Blog - Page 3 of 4 - Alternative.Investments

Oaktree Launches Non-traded BDC : Oaktree Strategic Credit Fund

Oaktree Capital filed a registration statement for a new non-traded BDC: Oaktree Strategic Credit Fund. Oaktree is joining Bain Capital, Apollo, and Blackstone by making high net worth retail investors an important part of their fundraising strategy. In this article we provide a preview of Oaktree’s new non-traded BDC.

Oaktree Strategic Credit Investment Strategy

According to the prospectus, Oaktree Strategic Credit will focus on private debt opportunities, mainly in US companies. The prospectus also allows them to invest in European companies. However, to maintain compliance with the regulatory requirements of a business development company, they must put at leas ty70% of their assets in private US companies. Most of their debt investments will be non rated. They will invest opportunistically, so the investment portfolio will change with market conditions. Oaktree believes the market for lending to private companies is underserved. Key themes they will focus on will be stressed sector/rescue lending, situational lending, sponsor related financing, secondary private loans, and loan portfolios.

Fund Structure

Oaktree Strategic Credit Fund has a maximum capital raise of $5 billion The latest prospectus includes three classes of shares: Class S, Class D, and Class I . Class S shares will have a servicing/distribution fee of 0.85% per year, with a 3.5% cap. Class D wil have a shareholder servicing/distribution fee of 0.25% per year with a 1.5% cap. Class I shares will not have any shareholder servicing or distribution fees. The minimum initial investment for Class I shares is $1 million.

Oaktree’s new BDC will have a base management fee of 1.25% per year. Additionally, it will charge an incentive fee consisting of two parts. The first part of the incentive fee is based on income- the manager will receive 12.5% of pre incentive fee net investment income over a 5.0% hurdle rate. Additionally, the fund will pay the manager 12.5% of cumulative realized capital gains.

Notably this fee structure is nearly identical to that of Apollo’s new non-traded BDC.

About Oaktree Capital

Oaktree Capital Management is a global alternative asset manager with more than $158 billion in AUM as of 9/30/2021, according to its website. They have deep expertise across the capital structure. They organize their investment professionals into four broad categories: credit, private equity, real assets, and listed equities. Well known for their expertise in distressed debt, approximately 69% of their assets are in credit. Their clients include 67 of the 100 largest pension plans in the US, 40 state retirement plans along with 15 major sovereign wealth funds and 500+ corporations around the world. In 2019 Brookfield Asset Management acquired a majority interest in Oaktree. Oaktree entered the non-traded REIT space back in 2017. After transitioning the management over to Brookfield, this REIT has over $500 million in net assets. It is likely Oaktree will quickly gain market share in the non-traded BDC industry.

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Fund Launch: Apollo Debt Solutions BDC

Apollo Global Management has launched a new non-traded BDC: Apollo Debt Solutions BDC. The SEC declared the Apollo’s new BDC effective on October 29, 2021.

Investment Strategy

According to the prospectus for Apollo Global Debt Solutions:

Our investment strategy is focused on sourcing deals directly with large private U.S. borrowers who seek access to financing and who historically relied heavily on bank lending or capital markets. We believe there is a market opportunity for these large private U.S. borrowers.

They will focus on companies with at least $75 million in EBITDA, but they might adjust this threshold for market disruptions, M&A related charges and synergies, etc. Quoting from the prospectus again:

We believe this opportunity set generates favorable pricing and more rigorous structural protections relative to that offered by investments in the broadly syndicated markets. From time to time, we may also invest in loans and debt securities issued by corporate borrowers outside of the private large borrower space to the extent we believe such investments enhance the overall risk/return profile for our shareholders and help us meet our investment objectives.

The fund was launched as a blind pool, but they already had a financing facility agreement on the date of the launch.

Apollo Debt Solutions Fund Structure

Apollo Debt Solutions BDC has a maximum capital raise of $5 million. The latest prospectus includes three classes of shares: Class S, Class D, and Class I . Class S shares will have a servicing/distribution fee of 0.85% per year, with a 3.5% cap. Class D wil have a shareholder servicing/distribution fee of 0.25% per year with a 1.5% cap. Class I shares will not have any shareholder servicing or distribution fees.

