Fund Structuring, Regulation and Taxation
November 15, 2019
By Alex Turk
EisnerAmper was the lead sponsor at The Emerging Manager Forum held in San Francisco in November. The event covered many issues of interest to emerging and start-up managers in the financial services sector. On the topic on “Fund Structure, Regulation and Taxation,” EisnerAmper Tax Partner Katie Brandtjen joined the panel alongside fellow thought leaders Ildiko Duckor, Senior Counsel, Pillsbury; and Yulia Perruzzi, Controller, Partner Fund Management. The panel was moderated by Mark Perlow, Partner, Dechert.
The group stressed that before structuring a fund, the fund manager needs to understand who the target investor base will be, what their budget is, and what the investment strategy is. Some managers have spent significant portions of their budgets crafting complex structures only to discover a simpler structure would have been sufficient and more cost effective. However, blockers may be of use to fund managers targeting tax-exempt investors, foreign investors and institutional investors.
If assets under management (“AUM”) are expected to be under $100 million, there may be state regulatory issues; if AUM exceeds $100 million, then Securities and Exchange Commission (“SEC”) issues may prevail. If a manager does not want to register with the SEC so as to avoid being classified as an “investment company” under the Investment Company Act of 1940, the manager should then attempt to qualify for the 3(c)(1) or 3(c)(7) exemptions, which may affect the investor base and to whom the fund markets.
Will the fund investment strategy be a simple equity long-short fund, or will it be trading forwards, futures, commodities or swaps? These can all lead to traps for the unwary, such as being classified as a “commodity pool,” which are regulated by the Commodity Futures Trading Commission, not the SEC.
It is important from a tax perspective to understand the investor’s tax status and domicile. Being conscious of an investor’s concerns helps the manager as well as the investor who is considering subscribing in the fund. Tax-exempt entities will generally be concerned with unrelated business taxable income (“UBTI”), while foreign investors will be primarily concerned with effectively connected income (“ECI”). UBTI can be generated through holding other partnership interests that have invested or engaged in a business or through the use of leverage. ECI is similarly generated through investing in U.S. trade or businesses.
Funds can avoid these issues by allowing these investors opt-out provisions, the use of a blocker corporation, or the use of side-by-side structures. By inserting a corporation, the ECI or UBTI is “blocked” at the corporate level. A side-by-side structure would have a similar result, because the investors would use a parallel fund that makes direct investments in accordance with the investment strategy. Besides the increase in administrative and operating costs to operate, managers need to understand the differing performance between the parallel funds due to capital reallocation, fees, expense ratios and other items in order to explain differing performance records between the parallel funds to prospective investors.
The industry has changed dramatically over the years, and compliance is no longer ancillary but a core component of running a fund. Internal controls are more important than ever. The SEC has issued more inquiries, and it is vital to be prepared with documentation and procedures. Preparation is very important, and having a risk-based compliance program can be extremely helpful. It is important for both emerging and established managers to understand their investors’ concerns as well as their own risk areas. Click here to learn more.