The separation of funds and managers: a theory of investment fund structure and regulation.

• Author: Morley, John
• Position: Introduction through III. Explaining the Separation of Funds and Managers A. Exit Rights and Performance Incentives c. Private Equity Funds, p. 1228-1255 - Author abstract

ARTICLE CONTENTS INTRODUCTION I. INTRODUCTION TO INVESTMENT FUNDS A. Types of Investment Funds B. Literature Review II. INTRODUCTION TO THE SEPARATION OF FUNDS AND MANAGERS A. Basic Summary B. The Consequences of Separation C. Possible Alternatives III. EXPLAINING THE SEPARATION OF FUNDS AND MANAGERS A. Exit Rights and Performance Incentives 1. Exit Rights a. Mutual Funds b. Hedge Funds c. Private Equity Funds d. A Note on Imperfections in Exit Rights 2. Performance Incentives B. Unusually Strong Preferences for Precision in Risk-Tailoring C. Economies of Scope and Scale and the Operation of Multiple Funds 1. Preventing the Spillage of Risks Across Funds 2. Maintaining Management Companies as Going Concerns 3. Addressing Conflicts of Interest D. A Note on Causation IV. SPECIAL CASES AND OBJECTIONS A. Special Cases 1. Closed-End Funds 2. Asset Securitization Vehicles 3. Donative Trusts B. Objections 1. Taxes 2. Regulation 3. The Limited Partnership Form 4. The Vanguard Mutual Fund Management Company V. POLICY IMPLICATIONS A. The Desirability of Separating Funds and Managers B. The Functions of Investment Fund Regulation C. The Definition of an Investment Fund D. Distinguishing Open- and Closed-End Funds E. The Janus Decision CONCLUSION INTRODUCTION

Investment funds control a vast amount of wealth. By some estimates, the various types of funds--including mutual funds, hedge funds, private equity funds, venture capital funds, exchange-traded funds, and closed-end funds--collectively hold about $18 trillion in the United States. They hold substantially more assets than the commercial banking system and almost enough assets to equal the value of all domestic equity securities listed on the New York Stock Exchange and NASDAQ combined. (1)

Legal scholars have largely overlooked these enterprises, however. Although financial economists have extensively studied investment funds' performance and operation, (2) legal scholars have rarely examined their structure and regulation. Little is known about foundational issues such as why investment funds adopt their basic patterns of organization, why they are regulated differently from operating businesses, and how we can distinguish them from operating businesses.

In this Article, I offer a broad perspective by suggesting for the first time that the essence of investment funds and their regulation lies not just in the nature of their assets or investments, as is widely supposed, but also--and more importantly--in the nature of their organization. An investment fund is not simply an enterprise that holds "investments"--it is an enterprise that holds investments in a particular way. And the regulations that govern these funds are at least as concerned with the funds' peculiar patterns of organization as with their peculiar kinds of assets.

Specifically, nearly every enterprise that we commonly think of as an investment fund adopts a pattern of organization that I call the "separation of funds and managers." These enterprises place their portfolio securities, currency, and other investment assets and liabilities into one entity (a "fund") with one set of owners, and their managers, workers, office space, and other operational assets and liabilities into a different entity (a "management company" or "adviser") with a different set of owners. The Fidelity management company, for example, operates several dozen mutual funds under the Fidelity brand name. Each fund is a separate entity with separate owners, and so is Fidelity itself. (3) In connection with this system, investment enterprises also tend to radically limit fund investors' control. A typical hedge fund, for example, cannot fire and replace its management company or its employees--not even by unanimous vote of the fund's board and equity holders. (4)

This pattern remains poorly understood. To my knowledge, it has never been identified as a common feature of the various types of investment funds. And in commentary about individual types of funds--particularly mutual funds--the pattern is often viewed as a land of scam, depriving investors of the rights to control their managers and share in their managers' profits. (5)

This Article thus identifies the separation of funds and managers as a central phenomenon and explains its functions. I argue, paradoxically, that this pattern benefits fund investors for precisely the reasons it is often said to harm them: it limits their control over managers and their exposure to managers' profits and liabilities. These limits are particularly efficient in investment funds for three reasons. First, most fund investors have special rights of exit and are protected by unusually strong incentive compensation systems. Control thus resides more efficiently in the hands of management company investors than in the hands of fund investors. Second, fund investors have particularly strong desires for precision in the tailoring of risk. They desire exposure only to the risks of investment assets and not to the risks of management businesses. Third, fund managers can achieve economies of scope and scale by simultaneously managing multiple funds. For reasons I explain, this simultaneous management is only possible when fund investors' control rights and exposures to managers' earnings and liabilities are tightly restricted by the separation between funds and managers.