Apollo’s new BDC will have a base management fee of 1.25% per year. Additionally, it will charge an incentive fee consisting of two parts. The first part of the incentive fee is based on income- the manager will receive 12.5% of pre incentive fee net investment income over a 5.0% hurdle rate. Additionally, the fund will pay the manger 12.5% of cumulative realized capital gains.

About Apollo Global Management

Apollo is a leading global alternative asset manager with approximately $480 billion in AUM, according to a recent investor presentation. Apollo Global Management is listed on the NYSE under the symbol APO. They have three main business segments: Private Equity, Credit, and Real Assets. IT believes it is distinct from other alternative managers in the way it operates its three primary business segments: private equity, credit, and real assets, in an integrated manner. Apollo has been part of a broader trend of institutional alternative managers making the big shift into the retail channel. On recent conference calls, management has hinted at early success raising capital from retail investors.

Apollo Debt Solutions will be a good fund to watch in the coming months. Blackstone’s non-traded BDC has over $18 billion in assets. It will be interesting to see if Apollo achieves similar fundraising success.

Want to learn more about non-traded BDCS? Click here to access free tools and data.

Hospitality Investors Trust Files For Bankruptcy

Things went from bad to worse at Hospitality Investors Trust. Last year, they had to enter into a forbearance agreement with certain lenders. Earlier this year the DI Wire reported on a liquidity dilemma at Hospitality Investors Trust. Now at last the inevitable has happened. Hospitality Investors Trust has filed for bankruptcy.

FactRight sums up the current situation here:

On May 19, 2021, Hospitality Investors Trust, Inc. (HIT) announced that it and certain operating subsidiaries had filed voluntary bankruptcy petitions under Chapter 11 of the Bankruptcy Code. The United States Bankruptcy Court for the District of Delaware is administering the cases under the caption In re: Hospitality Investors Trust, Inc., et al.
HIT and affiliates filed for first day relief including the authority to pay certain vendors, suppliers and employee wages and benefits in the ordinary course of business as well as for approval of a debtor in possession (DIP) financing facility of up to $65 million in aggregate principal balance. Brookfield (via multiple affiliates), which had previously made an approximately $300 million investment in HIT, has agreed under a restructuring support agreement to “support and take any and all commercially reasonable, necessary or appropriate actions in furtherance of the consummation of the restructuring transactions.” HIT noted that it had received approval from “certain of the Company’s lenders, franchisors and other parties in interests” regarding the planned restructuring and that implementation of the planned restructuring will not constitute a default or triggering event under certain loans or financial obligations.

Under the proposed restructuring plan, the existing common stock will be cancelled and exchanged into non-transferable contingent valuation rights (CVRs) which will receive distributions once certain hurdles are achieved for Brookfield. The maximum value of the CVRs is $6.00. Considering the retail investors originally bought in at $25.00, this is probably a painful outcome. At least there will be some tax benefits.

Backstory

Hospitality Investors Trust has a long and sordid backstory. Formerly known as American Realty Capital Hospitality Trust, it raised capital quickly from the broker-dealer channel right at the peak of Nick Schorsch’s reign as the non-traded REIT Czar. However it got overextended financially, and everything unwound right as an accounting scandal broke out at American Realty(now known as VEREIT. (See “History Repeats: The Serpent on the Rock” for details on this). Eventually they struck a Faustian bargain with Brookfield, who bailed them out in exchange for some extremely generous preferred stock. Then the pandemic hit.

Possible Recovery?

Many analysts have speculated that there is a lot of pent up demand for travel. If that is the case, then there is a lot of upside for the hospitality industry. There might be upside for Hospitality Investors Trust, but its complex capital structure means it will take a lot before the outside shareholders benefit. Its possible that the CVRs resulting from this bankruptcy might achieve the full targeted payout of $6.00. Considering that shares have recently exchanged hands at $0.50, this might be an extreme deep value play, albeit with a lot of risk. One thing is for certain: Brookfield will do extremely well no matter what happens.

Fund Launch: KKR Real Estate Select Trust

KKR has launched a new non-traded REIT: KKR Real Estate Select Trust, Inc. The REIT filed an initial registration statement on May 28, 2020, and the SEC declared the revised version effective on May 18, 2021. In this article we examine the key features of KKR’s new non-traded REIT.

