Alternative asset managers in the quest for capital: attracting Canadian retail investors through mutual fund trusts

 
In each of Canada and the United States, several recent developments are expected to further enhance access by retail investors to alternative assets by making it easier for alternative assets to be held in registered accounts. In Canada, “Consultation on Qualified Investments for Tax-Advantaged Savings Plans”² was recently completed (with a report to follow), which aims to modernize the qualified investment rules that apply to several registered plans. In the United States, U.S. President Donald Trump recently signed an executive order³ promoting greater access to private equity and other alternative assets by defined-contribution retirement savings plans, such as 401(k) plans, as further described in our article on U.S. retail funds.

Generally, registered accounts cannot directly invest in alternatives: they are limited to directly holding “qualified investments” which generally do not include partnership interests, or private debt or equity. Registered accounts can invest in mutual fund trusts and segregated funds which themselves can invest in alternatives. While there are several limitations to using mutual fund trusts and segregated funds for alternative investment funds, there has been tremendous growth in mutual fund trusts and segregated funds designed to provide retail investors with access to alternative assets through their registered accounts. In the discussion that follows, we explore how mutual fund trusts can be used for alternative investments for retail investors.

What is a mutual fund trust (MFT)?

A mutual fund trust (MFT) is a form of “unit trust” that enjoys certain tax advantages as an investment entity, including that its units will be qualified investments for registered accounts⁴. MFTs must meet certain statutory requirements to qualify as an MFT under Canadian tax legislation. An MFT cannot carry on a business—its only undertakings must be limited to: (i) investing its funds in property (other than real property or an interest in real property); (ii) acquiring, holding, maintaining, improving, leasing or managing any real property (or an interest in real property) that is capital property of the trust; or (iii) any combination of these restrictions.

An MFT must be resident in Canada and have a class of units that is qualified for distribution to the public. MFTs must also have at least 150 unitholders (i.e., investors) within 90 days after the end of the MFT’s first taxation year, with each unitholder required to hold units with an aggregate fair market value of at least $500.

Unlike a typical closed-end private fund, the units of an MFT must be redeemable on demand by a unitholder, meaning MFTs must have the ability for investors to redeem their interests (which requirement applies regardless of whether the MFT has any registered account unitholders). This redeemable on demand tax requirement results, for purposes of Canadian securities legislation, in the MFT being qualified as a “mutual fund” (and thus an “investment fund”), which also makes these funds and their sponsors subject to certain securities regulatory requirements. However, to avoid requirements that would make these vehicles impractical, these funds typically remain offered only to “accredited investors” under Canadian securities laws, which ensures that the full scope of regulatory requirements applicable to public mutual funds does not apply to them.

Redeemability on demand vs. illiquid assets: the struggle

A typical retail MFT invested in publicly traded securities can usually satisfy the “redeemable on demand” test because its portfolio is liquid and it maintains a small cash buffer to manage day-to-day trading activity. By contrast, an MFT holding alternative assets faces greater challenges: these assets are generally illiquid and have long lifespans. While such long-term horizons may align well with retail investors saving for distant goals like retirement, where immediate liquidity is less critical, certain aspects of the MFT rules promote liquidity more than investment alignment.

To satisfy the “redeemable on demand” test, an MFT must have terms requiring it to accept the surrender of trust units at the holder's demand. In order to do so, MFTs have typically maintained a portion of the portfolio in liquid assets⁵ and used cash generated from new subscriptions. However, recent alternative investment MFTs have introduced additional features to ensure sufficient liquidity to meet expected redemptions, as described below. In practice, whether a fund can operate on a “redeemable on demand” basis depends on several factors, including the likelihood that investors will seek to redeem (i.e., attracting investors who have a long-term horizon and no need to redeem before expected maturity) and the MFT’s ability to pay the redemption price in cash or in-kind within a reasonable period of time (i.e., maintain liquid assets and be able to satisfy redemption requests in-kind).