This multifaceted explanation may seem complicated, but the intuition behind it is simple: in terms of their rights and risks, fund investors look more like buyers of products or services than like investors in ordinary companies. In much the same way that product buyers can "exit" by refusing to buy more products, for example, fund investors can often exit by withdrawing their money and refusing to pay managers' fees. And in much the same way that product manufacturers simultaneously produce multiple products, fund managers simultaneously operate multiple funds. The reasons why fund investors have no ownership or control over their management companies thus resemble the reasons why product buyers generally have no ownership or control over their manufacturers. (6)

This positive explanation for investment funds' basic structure has extensive normative implications. Among other things, it illuminates the function of investment fund regulation. The key function of the Investment Company Act of 1940 (ICA), (7) it turns out, is not merely to address the peculiar problems created by securities investing, as is widely believed, but also to address the peculiar problems created by the separation of funds and managers. This theory also suggests we should change the way we define investment funds. Regulation and academic research currently distinguish investment funds from operating businesses by looking at the nature of their assets. That is, an investment fund is said to be an enterprise that holds a large amount of securities. I suggest, however, that the essence of an investment fund lies more precisely in the nature of its organization. Focusing on organization solves an array of practical and conceptual problems, such as how to distinguish private equity funds from conglomerates.

The paper proceeds as follows: Part I reviews the literature and provides a basic description of investment funds. Part II describes the separation of funds and managers and its consequences. Part III explains this pattern by identifying the peculiar features of investment funds that make the pattern efficient. Part IV addresses objections to this explanation and applies the explanation to several special cases, including closed-end funds, asset securitization vehicles, and donative trusts. Part V suggests policy reforms.

1. INTRODUCTION TO INVESTMENT FUNDS

   1. Types of Investment Funds

      The separation of funds and managers is nearly universal among the types of enterprise that we commonly think of as investment funds. An overview of the different types of funds may therefore be useful. (8) By far the largest category of fund is the "mutual" fund. Mutual funds are commonly defined as pools of stocks, bonds, and other investment securities. Mutual funds issue shares in these pools to members of the public, who can buy the shares to invest for retirement or other purposes. Because mutual funds sell their shares widely to the general public, they must register with the SEC and comply with the ICA.

      A key feature of mutual funds is that they allow their shareholders to "redeem" their shares. In other words, shareholders can return their shares to the funds in exchange for the cash value of their shares. This value equals the value of the portion of a fund's net assets that corresponds to each share. Mutual funds typically allow their shareholders to redeem every day. "Exchange-traded" funds (ETFs), which have received a great deal of attention in recent years, are a special kind of mutual fund. (9)

      Mutual funds are sometimes called "open-end" funds to distinguish them from "closed-end" funds. Closed-end funds are similar to mutual funds in many respects. They are pools of investment securities, they sell interests widely to the general public, and they must comply with the ICA. The primary difference is that closed-end funds do not allow shareholders to redeem. Rather than redeeming, closed-end fund shareholders dispose of their shares by selling them on stock exchanges, just as they might do with the shares of operating companies.

      "Hedge" funds are pools of investment assets similar to mutual funds. But unlike mutual funds, hedge funds issue securities only to limited numbers of institutional investors and wealthy individuals. Hedge funds therefore do not have to register with the SEC or comply with the ICA. (10) Like mutual funds, hedge funds allow their shareholders to redeem their shares. However, hedge funds typically allow redemptions only once per month or once per quarter, rather than daily as mutual funds do. (11)

      "Private equity" funds are...