KKR Real Estate Select Trust Investment Strategy

KKR Real Estate Select Trust’s vestment objective is to provide attractive current income and its secondary objective is to provide long term capital appreciation. The REIT has a broad investment thesis targeting single-tenant net lease properties, preferred equity investments and private real estate debt in the United States, as well as developed markets in Asia and Europe. The prospectus highlights several trends that it believes will be favorable to the REIT’s investment strategy. In particular, it plans to focus on opportunities in population centers that have favorable demographic, technological and preference changes accelerating urbanization.

Fund Structure

According to the prospectus, KKR Real Estate Select Trust is raising $2 billion, and offering four different share classes. The perpetual life REIT will price NAV and accept subscriptions daily. Class S shares will have an up front sales load of 3.0%, and a dealer manager fee of 0.5%. Class D, Class U, and Class I shares have no up front selling costs. However Class S and Class U both pay ongoing distribution fees of 0.60%, and shareholder servicing fees of 0.25%, while Class D shares pay shareholder servicing fees of 0.25% Class I shares have no distribution or servicing fees. The REIT will charge a base management fee of 1.25%, and a performance incentive fee of 12.5% of portfolio operating income.

More details on KKR Real Estate Select Trust’s fee structure and investment strategy is available to premium subscribers. Click here to learn more about data and tools available to premium subscribers.

KKR Select Real Estate Select Trust is relatively unique in that it is both a non-traded REIT, and a Tender Offer Fund. Real Estate Investment Trust, or “REIT” refers to its tax status. As a REIT, it is subject to a range of requirements, especially around distributing income to investors. As a tender offer fund, it is subject to disclosure requirements of the 1940 act. Broadstone Real Estate Access Fund, a closed end interval fund, is another example of a fund using this combination of regulatory structures.

About KKR

Founded in 1976 KKR was one of the pioneers in private equity and alternative investments. Today it operates globally, with 20 offices, and 1600 employees. As of December 31, 2020, KKR had approximately $252 billion in assets under management. Since 2004, KKR’s AUM has grown twice as fast as the broader alternative investment industry. Private equity remains the dominant strategy in KKR’s portfolio, accounting for 68% of total AUM. In recent years they have been expanding their real estate capabilities. KKR Real Estate has around 90 employees dedicated to real estate, with AUM of approximately $28 billion Additionally KKR has been expanding its focus on retail investors, with the launch of various non-traded BDC and Interval Fund products. This is KKR’s first non-traded REIT.

Is David Swensen To Blame For High Fees?

The untimely passing of David Swensen has led to a lot of self reflection in the world of asset allocators and alternative investment professionals. Swensen pioneered an investing method that moved beyond traditional stocks and bonds, and into more exotic alternative investments and real assets. In a previous article, we highlighted the three pillars of David Swensen’s method of investing, as summarized in the Economist. John Authers of Bloomberg recently added to the voluminous commentary around his death.

Although the endowment method has been covered extensively in books, articles, and webinars, few imitators have been as successful at achieving the level of returns achieved by Swensen. As Authers notes:

But it’s still necessary to understand a little more about the man’s legacy. None of his imitators have managed to perform as well, even though many are just as clever as he was, and enjoyed comparably big inbuilt advantages. Why did Swensen apply his own model so much better than the many brilliant asset allocators who have followed him?

Authers posits that he enjoyed first mover advantage. When he started allocating to hedge funds and private equity funds, they were exploiting truly unique market anomalies that no one else had noticed. Over time more and more funds entered the space, and the returns were arbitraged away. Moreover, more and more opportunistic and unscrupulous people entered the industry. Meanwhile, the early successful funds closed to new investors. Late adopters were left with a difficult problem of filtering a less stellar opportunity set.

Yet there was more Swensen’s success than just the first mover advantage. Quoting from the article:

This is important to note because there is some revisionism afoot. He showed that it was possible to make a lot of money in alternative assets; many alternative asset managers showed that it was possible to get very rich by feeding the appetite for their product that Yale had created. Hence there are attempts to blame Swensen for the growth of “2-and-20” hedge funds, after a decade in which their business model has looked ever worse.
That is more than a little unfair. What follows is my attempt to summarize and synthesize what might be called the “soft skills” that allowed Swensen to make the Yale model work so well for so long.

