More Disclosure Requirements for Investment Funds

Background

Ever since the 2008 financial crisis, followed by Bernie Madoff’s multi-billion dollar Ponzi scheme that rocked the investor world, there has been a call for more transparency of investment fund financial reporting from regulators and the investment community alike. Investors of “Madoff feeder funds” which were those funds that invested heavily in Madoff Securities, either directly or through another intermediary vehicle were particularly duped, as many of these investors did not even know what they were investing in. Back in 2011, as part of an investment companies project, the Financial Accounting Standards Board (FASB or the “Board”) discussed concerns about the transparency of information about an investee fund to investors in an investment company and proposed amendments to the scope, measurement and reporting requirements of these entities.

As part of that project, the Board initially decided that an investment company should consolidate investments in other investment companies where it has a controlling financial interest in a fund-of-funds structure. This was strongly opposed by stakeholders and practitioners, and as a result, the Board opted to not require consolidation, but instead increase transparency into investee funds by requiring more disclosures about an investment company’s investments in other investment companies. In December 2014, FASB issued an exposure draft for a proposed Accounting Standards Update of Topic 946 (the “Update”) which, among other things, would require a feeder fund in a master-feeder arrangement to provide the master fund’s financial statements along with its financial statements. This is already a requirement by the Securities and Exchange Commission (“SEC”) for investment companies regulated under the Investment Company Act of 1940 (“RICs”). The proposed amendments also would expand the scope of the current requirement to disclose certain information about investments held by investee funds that exceed 5 percent of the reporting entity’s net assets to include RICs. (This is already a requirement for non- regulated funds).

Considerations to Implementation

“Master/ Feeder” vs “Fund of Fund”
The comment letter period deadline was by February 17, 2015 and, while most constituents agreed that requiring additional disclosure requirements is a good idea, and in most cases already industry practice (for instance, non-registered investment feeder funds will typically include their master fund’s financial statements as an attachment); however, there are some challenges to implementation that the FASB should consider. For one thing, the definition of master- feeder structures should be clearly defined in the Update. Most consider a “master-feeder” as a two-tiered investment structure in which investors contribute capital into a feeder fund (“feeder”), which in turn invests in a master fund (“master”) that has the same investment objective. However, in some cases, this may not be the only objective of an entity. We’ve seen investment funds set up that initially invest substantially all of its assets into an affiliated fund controlled by “master fund’s” investment manager, but over time, the fund expects to have its own portfolio. Early on, the master-feeder presentation would appear to be most appropriate; however as the portfolio of other investments builds over time, a fund of fund reporting treatment may be more informative and representative of the results of the entity for the investor. ASC 946 requires current specialized accounting for master-feeder structures whereby the feeder fund will present its investment in the master on the balance sheet and break out all the components of profit and loss- including interest, dividends, fees, realized and unrealized gain and loss allocated from the master fund on its income statement.The financial statement presentation for a fund of fund is quite different, which typically shows the change in value of the investor fund’s interest in all investee funds held as one line item on the income statement. Guidance from the FASB as to what constitutes a master-feeder fund is needed in order for preparers to implement and ensure they are appropriately following this new proposed standard. This guidance should include precise definitions for the terms “master/feeder and “fund of fund” and whether the evaluation should be based on the investor fund’s ownership interest of the investee fund, the investor fund’s concentration of capital into the investee fund, or the investment object and legal structure as stipulated in the offering memorandum.

Unaffiliated Funds
Once established that you are a feeder fund in a master-feeder structure, you must consider the practicality of following the requirement of “presenting a complete set of the master fund’s financial statements with (the feeders) own financial statements”. This is easier said than done for feeder funds not affiliated with the master. In the case of Madoff, there were several unaffiliated “feeder funds” that were managed by unrelated investment advisors. Their financial statements were audited by different auditors and signed off on different dates. In these instances, the feeder funds were most likely not authorized to include the “master fund’s” financial statements attached. In other instances, the master fund may not be required to prepare financial statements, or the financial statements may not be prepared in accordance with GAAP. There could also be restrictions for use and distribution on the audit opinion which would preclude feeder funds from attaching the financials. In those situations, where the entity is not able to obtain permission to provide the financial statements of the unaffiliated investee fund, the FASB should provide guidance in the Update regarding acceptable disclosure for the investor fund’s investment in the unaffiliated fund so that its investors are provided with sufficient information about the types of investments, investment activity, obligations and financial results of the unaffiliated investee fund.

Fund with Different Year-Ends
There can also be scenarios whereby the master fund, whether affiliated or not, has a different year-end than that of the feeder. Would it be acceptable to include the latest year-end financial statements of the master, even if the year-ends don’t coincide or would there be a requirement to disclose the same period financial statements for both master and feeder? As stated in the AICPA’s Investment Companies Accounting and Audit Guide, for regulated investment companies when the master and feeder funds have different year-ends, the SEC would not object if, at each feeder investment company year-end, the audited shareholder report of the feeder is accompanied by the latest audited shareholder report of the master as well as an unaudited balance sheet and schedule of investments of the master as of the date of the feeder’s financial statements. FASB should consider following this direction for the new guidance. However, there would be a cost associated with procuring this information and including in the financials, whether they be audited or not. Could these additional costs preclude such investments into master funds?

The Board should include a practicality exception for situations described above where it is not feasible to include the master fund financial statements. Alternatively, other disclosures describing its investment in the master, including strategy and risk considerations, significant accounting policies and liquidity provisions of the master fund, and related party transactions and fees charged could be required of the feeder fund. In situations where master financial statements are available and can be attached, the Update should include guidance to auditors on their responsibility of the attached master fund financial statements when the audit firm, sign off date and/or year-ends differ.

5% Look Through Requirement
Current accounting guidance for unregistered funds requires disclosure of any positions held by an underlying investee fund whose proportionate interest to the reporting fund exceeds 5% net assets (partners’ capital). The proposed guidance expands the scope of this requirement for registered funds (RICs) as well, to provide more transparency into these investee funds and to improve consistency between both registered and unregistered funds. The required disclosure includes the name, investment type, shares (or interest) of the investment, as well as the fair value and proportionate value to the reporting fund. The investee fund disclosures can be provided on the schedule of investments as a component of the investments in an investee or in a note to the schedule. It is unclear, however, whether or not the 5% investment exposure calculation should be based on each individual investee fund or be aggregated among all investee funds, and we’ve seen some diversity in practice. Furthermore, some constituents have voiced operational concerns with the proposed disclosures for RICs who are already required to file quarterly, semi- annual and annual reports with the SEC on a tight deadline that include detailed descriptions of investments held by the reporting fund. They believe the costs associated with developing, monitoring and reporting this information for each reporting period, which would ultimately be borne by the shareholders, would outweigh any benefits of increased transparency and may even confuse investors. For this requirement, the Board should consider clarifying the guidance and expanding the practicality exception when there are legal, confidential and operational restrictions to disclosing this information. This will benefit both registered and unregistered funds.

Effective Dates and Concluding Thoughts
The amendments to the proposed guidance would be applied prospectively and early adoption would be permitted. The Board will determine an effective date for implementation after it considers the feedback and comments received on the Update. We are hopeful that the Board will consider the issues described above and the final amendments will not only improve financial reporting for existing and potential investors, creditors and other users, but will also be operable and auditable and not result in significant additional costs or significant changes in practice for most entities.