Recent years have brought about quite a revolution in the capital markets. Of course, it is already known that Alternative Investment Fund (AIF) are replacing the hitherto popular classical investment funds at a rapid pace. We wrote more about this topic in the article “AIF leads the way on the Polish capital market“. The question, however, is whether in this situation the investment activity conducted with the use of non-public CEFs is still profitable at all? 

Contents
1. A few words about CEFs
2. Flexibility or formalism?
2.1. The forced “supervisor” of a non-public CEF: Investment Fund Company (IFC or in Polish Towarzystwo Funduszy Investycyjnych – TFI)
2.2. Necessary minimum to enter into an investment
2.3. Double control of Closed-end Investment Funds
2.4. Reporting and internal procedures
3. Costs of running non-public CEFs
4. Do Closed-End Investment Funds Pay Off – Summary

A few words about CEFs

Closed-end investment funds are a form of collective investment aimed at capital multiplication and are divided into public and non-public ones. The participation units in investment funds, regardless of their type, are investment certificates, however non-public CEFs, and it is them that will be discussed in this article, issue certificates that are not admitted to trading on a regulated market – in contrast to those issued by public funds. Non-public funds may issue a maximum of 149 certificates in one issue, intended for a limited group of investors – both private and institutional, and the establishment of such a fund does not require a permit from the Polish Financial Supervision Authority. The latter sounds quite encouraging. But what is it like in practice? 

Flexibility or formalism? 

The forced “supervisor” of a non-public CEF: Investment Fund Company (IFC or in Polish Towarzystwo Funduszy Investycyjnych – TFI)

Although the establishment of a private closed-end investment fund does not require obtaining a permit from the Polish Financial Supervision Authority, it absolutely requires the participation of an Investment Fund Company (TFI), i.e. an entity that holds such a permit. The Investment Fund Company (TFI) acts as the so-called “supervisor” of the fund. What does that mean? Its role is to represent the fund, manage it, and control its activity. As a result – practically every business/investment decision of the fund requires TFI’s involvement and is connected with the necessity of obtaining its approval. Not to mention other obligations, of which more later.

Another difficulty is the selection of the depositary bank. Due to the increasing requirements of the regulator, a very restrictive supervisory policy and consequently a significant increase in the business risk of such activities, individual banks have withdrawn their offers to service non-public CEFs, and the rates of those that remained on the market have long since skyrocketed. Worse still, their approach to supervising the activities of CEFs has become inflexible, which makes it more difficult for CEFs to operate and carry out transactions.

These (the above-mentioned) and other factors have resulted in a significant increase in the operating costs of closed-end investment funds in recent years.

The changing conditions and scrutiny in the fund market have had a major impact on limiting the investment freedom of the funds themselves. In practice, various restrictions have hit hard. These include, for example, surprising decisions of TFIs which, fearing repercussions of the regulator, preferred to question investments just in case. The time needed to take a position on joining the investment is also a considerable obstacle, far exceeding the market transactions’ standards. In the example known to us, an offer to join a transaction (via CEF) was valid for 2 weeks, while TFI (managing this CEF on behalf of the investor) needed as much as 4 weeks to analyse it. The bidder was not able to wait for a decision, especially since it was not known whether it would be positive. Therefore, it is hardly surprising that such investment conditions have strongly weakened the position of non-public CEFs.

Necessary minimum to enter into an investment

What is more, apart from limiting the number of issued certificates to 149 in one series, the legislator has also limited the possibility to purchase the certificates of the first issue by interested retail clients. Well, natural persons may purchase investment certificates of the fund if the value of the first-issue investment certificate of this fund is not lower than the PLN equivalent of EUR 40,000. If the participants of the investment fund are natural persons, then the issue price of the second or subsequent issues of investment certificates may not be lower than the value of the fund’s net assets per investment certificate according to the valuation of the fund’s net assets. The valuation must be made seven days before the opening of subscription for the certificates of the subsequent issue. At the same time it is not possible for such a fund to allot certificates of the second, or subsequent, issue to a natural person if the payment for certificates of this issue would be lower than the PLN equivalent of EUR 40,000. 