Everybody has their own interpretation of what made Swensen succesful. Here are the key tenets that Authers identified:

Know your comparative advantage
Be the best client you can be
Be a Coach
Be a scout
Don’t just take what’s on offer
Minimize turnover
Treat your bosses well(and choose your bosses if you can)
Groom successors
Risk control, risk control, risk control

Perhaps the last item is the most underrated. Indeed all of the other tenets of Swensen’s method were joined under the discipline of risk control. He had deeply studied academic literature on risk management, and this allowed him to be comfortable making contrarian long term bets.

Its well worth checking out the full article on Bloomberg. Checkout our previous commentary on the endowment method here.

3 Pillars of David Swensen’s Method

David Swensen (January 26, 1954- May 5, 2021) served as chief investment officer at the Yale University Endowment from 1985 until his death in 2021. His legacy is that of a pioneer in the world of asset allocation and alternative investments. Prior to the 1980s, endowments had invested exclusively in stocks and bonds, with an especially large allocation to the latter. His performance far exceeded that of other university endowments. When he started the endowment had $1 billion in assets. When he died it had $31 billion. Yet a 31x return actually understates his impact.

He attracted a legion of imitators, forever altering the intellectual landscape of investing. . His approach, which included a large allocation to equities and alternative investment products, but a relatively low allocation to fixed income is sometimes called the “endowment method”. Others just call it the Swensen Approach. Many family offices, sovereign wealth funds, and large pension funds use the Swensen Approach.

A whole slew of obituaries and commentaries followed his untimely death at the relatively young age of 67. These obituaries were a chance to reflect both on a life well lived, and an intellectual legacy. The Economist recently featured an article that outlined the three pillars of David Swensen’s thinking. These three pillars also formed the basis of his competitive advantage.

Time Horizon

While most investors are focused on day to day price movements, endowments think long term. Like really long term. The defining feature of endowments is that they have obligations extending far out into the future. Unlike most investors, they don’t need to worry much about liquidity and ease of trading. Endowments can harvest an illiquidity premium. Being more patient than your counterparties can be an important advantage in markets.

Information

Public stock markets are mostly efficient. It’s nearly impossible to get an informational edge. In contrast, private markets reward people who do deeper homework. Reliable data and analysis are harder to acquire in public markets. Swensen built out research teams to cover markets where nobody else was paying attention.

Closely related to this, Swensen was able to get in on the ground floor with a lot of emerging managers in the early days of alternative investments. Many of the funds he invested in during the 1980s and 1990s have stellar track records, and are now closed to new investors. Superior access is a corollary to superior information. While anyone can theoretically get access to superior information on individuals in private markets, superior access requires being in the right place at the right time, and developing connections over years. There is a feedback loop that allows superior access to grow in importance.

Contrarian Mindset

Swensen was a contrarian before it was cool. The extent of Swensen’s contrarian mindset is best illustrated with an anecdote:

Following the stockmarket crash in October 1987, he had loaded up on company shares, which had become much cheaper, by selling bonds, which had risen in price. This rebalancing was in line with the fund’s agreed policy. But set against the prevailing market gloom, it looked rash. His investment committee was worried. One member warned that there would be “hell to pay” if Yale got it wrong. But Mr Swensen stuck to his guns. The decision stood—and paid off handsomely.

Another notable aspect of Swensen’s legacy is his mentorship. Dozens of alumni of Yale’s Endowment fund have taken senior positions at other endowments.

Invesco Launches Non-Traded REIT

Invesco has entered the non-traded REIT space with the launch of a new fund: the Invesco Real Estate Income Trust, Inc. This fund filed an initial draft registration statement on December 31, 2019, and conducted a private offering in 2020. On March 31, 2021, it filed a registration statement for a public offering, which the SEC declared effective on May 14, 2021.

Investment Strategy

The Fund’s investment objective is current income and capital appreciation. It will invest primarily in stabilized, income-oriented commercial real estate in the United States. Invesco Real EState Income Trust will invest in a broad range of property types including multifamily, industrial, retail, office, healthcare, student housing, hotels, senior living, data centers and self-storage. It will use the FTSE EPRA/Nareit Developed Index as its benchmark.

The fund has a mandate that allows it to invest globally. In order to fund liquidity for distribution payments, and the repurchase plan, it may also hold more liquid real estate related securities.

