SEC Regulatory Framework for Fund of Funds Arrangement

SEC Adopts New Framework for Fund of Funds Arrangement 2021

The Securities and Exchange Commission introduced a new rule 12d1-4 under the Investment Company Act of 1940, the “Investment Company Act” and amended rule 12d1-1 and Form N-CEN, for the fund of funds arrangement.

A fund of funds (FOF)—also known as a multi-manager investment—is a pooled investment fund that invests in other types of funds. 

The new rule permits a registered investment company or business development company also referred to as “acquiring funds” to acquire the securities of any other registered investment company or business development company referred to as “acquired funds” in excess of the limits set by the Investment Company Act subject to certain conditions.

It also prohibits registered funds from owning more than 3% of another registered fund’s outstanding voting securities, investing more than 5% of the fund’s total assets in another registered fund, and investing more than 10% of the fund’s total assets in other registered funds in the aggregate. The rule was designed to streamline and enhance the regulatory framework for funds that invest in other funds ; “fund of funds” arrangements. 

Additionally, a registered open-end fund is prohibited from selling securities to any fund (including unregistered funds) if, after the sale, the acquiring fund would:

  1. Together with companies and funds it controls, own more than three percent of the acquired fund’s voting securities
  2. Together with other funds (and companies they control) own more than ten percent of the acquired fund’s voting securities.

Prohibitions for Fund of Funds Arrangement

Furthermore, the rule prohibits registered funds (together with companies or funds they control and other registered funds that have the same adviser) from acquiring more than 10% of the outstanding voting stock of a registered closed-end fund.

However, the funds of funds arrangement permits a registered open-end fund to acquire an unlimited amount of shares of registered open-end funds and UITs that are part of the same “group of investment companies” as the acquiring fund

Rule 12d1-1: Investments in Money Market Funds (Amendments)

The fund of funds arrangement allows funds to invest in shares of money market funds in excess of the limits defined by the act.

The rule is also designed to permit “cash sweep” arrangements in which a fund invests all or a portion of its available cash in a money market fund rather than directly in short-term instruments.

Scope of exemption to Fund of Funds Arrangement

(a) Registered Money Market Funds

  • The rule permits a fund to invest an unlimited amount of its uninvested cash in a money market fund rather than directly in short-term instruments.
  • Any investment would, of course, have to be consistent with the fund’s investment objectives and policies.
  • The acquired fund may be a fund in the same fund complex or in a different fund complex. Thus, a fund in a small complex that does not have a money market fund may invest available cash in an unaffiliated money market fund.

 (b) Unregistered Money Market Funds

 The rule permits funds to invest in money market funds that are not registered investment companies (“unregistered money market funds”). Unregistered money market funds are typically organized by a fund adviser for the purpose of managing the cash of other funds in a fund complex and operate in almost all respects as a registered money market fund, except that their securities are privately offered and thus not registered under the Securities Act.

(c)Unregistered Funds of Funds

 This rule permits unregistered funds to invest their cash in shares of a registered money market fund as it results in creation of a hedge fund.

Amendments to Disclosure Forms: Transparency of Fund of Funds Expenses (N-CEN)

The amendments introduced disclosure requirements to require each fund that invests in shares of other funds to disclose in its prospectus fee table, the expenses of funds in which it invests

The amendments are designed to provide investors with a better understanding of the actual costs of investing in a fund that invests in other funds, which have their own expenses that may be as high or higher than the acquiring fund’s expenses,

Open-End Funds Form N-1A is used by open-end management funds to register under the Act and to offer their securities under the Securities Act. Form N-1A sets forth the disclosure requirements for fund prospectuses. Amendments to Form N-1A require any registered open-end fund investing in shares of another fund to include in its prospectus fee table an additional line item titled “Acquired Fund Fees and Expenses” under the section that discloses total annual fund operating expenses.

Whereas amendments to Form N-2 require a registered closed-end fund of funds (including a closed-end fund of hedge funds) to include it’s the cumulative expenses charged by the acquired funds, including management fees and expenses, transaction fees and performance fees as a line item in its fee table.

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