Demystifying Private Liquidity Funds

Executive Summary

Important regulatory changes to institutional prime money market funds are forcing new ideas and new interest in prime fund alternatives. With the SEC Form PF aggregate data, we reconstructed a profile of unregistered private liquidity funds promising investors stable $1.00 NAVs without liquidity gates.
We discuss the drawbacks with private funds as being unfamiliar to the institutional cash community, the mishap with a large fund during the financial crisis, the vulnerable liquidity model, the requirement for investor sophistication, poor transparency, the risk of liquidity lockups and share suspensions, and their uncertain future related to systemic concerns.
In the tradition of our recent publications on separately managed accounts, we advocate for separately managed accounts over private funds, highlighting six relative advantages:

1. A clearer advisory relationship and stronger account governance
2. A simpler legal structure and accounting/tax considerations
3. Freedom from shared liquidity risk
4. Better transparency
5. Tailored risk management
6. Higher yield potential

We recognize the merit of private liquidity funds for certain sophisticated investors in special circumstances, but we caution the general treasury management community against plunging in before fully understanding the product’s legal complexity and liquidity risk profile.

Introduction

It has been several months since SEC reforms took effect requiring institutional prime money market funds to float net asset values (NAVs) and impose redemption fees and gates. After a steep drop of 92% in assets through the end of October 2016¹, prime funds saw moderate inflows in both January and February 2017. The majority of institutional liquidity investors, however, seem to remain on guard despite an enticing yield advantage prime funds provide over government funds.
It is understandable that the debate on alternative liquidity options that began when the SEC finalized the new rule in 2014 lives on after its implementation. No clear winner emerges to replicate the safety, liquidity, yield, and ease of use of the “old” prime funds, but not for lack of trying. For some fund families, private liquidity funds hold the promise of being the closest replica.
With limited public information in the early stages of marketing, we attempt to lift the veil on private liquidity funds and assess their suitability as a liquidity product for the corporate and institutional cash investor base at large.

The Allure of the Non-2a-7 “Money Market Fund”

Without a doubt, the greatest appeal of a private liquidity fund to institutional investors is the reversal of fair value pricing in NAV calculations to the old amortized cost method, which restores the stable $1.00 NAV. Funds designed to win back institutional prime shareholders may commit to not impose liquidity fees and gates, another undesirable feature from the recent reform.
To allay investors’ concerns on investment risk, many, although not all, of the funds may pledge to be in compliance with the SEC’s rule 2a-7 on money market funds regarding credit, diversification, maturity, and liquidity limitations. They may disclose holdings data more frequently than required. A portfolio manager may apply the same investment strategy and run the fund concurrently with registered money market funds. Simply put, the funds aim to replicate money market funds without being labeled as such.
If the funds are as good as money market funds but without the undesirable attributes, what could be their possible drawbacks? The short answer is that they do not provide the same level of investor protection as money market funds or mutual funds in general.

Private Liquidity Funds Explained

The SEC defines private funds as “pooled investment vehicles that are excluded from the definition of investment company under the Investment Company Act of 1940 by section 3(c)(1) or 3(c)(7) of that Act. The term private fund generally includes funds commonly known as hedge funds and private equity funds.”² Private funds are not registered with the SEC, but their investment advisors may be subject to SEC oversight.
Private liquidity funds entered the SEC vocabulary as the result of the February 2010 money market fund reform, which required private fund investment advisors to file Form PF by December 2012. The SEC defines liquidity funds as “any private fund that seeks to generate income by investing in a portfolio of short term obligations in order to maintain a stable net asset value per unit or minimize principal volatility for investors.”³
The SEC requires investment advisers with at least $150 million in private funds assets to file, on a non-public basis, Form PF annually for the funds they manage. Advisors with at least $1 billion in combined private and money market fund assets also file quarterly “Section 3” of Form PF. The regulatory agency revised the Form PF to keep an eye on the pooled investments not subject to its oversight, but that may have systemic consequences.
By definition, private fund information is unavailable to non-shareholders. The SEC, however, provides aggregate quarterly fund statistics. Its website has seven quarters of data through the second quarter of 2016.⁴ Although the current statistics do not cover the period since the October 2016 reform, investors may still glean some helpful insight into the private fund world.
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¹iMoneyNet Domestic Market Shares as of October 31, 2015 and October 31, 2016.
²See the SEC’s Private Fund Advisor Resources web page, https://www.sec.gov/divisions/investment/guidance/private-fund-adviser-resources.htm
³See the SEC’s instruction on Form PF filing, https://www.sec.gov/about/forms/formpf.pdf, Page 5.
⁴SEC Division of Investment Management, Private Funds Statistics, https://www.sec.gov/divisions/investment/private-funds-statistics.shtml