Since the fund conducted a private offering, it already has $31 million in net assets in the portfolio. The following table summarizes its property type allocation.

Share Classes

According to its prospectus, Invesco Real Estate Income Trust is raising up to $3 billion, and will have a total of 5 share classes. Class T, Class S, and Class D shares all have varying levels of up front selling commissions. Class I and Class E shares however, will not have any upfront selling costs. The minimum initial investment for Class T, Class S, Class D and Class E shares is $2,500. Class I shares are intended for institutional investors, and have a $1,000,000 minimum initial investment.

The fund will pay an annual management fee equal to 1.0% of NAV. Additionally, the Adviser will be entitled to a performance allocation of 12.5% over a 6.0% hurdle, with a high water mark, and catch up feature. The fund will not charge any acquisition, disposition, or financing coordination fees.

More details on Invesco Real Estate Income Trust’s strategy is available to premium subscribers. Click here to learn more about data and tools available to premium subscribers.

About Invesco

Invesco is a global investment manager with $1.2 trillion in assets under management. Headquartered in Atlanta, Georgia, it has more than 8000 employees branch offices in 20 countries. Invesco’s common stock also trades on the New York Stock Exchange under the ticker symbol “IVZ”. Invesco’s funds have a diverse investor base. According to its most recent annual report, approximately 70% of IVZ’s AUM is from retail investors, and 30% is from institutional investors. Invesco Real Estate buys and sells approximately $7.4 billion in real estate globally, in addition to real estate related securities.

Although This is Invesco’s first non-traded REIT, it has extensive experience marketing alternative investment products in the retail channel. Notably, Invesco has one of the longest running interval funds. Additionally, it is in the process of converting one of its closed end funds into an interval fund.

Why Firms Should Adopt the CFA Asset Manager Code

The CFA Institute Asset Manager Code is a valuable guide for asset management firms that aspire to high standards. The purpose of the Asset Manager Code is to foster a culture of ethical and professional behavior that protects the interest of investors, protects and enhances the reputation of the investment firms. It also provides a useful framework for asset management firms to provide services in a fair and professional manner with full disclosure. The Code helps asset managers gain the confidence of clients, ultimately leading to higher profits.

Broadly speaking, there are six general principles to the Code:

Managers must

Act in a professional and ethical manner at all times
Act for the benefit of clients
Act with independence and objectivity
Act with skill, competence, and diligence
Communicate with clients in a timely and accurate manner.
Uphold the applicable rules governing capital markets.

The details matter. In this article we’ll examine the key sections of the Asset Manager code.

There are six sections to the Code:

Loyalty to Clients
Investment Process and Actions
Trading
Risk Management, Compliance and Support
Performance and Valuation
Disclosures

Loyalty to Clients

A firm must prioritize clients interests ahead of firm and employees, maintain confidentiality, and refuse inappropriate gifts or business relationships.

Firms need to develop policies and procedures to ensure that client interests are paramount in all aspects of the manager-client relationship. This includes things like investment selection, transactions, monitoring and custody. Managers should avoid situations that create conflict of interest. Moreover they should implement compensation arrangements that ensure these interests are aligned, and no in conflict.

This also includes being careful to maintain client confidentiality (ie a privacy policy). This of course does not apply if information must be legally disclosed.

Asset managers also need to be careful to avoid getting into business relationships that create conflicts of interest. This can be challenging for due diligence analysts who constantly receive gifts from potential investments.

Investment Process and Actions

This requires reasonable care and judgment when making investment decisions, fair dealing, sufficient due diligence, and avoiding manipulation of securities prices and volume.

A rigorous due diligence process is part of the Asset Manager code. This means using reasonable care and prudent judgement in setting the investment policy, and having a reasonable and adequate basis for all investment decisions.

Manipulating securities market, or treating clients unfairly is a violation of this part of the code. Note that this provision doesn’t prohibit side-letter arrangements, als long as they are fairly allocated among similarly situate clients for whom the opportunity is suitable.

The CFA Institute provides additional guidance on this part of the code that pertains to the differences between managing pooled funds and separate accounts. When a pooled vehicle has a specific mandate, strategy, or style, the investors should take only investment actions that are consistent with those constraints or objectives. If there is any change in the investment style or strategy, you should inform investors before making the changes. That way clients can decide if the new strategy still fits with their objectives.

