August 2023 Newsletter

SEC adopts Private Fund Advisor Rules under the 1940 Advisors Act.

These changes pertain to RIA/Financial advisors as well as the private funds. The SEC supplied a simple fact sheet to help understand the changes. I also wanted to add a little commentary to help explain what this might mean for you as investors.

Statement Rule:

Disclosure of private fund fees and expenses. It is important to distinguish between management fees, incentive fees, and fund expenses. Many funds only mention the first two fees and conveniently ignore the fund expenses. As an investor, it is crucial to collect information about both the fees allocated to the fund and the fees paid by the fund as fund expenses.

Must state RIA’s compensation and its affiliates. I find it concerning that many RIAs are starting Broker-Dealers and vice versa. This creates conflicts of interest when these two entities are owned by the same shop. They can charge fees to both investing clients and fund clients without proper disclosure of these relationships.

Standard Fund Performance: Performance varies among investors for various reasons, but it is crucial to demonstrate performance in a consistent manner. If a Fund Administrator is employed, they must ensure a systematic and uniform approach to this.

Audit Rule:

RIAs must ensure that each fund goes through an audit process. Our fund is audited by a well-respected firm that works with numerous funds. Please make sure to research and confirm that the auditor is truly independent and has relevant experience in investment funds. I have observed funds attempting to be audited by accounting firms owned by their relatives.

 Compliance Rules: 

RIAs, regardless of whether they have private funds or not, must annually disclose their compliance policies and procedures in writing.

Advisor Led Transactions:

Advisors who cause a transaction in a fund must get a fairness opinion or valuation opinion to support the transaction. This will ensure that the transaction is fair and does not harm other investors' investments in the fund.

Restricted Activities for RIA and Private Funds:

To proceed with restricted activities, a majority of investors must approve them. Approval from an LP Advisor Committee alone is not enough. This is good as it's important to note that smaller investors were greatly underrepresented on these committees, which was not ideal.

These changed rules do not apply to you as investors in the Kirkland Income Fund. However, I have listed some of them just in case you have other investments where they do apply.

• Funds bearing regulatory or compliance-based fees charging them to the fund (disclosed quarterly). If the fund incurs expenses for them being reviewed/investigated, they can’t charge the fund for the investigation.

• Pre-tax and post-tax clawback amounts must be disclosed.

• Charging Investment related expenses in a non-pro rata basis across funds that are in the same investment must be disclosed beforehand. (The allocation of expenses must also be explained as to why it is fair and equitable for each fund.)

Preferential Treatment Rule:

Advisors must disclose any preferential terms investors have to all investors, including those in funds with similar portfolios. This practice used to be prohibited but is now allowed, as long as it is disclosed.

We do not have any side letters that state preferential treatment for any investments made by Limited Partners in the Kirkland Income Fund. Additionally, we did not have an anchor investor to assist us in starting the fund. It is a common practice for anchor or early investors to have slightly different terms in a fund. Make sure to inquire about this during your due diligence.

Above is just a summary of the changing rules. If you feel more adventurous the 660-page ruling is Final rule: Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews (sec.gov)

Cash Drag Blues 

Our team usually manages to balance between available funds and the loans that we fund. Of course, we aim to be fully deployed to provide the highest returns to our investor family. To maintain this balance, we try to influence the number of loans in the pipeline. We do this by adjusting our marketing efforts and loan rates. However, one thing we never compromise on is the quality of our loans and the thorough due diligence we perform. It's painful to have cash drag and deliver lower returns, but we'd rather hold onto some cash than invest in poor quality loans.

 In August, we had a couple of loans in the due diligence phase with a total amount over $2 million. Most of the work had been done, but there were still some tasks left. Unfortunately, both loans failed to fund.

For cash-out loans, we sometimes require a debt reserve to cover the initial payments. This lowers the loan-to-value ratio and reduces risk. On one loan, the borrowers requested to waive the debt reserve at the last minute. However, considering the significant cash-out amount and the relatively small debt reserve, we refused their request. In the end, they decided not to proceed with the loan.

On the other loan, we discovered during due diligence that the borrower had an undisclosed business loan. It's important to assess the borrower's ability to make payments. In this situation, our model showed that the current loan payments, along with the new loan from Kirkland, did not meet our affordability level.

After the loans failed to fund, we sent a marketing email to our loan broker network. It was the first time we had done so in over 18 months. The response was positive. Many new loans were submitted, which will help us deploy and put the cash available to work.

When you have any questions or would like to discuss these further, please do not hesitate to reach out.