This is an exciting time in the world of registered funds — there are new products frequently entering the marketplace in a myriad of ways! Historically we have seen many registered funds, including mutual funds, exchange-traded funds and closed-end funds, come to market by way of a cash seeding. Today, however, we see about as many funds brought to market through a restructuring or reorganization of other unregistered offerings, such as private funds or the pooling of separately managed accounts. Often, advisers intentionally “incubate” investment strategies in-house to build a track record with the intent of eventually repackaging their product as a registered fund.
We have also found, particularly in our early discussions with advisers considering a launch that will not be part of an existing trust, that most have not considered the accounting treatment of start-up costs — and have little, if any, interest in the topic. While this is understandable, there are specific rules within Generally Accepted Accounting Principles (GAAP) relating to the classification and treatment of these costs.
Understanding from the outset the proper accounting treatment and the impact of these costs on the presentation and performance of a fund can have a meaningful impact on decisions advisers will make early in the start-up process. Below we address several key areas surrounding start-up costs to address sooner rather than later with administrators, legal counsel and auditors.
Consider who will incur the costs on behalf of the new fund. The two scenarios below present the options:
Scenario 1 – Adviser Absorbs Start-Up Costs. If the adviser intends to absorb these costs, there is no impact to the fund or its financial statements. No further consideration of the treatment of these costs is necessary.
Scenario 2 – Fund Absorbs Start-Up Costs. If, however, the adviser does not intend to absorb the start-up costs, one must consider their treatment on behalf of the fund. It’s important to properly account for these costs in the seed financial statements and in the fund’s financial statements for its first year of operations.
Within GAAP, there are two types of costs to understand on a foundational level: organizational and offering.
Organizational Costs
In the process of establishing a new investment company, and sometimes even a new series of a previously established investment company, organizational costs will be incurred so the entity is legally able to operate. Such costs can consist of audit fees in connection with the seed financial statements and services rendered by legal counsel, including fees to incorporate and organize the entity, drafting the bylaws, drafting agreements with third-party service providers, trustee fees for the organizational board meeting and ad-hoc research deemed necessary.
For GAAP purposes, these costs are expensed as incurred.
Offering Costs
Offering costs can include legal fees for the preparation of the initial registration statement, registration fees (SEC, Blue Sky, etc.), underwriters’ fees and printing costs.
For GAAP purposes, these costs are capitalized and amortized to expense over 12 months on a straight-line basis.
As part of the organization of a new trust, seed financial statements are required. These are generally comprised of a statement of assets and liabilities, which, in its simplest form, presents seeding cash (minimum of $100,000) and the issuance of shares as of the seed audit date. Many registered funds are now seeded with securities coming from a private fund or separately managed accounts on the seed balance sheet date. In those cases the seed audit would also include a schedule of investments; the auditor would also perform procedures to verify with both the existence and value of the securities transferred in. Additional scenarios where a fund is seeded by assets other than cash prior to the seed balance sheet date present additional issues and work (both audit and tax), which results in additional start-up costs.
The decision for a fund to incur start-up costs also has an impact on the seed financial statements. As noted above, organizational costs are to be expensed as incurred under GAAP, which results in the need for a statement of operations as the fund must present the expense. Alternatively, GAAP treatment for offering costs is to amortize over 12 months so there is no impact to the statement of operations.
In most cases, when the adviser determines the fund will absorb the start-up costs, there is also an expense limitation agreement in place; any organizational expenses presented in the statement of operations are offset by an expense reimbursement by the adviser, effectively negating the impact of the expense. Ultimately, the presentation of organizational and offering costs in the seed financial statements has no net impact on the net assets or operations of the fund.
The true impact of presenting start-up costs on the seed financial statements is that it sets up the ability to recover the reimbursement of these expenses as the fund grows to scale. Most expense limitation agreements allow the adviser to recover the waiver over a period of three years, to the extent the fund’s expense ratio falls below the lesser of the rate in place at the time of the waiver or the current rate agreed to. If applicable, disclosure in the seed financial statements should include the terms of the expense limitation agreement and the period over which reimbursements can be recovered.
The financial statements for the first year of operations will then also include the organizational costs incurred as well as any offering costs amortized during the period, effectively the pro-rated 12-month amount.
A note of caution: the accounting for the organizational and offering costs described above is usually reflected as a top-side entry as opposed to being recorded in the accounting system. As a result, it happens often enough that the fund fails to account for the accrual of the offering costs over the first 12 months as described above. This usually does not have an impact on operations or the net asset value of the fund, as most funds continue to be in expense reimbursement for at least the first year. However, theoretically it could have an impact if the fund grows to a size where the adviser is no longer waiving expenses.
Additionally, if the fund does not account for the organizational and offering costs in the accounting system, there is the possibility of not considering these expenses when preparing the first year’s semi-annual and annual financial statements, which could be considered a deficiency in the control environment.
The treatment of start-up costs is just one of many considerations in launching a registered fund, whether it’s seeded with cash or securities. Early conversations and a thoughtful approach and coordination with a fund’s administrator, legal counsel and auditors will help tackle at least this one challenge in a relatively painless manner.
Contact John Braun or a member of your service team to discuss this topic further.
Cohen & Co is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law with your professional advisers.