When managing separate accounts there are additional subtleties. You should evaluate and understand the client’s objectives, risk tolerance, time horizon, liquidity needs, financial constraints and unique tax, legal, and regulatory constraints that would impact the policy. Only make decisions that are suitable for clients given these circumstances.

Trading

This section includes not using material non-public info for trading purposes (regardless of local law), the prioritization of clients over the firm, the proper use of client commissions, and making sure your clients get best execution and the development policies of fair and equitable trade allocation.

Firms need to establish compliance procedures to ensure they avoid insider trading.
Additionally, they need to give priority to clients made on behalf of the client over those that benefit the Manager’s own interests.

Commissions generated from trades should only be used t o pay for investment related products or services that assist in the investment management process, not with management of the firm. This goes back to the general principle of putting clients first. Closely related, Managers need to seek best trade execution for clients. This can add a lot of value for strategies that deal in illiquid securities, or make large investments. As with everything else, the firm needs to document this with proper policies and procedures.

Risk Management, Compliance and Support

The asset manager code requires detailed policies and procedures in order to ensure compliance with the Asset Manager Code. The firm’s compliance department needs to develop extensive written policies and procedures to ensure that all activities comply with the Asset Manager Code, and with all legal and regulatory requirements.

The compliance officer should be independent from investment operations if possible. Additionally, they should report directly to the CEO or board. The compliance officer also needs to make sure all client communications are accurate and complete. Additionally, third party confirmation is essential. Maintain records for at least seven years, or as required by local law. Keeping top quality staff isn’t just good business sense, its also required by the Asset Manager Code. A disaster recovery and business continuity plan is also part of this section of the Asset Manager Code.

The firm should establish a firmwide risk management process that identifies, measures and managers the risk position of the manager. An effective risk management process will identify risk factors for individual portfolios, as well as for the manager itself. This includes, stress tests, scenario testa, and backtests.

Performance and Valuation

The asset manager code requires the use of fair market prices or commonly used valuation methods, as well as data that is accurate, relevant, timely and complete.

Managers need to present performance data that is fair, accurate, relevant , timely and complete. Its critical that managers must not misrepresent hte performance of individual portfolios or their firm. The GIPS standard provide a good standard, although its not required. MAnagers should not cherry pick performance, or take credit for performance that occurred before they took over management.

Some securities can be hard to value. The code requires Managers to use fair market prices to value client holdings and apply, in good faith, methods to determine the fair value of any securities for which no independent third party market quotation is available. Management fees are generally calculated based on asset valuation, so this has the potential to crate a major conflict of interests. The best practices is to transfer responsibility to an independent third party. For pooled funds with independent directors, best practices is to have independent directors review valuation.

Disclosures

Disclosure is a theme that runs through all sections of the Asset Manager Code . Firms must provide ongoing , timely communications with clients. These communications must be truthful, accurate, complete, and understandable. Moreover these communications must include all material facts regarding the firm, personnel, investments, and the investment process.

Key guidance for disclosure:

Communicate with clients on an ongoing and timely basis. Managers should establish lines of communication that fit with their situation.
Ensure that disclousrs are truthful, accurate, complete and understandable and a re presented in a format that communicates effectively.
Include any material facts when making disclourures or providing information to clients regarding htemselves, their personnel, investments, or the investment process.
Things that require disclosing include
- Conflicts of interest from relationships with brokers or other entities, other client accounts, fee structures or other matters
- Regulatory or disciplinary actions against the manager.
- Thei investment proces , including information regarding lock up periods, strategies, risk factors, and use of derivatives and leverage
- Management fees and other investment costs charged to investors, including what costs are included and methodologies for determining fees and costs.
- The amount of any soft or bundled commissions, the goods and or services received, and how they benefit client
- Performance of clients investments on regular basis. The CFA Institute recommends at least quarterly when possible, and within 30 days after th end of the quarter
- Valuation methods used – must be specific, not boilerplate
- Shareholder voting policies
- Trade allocation policies
- Results of the fund audits.
- Significant personnel changes
- Risk management processes.

By adopting this code, firms demonstrate their commitment to ethical behavior and the protection of investor interests.