To put it simply – a single payment for the certificates is at least EUR 40,000! There is no denying that such – quite stringent – requirements may effectively discourage investors interested in the certificates from investing. That happens especially if the investor has an alternative, albeit in the form of alternative investment funds or simple joint-stock companies.

Double control of Closed-end Investment Funds

As it turns out, the Investment Fund Company is not the only entity exercising control over a non-public CEF. The Law on Investment Funds and Alternative Investment Fund Management also provides for the obligation to establish a depositary. A TFI must provide a depositary for each closed-end investment fund it manages. What is the purpose?  The depositary is in essence a double protector of sort. It controls the funds’ activities in terms of raising capital, issuing certificates, selecting investments, their execution and…, as we may have expected that, its participation increases the cost of servicing the fund. 

Reporting and internal procedures

A number of information and reporting obligations have been imposed on the funds towards the Polish Financial Supervision Authority. We are talking about current reports on the conducted activity and financial condition. Excessive formalism, procedural requirements and the necessity of reporting significantly reduce the chances of efficient investment based on the “action-reaction” principle, so important in the capital market. Non-public CEFs must also develop and implement a number of internal regulations specifying remuneration, risk management and conflict of interest policies, as well as procedures for maintaining liquidity, reporting and valuation of assets. Speaking of valuation… The fund’s articles of association should contain clear information on the frequency of such valuations and the methods used. However, the valuation may not take place at least once every quarter – in practice, valuation every 3 months is considered to be relatively frequent. In addition, the fund makes a valuation also 7 days before the start of subscription for certificates of the next issue and on the day of redemption of certificates. On top of this, there are also the obligations, and costs, associated with carrying out audits. 

Costs of running non-public CEFs

In summary, the costs of running a closed-end investment fund consist of:

  • remuneration of the Investment Fund Company;
  • remuneration of the depositary;
  • costs of quarterly valuations;
  • accounting/bookkeeping fees & audit costs;
  • costs related to fulfilling reporting obligations towards the PFSA;
  • legal costs (usually higher than AIF legal costs, which is largely due to formalism).

Adding up the costs, they may even reach several hundred thousand annually. Most of these costs are not duplicated in the case of an AIF, which does not have to use a TFI, a depositary; whose valuations are not quarterly and whose legal services are very simplified. 

Do Closed-End Investment Funds Pay Off – Summary

When analysing the principles and operating costs of private closed-end investment funds in the current realities of the capital market, without losing sight of the role of Alternative Investment Funds, one cannot help but notice that for many investors the creation, and maintenance, of a structure based on a non-public CEF is simply not profitable. 

We wrote about the details of the alternative investment fund, and its advantages, in the article “Alternative Investment Fund (AIF). A first-class investment vehicle at your fingertips“. However, as a reminder, there is no doubt that in comparison with a non-public CEF, the total operating costs of AIF in trading are much lower, even by PLN 20-30 thousand. In the case of Alternative Investment Funds, there are no obligations (and thus no fees) related to:

  • covering TFI costs;
  • establishing a depositary, and incurring related costs;
  • the introduction of persons with specific competences into the management board; no expertise requirements for the organs of the management entity;
  • developing and implementing specific risk and liquidity management regulations;
  • performing quarterly valuations;
  • ensuring a specific level of capital;
  • rigorous reporting.

Not surprisingly, market trends are what they are and AIFs are gradually displacing traditional investment funds. The activity carried out with the use of a private investment vehicle, such as an Alternative Investment Fund due to the fact that it is not subject to regulatory restrictions proper for closed-end investment funds, does not generate such high costs and, consequently, is simpler and much cheaper to maintain.

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