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Due Diligence Best Practices for Registered Funds

As registered funds increase in popularity, it’s important that financial advisors apply the same level of due diligence that they would for a private market investment.

Registered funds have helped to democratize hedging strategies and private market investments, allowing advisors and investors to access asset classes such as private equity, private credit, real assets and certain hedge fund strategies. These investment types are valuable tools in achieving clients’ long-term goals and objectives.

Registered funds are subject to the Securities Act of 1940 and its investor protection provisions. These include enhanced governance and direct SEC oversight and the requirement that each fund have an independent board of directors to manage potential conflicts of interest between managers and investors. Registered fund sponsors must also develop and adhere to a code of ethics; maintain policies and enforcement of insider trading rules; disclose any changes to investment strategy; report holdings on a regular basis; obtain prior consent of shareholders to change advisory contracts; and comply with other regulatory obligations.

While registered funds that invest in hedging strategies and private market investments provide certain protections, they may not be suitable for all investors. It is important for advisors to conduct due diligence on registered funds, much like the diligence of private investment structures. Due diligence should focus on gaining a clear sense of a fund’s investment objectives and risks, management, fees and redemption options.

Assessing a Fund’s Investment Objectives and Risks

When considering an allocation to a registered fund, the most critical factors to review are a fund’s investment objectives and its expected risk and return profile. It is important to dig into the details here to ensure that you are setting appropriate client expectations for how a fund will perform.

There are several questions to ask to get a good sense of risk and return expectations:

  • What is a fund’s long-term investment objective?
  • Is it focused on income, growth or a combination of the two?
  • What strategies will the manager use to meet the objective?
  • How does the manager expect the fund to perform in various market environments?
  • What is the manager’s current market outlook, and does the manager expect the fund to perform well given that viewpoint?
  • What are the primary risks that this fund is exposed to, and how are they managed within the fund?

Once you feel comfortable that you understand the risk and return profile of a registered fund, you can determine if it aligns with a client’s investment objectives.

Evaluating Manager Track Record and Fund Fees

While evaluating the risk and return profile, you will get a sense of how a manager views the markets and how they apply their skills to manage the fund. Registered funds that incorporate hedging or private investment strategies could potentially have minimal, if any, track records, so it is important to investigate the manager’s background and previous investment experience running a similar strategy or their past performance with other fund companies.

Fees are another key area of due diligence. Most registered funds will have three distinct types of fees: upfront or offering fees; operating fees; and liquidation fees. Upfront fees include commissions and marketing fees. Examples of operating fees include real estate property management fees, financing fees, or performance-based fees based on achieving prespecified metrics. Liquidity fees include real estate disposition fees, loan termination fees, or other fees and expenses related to selling or liquidating fund assets. Fees can vary significantly by structure and asset type, so an important factor in reviewing fees is to compare similar funds.

Liquidity and Redemption Considerations

Another key area to review as part of the due diligence of a registered fund is its liquidity or redemption options. An example of key questions to ask include:

  • What, if any, redemption options does the fund provide?
  • At what frequency are redemptions offered, and what is the maximum amount of fund assets that can be redeemed in a given time period?
  • If a fund allows periodic redemptions and provides a certain amount of liquidity, how do they manage their cash?
  • What percentage of fund assets are needed to maintain liquidity, and what percentage has the fund held historically?
  • How does the manager balance liquidity while limiting the impact on returns of holding cash?

Growth in the registered fund market has given accredited and retail investors access to once inaccessible hedging and private investment strategies. However, it is critical that advisors perform proper due diligence of a fund’s investment objectives and risks, performance expectations, management, fees and redemption options. A full understanding of these characteristics will help you to properly position these funds in portfolios, so that your clients stay invested for the long term.

Laura Sexton is assistant vice president, research and diligence, iCapital Network.

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