Four Structuring Options for Retail Cryptocurrency Funds

Blockchain and cryptocurrency are major growth areas. According to Northern Trust:

According to Fidelity, one-third of institutional investors now hold digital assets such as Bitcoin,3 and 47% see digital assets as having a place in their portfolios.4 Given this data, it’s clear that their acceptance of cryptocurrency has come a long way in the last decade. As they embrace the idea of investing in cryptocurrency, pure-play crypto hedge funds and hedge funds who offer crypto funds are sure to see greater demand – and potentially already have.
The total AuM of global crypto hedge funds roughly doubled from 2018 to 2019.5 Family offices are leading the way in this movement, making up 48% of crypto hedge fund investors, while high net worth individuals make up 42%, indicating untapped opportunity to bring other classes of institutional investors – such as pension plans and foundations and endowments – into the fold.

In a previous post, we covered the Key Benefits and Challenges of Blockchain Technology. In this post we’re going to cover fund structuring options for asset managers focused on retail investors. A 2018 article in The Review of Securities and Commodities Regulation is a great place to start.

The caveat to this post is that regulatory issues surrounding blockchain, digital assets, an cryptocurrency are fast moving. Therefore, before getting ready to launch a fund, you should look for regulatory updates, and engage with appropriate legal counsel. Nonetheless Here is a quick overview of the options that you have.

Open End Fund

There are a still a number of outstanding issues that the SEC believes need to be addressed before anyone can launch an open end crypto fund (ie a mutual fund or an ETF). However there are many commentators who believe that the SEC will change its views in the near future. Moreover, many other countries including Canada, Sweden, and Switzerland, have already approved cryptocurrency ETFs.

Closed End Fund

In the US, closed end funds face many of the same hurdles that open end funds face when getting approved for cryptocurrency investment. Quoting from the article:

In light of the SEC’s concerns regarding exchange trading, a cryptocurrency fund, including a Closed-End Fund, may consider foregoing the listing and trading of its shares on an exchange. As an alternative, a Closed-End Fund could provide periodic liquidity to shareholders either by making periodic tender offers pursuant to Exchange Act tender offer rules (“Tender Offer Fund”) or could elect to operate as an interval fund under Investment Company Act Rule 23c-3 (“Interval Fund”). Importantly, although generally prohibited under Regulation M of the Exchange Act, a Closed-End Fund – whether a Tender Offer Fund or an Interval Fund – is permitted to continuously offer and redeem its shares simultaneously.13 Without this permission, a Closed-End Fund would either not be able to take in new capital or would not be able to offer shareholders liquidity.

Separate from the legal issues, closed end funds have a lot of economic advantages over open end funds for cryptocurrency investments. Check out: Closed End Funds Are A Better Solution For Digital Assets

33 Act/ETP Structure

Grayscale Bitcoin Trust reportedly attempted to register as an ETP, but was unable to do so. However, it was able to conduct an offering under a registration exemption under Rule 506(c) of Regulation D promulgated under the Securities Act of 1933. This process has proven much easier than using a 40 act structure(ie an open end fund or a closed end fund). However 33 Act companies often don’t have the same level of investment protection.

Commodity Pool

Given the growth of the cryptocurrency derivatives market, its likely some fund sponsors will come up with commodity pool structures that offer cryptocurrency exposure. These funds would be required to register with the CFTC as commodity pool operators, but would avoid some SEC complications.

Key Considerations Regardless of Structure

Regardless of fund structure, there are several issues a firm needs to concern. A key challenging is to find the right service providers to be partners in the strategy. Northern Trust, in a recent post suggested there should be three key considerations: (1) Previous experience servicing crypto strategies (2) Assistance with investor transparency and (3) Risk averse custody optoins.

4 Types of Institutional Investors

Broadly speaking there are four types of asset owners. Each has different purposes and constraints. Additionally each has a different strategy for allocating to alternative investments. This post summarizes the four different types of institutional investors.

Endowments and Foundations
Pension Funds
Sovereign Wealth Funds
Family Offices

Endowments and Foundations

Endowments are funds established to raise charitable contributions, and support the activities off a non profit organization. University endowments are probably the most common example. They receive donations from alumni, and use the investment income to support university operations. Notably some of the most prestigious colleges also have the largest endowments. Endowments vary widely in size.