Liquidity sleeves

It is typical for MFTs to maintain a dedicated “liquidity sleeve”, allocating a portion of the portfolio to highly liquid investments (e.g., temporary or short-term investments like government-sponsored securities, whether directly or through investments in money market funds) regardless of the fund’s underlying investment strategy. While we see a range in the size of this sleeve relative to the total net asset value of the MFT, the appropriate size should be tailored to the MFT’s specific strategy and portfolio composition, and ideally informed by a liquidity stress analysis conducted by the fund’s sponsor. Maintaining a liquidity sleeve/sub-portfolio to satisfy redemption requests can drag overall returns, since these assets typically generate significantly lower returns than the assets comprising the fund’s broader investment strategy. To mitigate the risk of insufficient liquidity, sponsors typically complement liquidity sleeves with additional tools such as redemption gates and redemption notes as we further discuss below.

Redemption gates

Redemption gates are used in many open-ended funds (whether structured via MFTs or not). They are primarily tools to help signal to investors that they should be purchasing an interest in the fund to hold it to maturity. The goal of the redemption gates for purpose of MFTs should not be to delay redemptions, as that would violate the redeemable on demand principle, but rather to discourage investors with very high liquidity needs to invest in the MFT. A redemption gate typically limits the volume of redemption requests that may otherwise be required to be satisfied during a specified period to ensure the fund has sufficient liquidity to satisfy redemption requests as received. In addition to preventing or otherwise delaying an investor withdrawal, a redemption gate can be structured as an early redemption fee or discount imposed on an investor who requires to be redeemed within a short period after their initial investment in the MFT. If a redemption gate kicks in temporarily, it likely does not immediately cause a fund not to be redeemable on demand, but redemption gates should nonetheless only be used sparingly and in exceptional circumstances.

Redemption notes

Having the ability to issue redemption notes permits an MFT to redeem its units (on demand) in-kind instead of in cash. Here, where an MFT does not have sufficient cash liquidity to meet redemption requests, the fund may instead issue to a redeeming unitholder an unsecured interest-bearing promissory note (often referred to as a “redemption note”) for its interest in the fund with respect to the portion of the redemption proceeds that cannot be honoured in cash. The redemption notes may be issued by the MFT, a subsidiary of the MFT or a special purpose (liquidation) vehicle set up for such purpose. It is important that redemption notes are structured so they do not unduly advantage redeeming unitholders, while still reflecting that the redeemed units have been paid for and containing terms that a reasonable investor would be expected to accept. The use of a redemption note is usually considered a measure of last resort, given that redemption notes are themselves non-qualified investments for registered plans, and a registered plan holding such redemption notes would be subject to a penalty tax on such investments and additional filing/reporting obligations. Due to those potential consequences, sponsors will generally present investors with the opportunity to push their desired redemptions to another redemption period rather than be redeemed in-kind for redemption notes.

Borrowing

In addition to the above liquidity management tools, sponsors will often look to permit the MFT to borrow to meet redemption requests. However, sponsors should be aware that a retail fund may not be able to put in place a traditional subscription line facility secured by undrawn capital commitments as some lenders take the position that retail investor capital does not provide a sufficient borrowing base.

Risk considerations and disclosure

Alternative investments are usually inherently less liquid and more risky than traditional public mutual funds or exchange-traded funds that invest in publicly traded securities, for which retail investors and their portfolio managers are generally more familiar and comfortable. Even with the liquidity management tools described above, these investments may not be suited for an investor that may need funds in the short term and who is not intending to hold to maturity. Furthermore, since it is possible for a registered account to receive an in-kind redemption in the form of a redemption note for which there would be penalty taxes until they can be disposed of, registered accounts should carefully consider whether the unique investment return offered by alternative funds meets their investment goals and risk tolerance. Given the above-described tension and consequences, sponsors must ensure there is an adequate level of disclosure contained in any offering memorandum or other marketing material to allow retail investors and their portfolio managers to fully understand the illiquid nature of alternative investments and the resulting risks. It should be noted that the Alternative Investment Management Association (AIMA) and the Chartered Alternative Investment Analyst Association (CAIA Association) have published risk rating guidelines for alternative funds in Canada⁶, which can assist sponsors in their disclosure with respect to retail funds.

Conclusion

MFTs represent an enticing opportunity for funds sponsors to involve retail investors and registered plans in their investor base. We expect further growth in the use of MFTs for alternative investments as demand for this asset class continues to increase, providing benefits to retail investors and fund sponsors alike.