The anatomy of an alternative mutual fund: dissecting the alternative investment vehicle following recent CSA amendments

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Traditionally, commodity pools existed as unique investment vehicles which, contrary to other Canadian public investment funds, were excluded from the investment restrictions and limitations codified in National Instrument 81-102 Investment Funds (NI 81-102). Earlier this year, as part of the final phase of its Modernization of Investment Fund Product Regulation Project, the Canadian Securities Administrators (the CSA) adopted a number of amendments to several National Instruments, including NI 81-102 and National Instrument 81-104 Commodity Pools (NI 81-104) (the Amendments), relating to the establishment of a regulatory framework for alternative mutual funds. When the Amendments came into force on January 3, 2019 (the Effective Date), all commodity pools that existed before the Effective Date were automatically converted to alternative mutual funds. A further six month period was granted to these converted funds to conform to the new requirements, which lapsed on July 4, 2019.

Genesis of alternative mutual funds

The Amendments introduced “alternative mutual funds”, also known as “liquid alts”, which constitute a new category of mutual fund. This new vehicle effectively replaces “commodity pools” that existed pursuant to NI 81-104. As defined in NI 81-102, the term “alternative mutual fund” refers to a mutual fund, other than a precious metals fund, that has adopted fundamental investment objectives that permit it to invest in physical commodities or specified derivatives, to borrow cash or to engage in short selling in a manner not typically permitted for other mutual funds. This new definition is reflective of the added investment flexibility granted to these types of funds.

Seed capital requirements

Under the previous NI 81-104 provisions, commodity pools had a minimum seed capital requirement of only $50,000 and were required to possess this amount in the fund at all times. The Amendments have harmonized the seed capital and start-up requirements for all mutual funds: (i) a fund requires $150,000 in seed capital, provided by either its manager or other related entities at inception; and (ii) the manager (or other seed capital provider) is barred from withdrawing any amount of that seed capital until the mutual fund has raised at least $500,000 from outside investors.

Select Investment restrictions

Some key investment restrictions imposed on alternative mutual funds under the Amendments are set out below:

  • Concentration restrictions: Alternative mutual funds are permitted to invest up to 20% of the fund’s net asset value (NAV) in securities of a single issuer, at the time of purchase. This represents an increase from the previous 10% of NAV limit that applied to all mutual funds (including commodity pools).
  • Investments in physical commodities: While conventional mutual funds are prohibited from investing in precious metal certificates (other than gold, silver, platinum or palladium) and are subject to a 10% of NAV limit on direct or indirect investment in physical commodities, alternative mutual funds are not subject to these restrictions.
  • Illiquid assets: The previous limits on investing in illiquid assets applicable to mutual funds (including commodity pools) have not changed and so there is a 10% of NAV limit in illiquid assets for alternative mutual funds.
  • Fund-of-fund investing: Alternative mutual funds are permitted to invest up to 100% of their NAV in any other investment fund that is subject to NI 81-102. This is a marked departure from the previous limit placed on commodity pools, which were restricted to investing only in conventional mutual funds that file a simplified prospectus.
  • Cash borrowing: Alternative mutual funds are permitted to borrow cash up to 50% of their NAV, for investment purposes. The ability to borrow cash on these terms is subject to the following restrictions: (i) the lender must be a qualified investment fund custodian; (ii) where the lender is an affiliate or associate of the fund’s investment manager, the fund’s independent review committee must provide its approval; and (iii) any borrowing agreement must be made in accordance with market industry practices and on standard commercial terms.
  • Short selling: Alternative mutual funds are permitted to short sell securities with a market value of up to 50% of the fund’s NAV, subject to a 10% of NAV limit for the securities of a single issuer.
  • Combined limit on cash borrowing and short selling: Alternative mutual funds can only borrow cash and short sell concurrently if the combined amount does not exceed 50% of NAV.
  • Leverage limits: Alternative mutual funds are permitted to use leverage, both directly and indirectly, through cash borrowing, short selling and specified derivatives transactions, excluding for hedging purposes, but their aggregate exposure to these types of transactions is limited to 300% of the fund’s NAV.
  • Other derivatives provisions: Alternative mutual funds are permitted to enter into specified derivatives transactions with counterparties that may not have an “approved credit rating”; however, a fund’s total exposure to any one counterparty under this type of transaction is limited to 10% of NAV on a mark-to-market basis.

Disclosure

The Amendments have also brought alternative mutual funds within the purview of the prospectus disclosure regime that applies to other mutual funds:

  • Form of prospectus: Alternative mutual funds are now fully within the prospectus disclosure regime meaning that alternative mutual funds not listed on an exchange now have to prepare and file a simplified prospectus, annual information form and Fund Facts. Alternative mutual funds listed on an exchange are required to file a long form prospectus and ETF Facts. Furthermore, in their disclosure, alternative mutual funds have to highlight how the alternative mutual fund differs from conventional mutual funds.
  • Financial statements: Now under the purview of NI 81-106, alternative mutual funds must include in their interim financial reports and annual financial statements disclosure related to their actual use of leverage over the reference period of the financial statements. Funds must also describe the impact of hedging transactions on the funder’s overall leverage calculations.

In summary, the Amendments reflect the CSA’s efforts to modernize the previous commodity pools system by crafting a regulatory framework that is effective in facilitating more alternative, flexible and innovative strategies while simultaneously upholding restrictions the CSA deems appropriate for products marketed to retail investors. As we proceed through the first year with the Amendments, it will be interesting to note how these changes influence the practice and success of alternative mutual funds and the seemingly inevitable promulgation of such funds in the future.

The author would like to thank Neil Rosen, articling student, for his assistance in preparing this legal update.

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