Endowments are known for their pioneering approach to alternative investments. Indeed the most robust research backed method for investing in alternatives is called “the endowment model. “ Endowments have light regulations, and exceptionally long time horizons, so they can theoretically invest in anything.

Foundations are similar to endowments, in that they depend on charitable contributions from supporters. Typically foundations are used to fund grants and charitable work. Like endowments, foundations have long time horizons and are able to invest in a wide variety of asset classes.

However, there is an important difference between endowments and foundations: Due to tax regulations, foundations are typically required to distribute a minimum percentage of their assets each year. The need to make regular distributions impacts asset allocation decisions.

Although endowments and foundations serve different purposes, and fall under different tax rules, they often have similar investment policies.

Pension Funds

Pension funds are one of the most common types of institutional investor. exist to provide retirement benefits for specific groups. The organization that sets up a pension fund is called a plan sponsor. The plan sponsor might be a corporation, nonprofit, or government entity.

There are four types of pension funds.

National Pension Funds

National Pension Funds provide basic retirement services to citizens of a country. The most famous example is the US Social Security Other economically important examples include South Kora’s National Pension Service, and the Central Provident Fund of Singapore. In some cases, national pension funds operate similarly to sovereign wealth funds. National Pension funds have massive scale and long term time horizons. As a result, they are able to invest in a wide range of alternative investments.

Private Defined Benefit Funds

Private defined benefit funds are another important type of institutional investor. They are set up to provide prespecified benefits to employees of private businesses. Benefits provided are typically based on years of service, salary etc. The plan sponsor is responsible for asset allocation. Private defined benefit funds are long term investors, although not as long term as national pension funds. Private defined benefit funds are able to invest in a wide variety of alternative asset classes.

For a variety of reasons, private defined benefit funds are becoming less common.

Private Defined Contribution Funds

Private defined contribution funds are now more common than defined benefits funds. With defined contribution funds, contributions are deposited into accounts linked to each beneficiary. Upon retirement, the employee gets the amount in the account. The employee is ultimately responsible for managing the plan and bears all the risk. The plan sponsor decides what investments are available for beneficiaries to select. Uneven payout timing of alternative investments, illiquidity, and governemnt regulations typically prevent these funds from offering a wide variety of alternative investments. Additionally, most participants typically fall below the income threshold. Defined contribution funds are typically able to invest in real estate and liquid alternatives though.

Individually Managed Accounts

Individually managed accounts the same as private savings plans. Asset allocation is directed entirely by employee. Examples include Roth IRAs and Traditional IRAs in the united states. These funds enjoy certain tax advantages. However these tax advantages come with additional regulatory scrutiny Consequently there are limits on the alternative asset exposure people can get in individually managed accounts. Private placements are normally not available. One big issue that often comes up is custody. Fortunately, a lot of companies are coming up with custody solutions and are generally working to make it easier for investors to access alternative investments in their individual retirement accounts. Consequently, investors can access precision metals, bitcoin, and certain alternative investments in their individual retirement accounts.

Sovereign Wealth Funds

National governments set up sovereign wealth funds (SWFs) to save and build on the country’s current income, in order to benefit future generations. They are similar to national pension funds in that they are government run, but unlike with national pension funds, they have a broader range of purposes than just providing retirement income.

OVer the past few decades , SWFs have become a major economic force because of their sca. The rise of SWFS has been tied to emerging economies that have large natural resource endowments. Typically SWFs grow when commodities are high. In other cases, such as with China, they are funded by large trade surpluses that give countries with huge amounts of foreign currency.

SWFS have broad investment mandates and long term investment horizons. However, depending on the politics of the particular country, there may be limitations on what they are allowed to invest in. Typically they invest a portion of their funds in alternative assets.

Family Offices

Family offices are organizations dedicated to the management of a pool of capital owned by a wealthy individual or family. Basically they are private wealth advisory firms. Family office is a broad, diverse category. In some cases they are spun off from operating companies, in other cases they are funded by legacy wealth. The goals and investments mandates of family offices vary widely. Sometimes they are focused on maintaining a standard of living. Other times they are focused on providing benefits for future generations, or on philanthropic activities. There are typically differences between the goals and strategies of first, second, and third generation family offices.

Family offices have long time horizons and large scale, so they are often able to invest in a broad range of alternative asset classes.

For more details, check out Alternative Investments: An Allocators Approach

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