managers should have an understanding of all the options and determine what works best for their strategy and their business.
7. Do I understand the tax implications of a registered fund?
While every product structure has different and often complex tax requirements, managers also need to be aware of the tax implications of a registered fund at a higher level. For example, they need to have the answers to the following questions:

  • Will my strategy qualify from a tax code perspective?

  • Will my investment mix pass the asset diversification test?

  • Do I have a firm grasp of ”good” income versus “bad” income?

  • Do I understand how the structure impacts the needs of different types of investors?

These may seem like obvious questions to some, but if they are overlooked from the onset, problems will arise further down the road. In addition, there are significant advantages for tax-exempt and pension plan investors, such as the elimination of unrelated business taxable income (UBTI) and an exemption from the ERISA1 rules, that could be touted if the advisor is aware of them. The answers to some of these questions may eliminate the possibility of a move to retail altogether. What’s most important, however, is that you are thinking about them.
8. Am I ready to make the commitment for the long haul?
When alternative managers make the decision to launch a registered fund, they have to be sure they’re fully committed – both mentally and financially – for the long haul. While there is the potential to access a whole new pool of investors and assets in a registered fund, it’s not an overnight proposition.
It takes time to build assets and a track record and it takes a financial commitment to fund operations while the assets are building. Like with most hedge funds, managers will have a management fee to cover expenses, although the fee could be limited by an expense cap. Therefore, a fund manager should prepare a break-even analysis, which the fund’s administrator can usually assist with. In the absence of this commitment, it will likely be a waste of time and money for managers to jump into the liquid alts arena.
9. Do I understand the track record implications?
Many investors make investment decisions based on a fund’s track record. Unfortunately for alternative managers making the shift into the registered space, their track records are rarely portable. Beyond that, it takes three years for a fund to get Morningstar® rated, which is a major validation point in the retail space.
In some cases, there are product structures that can potentially allow managers to leverage their track record from the alternative space. Managers need to fully understand track record implications before making the move to the registered space and work with a legal or compliance expert to make sure they’re taking all the right steps along the way.
10. Do I understand the regulatory implications?
Some alternative managers look at the mounting regulations in the private fund space and see the move into the registered space as an obvious one. They think that if they’re already dealing with increased regulation, they may as well make the move to retail and reap the rewards of gaining access to a new and larger capital base. But it’s not that simple.
The regulatory requirements in the registered world—from the need for independent boards to required compliance with a whole new set of SEC,2 CFTC3 and FINRA4 regulations — is different from the private fund world. Managers who aren’t realistic about this fact will be in for a rude regulatory awakening. It’s critical for managers to work with seasoned experts to gain a full understanding of the regulatory landscape and the implications it will have on their business in both the short- and long-term. However, advisors to registered funds get the benefit of avoiding the Form PF fi ling requirement.
11. Is the additional transparency that a registered product requires acceptable?
Transparency has become the norm for managers in all asset classes since the financial crisis. That said, when an alternative manager crosses over into the registered space, transparency becomes a regulatory requirement as opposed to simply an investor demand. You need to be aware of this shift and make sure you’re ready to execute on it. From a practical standpoint, this means:

  • Disclosing all investments over 1 percent or, at a minimum, the top 20 positions on a quarterly basis as opposed to only those that make up more than 5 percent of the total fund, and

  • Daily asset valuation and liquidity, if organized as an open-ended (mutual) fund.

 These are all factors you need to consider before making the move and deciding whether your strategy and your business are ready for the leap into the registered space.
12. Am I prepared for the change in mindset required to operate a mutual fund structure?
Moving to a liquid alts strategy seems simple enough for most hedge fund managers. It’s just a matter of executing a proven strategy in a different product structure, right? Well, not exactly.
What’s important to remember is that in a mutual fund structure, fund managers must report to a board that has a fiduciary responsibility to ensure that the shareholders’ best interests are being considered, such as reviewing investment decisions and fees charged to a fund. This requires a major change in mindset for most hedge fund managers who essentially ran their own fiefdom, answering only to investors with, in most cases, long-term lock-ups provisions.
Many managers can and have made the shift, but those who go in with that understanding from the get-go are much more likely to be successful long-term.
The Last Word
The liquid alternative space has grown at a breakneck pace in recent years, and there doesn’t seem to be any slowdown in sight. But while there is clearly a lot of opportunity, there is also a lot of competition, as well as the need to create the correct operational infrastructure, and it’s not the right fit for every manager.
Before making any move, managers need to take a hard look in the mirror and consider all the business implications — and consult with their service providers — before getting caught up in all the liquid alts excitement. The questions above may not be the only ones that need to be asked, but they’re a good place to start for any manager who’s thinking about following the flow of liquid alternatives into the retail space.

Come back Tuesday for the next Emerging Managers article or subscribe to Hedge IT and have it delivered to your inbox.

About the Authors

Frank Attalla is a principal at Rothstein Kass, located in the firm’s Roseland, N.J., office. He has over 15 years of experience exclusively in the financial services industry. He specializes in audit and tax services for a variety of investment partnership structures, including domestic and offshore funds, master-feeder structures, funds of funds, and registered investment companies. Frank is a certified public accountant in New Jersey and New York.
Marc Wolf is an audit principal in Rothstein Kass’ Beverly Hills office. Marc’s areas of specialization are focused within the firm’s Financial Services Group, specifically hedge funds, regulated investment companies (RICs), commodity pools, real estate, private equity and other types of investment vehicles, broker-dealers, private foundations and family offices. He is a certified public accountant in California, Colorado, New Jersey, New York and Texas.
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