April 24, 2000
Pooling 12b-1 revenue streams and securitizing them is attracting interest, according to new research released last month by Standard & Poor's, the credit rating agency of New York.
Standard & Poor's, which assigns credit ratings to mutual fund fee securitizations, has found that mutual fund advisers are not the only ones taking a look at expected future 12b-1 revenue streams. The investment banking industry is taking notice of this emerging asset class and hopes to tap 12b-1 revenue streams, according to S&P. Variable annuity providers, with over $1 trillion under management, may also soon seek to have their 12b-1 fees securitized, according to S&P.
A handful of investment banking firms have expressed interest in joining the handful of firms that currently securitize 12b-1 revenue streams, according to Lily Cheung, an analyst at S&P. Cheung, who spoke during an S&P teleconference April 11, declined to name those firms. Those firms that now securitize 12b-1's include Constellation Financial Management and Citigroup, both of New York, and Putnam, Lovell, de Guardiola & Thornton of San Francisco.
Based on its experience rating 12b-1 securitizations since 1996, S&P last month removed the ratings cap on the securities, making them now eligible for the full range of credit ratings.
Of the more than 8,000 existing mutual funds, B shares, which carry 12b-1 fees, account for about nine percent of all shares held, according to S&P. Of the more than $6 trillion held in mutual funds at the end of 1999, $500 billion was held in B shares, S&P estimates.
Mutual fund fee securitizations are a relatively new asset class. The product grew out of regulations which took effect in 1980 allowing fund advisers, through 12b-1 fees and contingent deferred sales charges, to recoup expenses related to the marketing, advertising, selling and distributing of fund shares.
Fund advisers created a new class of shares called "B" shares that did not have front-end sales charges. But investors had to pay for this privilege. Advisers who paid up-front costs to distribute their fund's shares, such as paying a broker/dealer a commission, did so out of their own pockets or their distributor's pockets. Fund advisers then recaptured those costs through fees charged to B class shareholders over an extended period. The 12b-1 fees, which can range from 0.25 percent to a maximum of 0.75 percent, are charged to investors monthly. According to S&P, more than 40 percent of funds currently use 12b-1 fees to cover at least a portion of their distribution expenses.
Contingent deferred sales charges, which most fund B shares carry, mean that investors who sell out of their funds within the first seven or eight years must pay a back-end sales charge that is a percentage of the amount redeemed. These charges again allow fund distributors to recoup the fees they already paid in connection with the initial sales of those shares. A typical contingent deferred sales charge starts at seven percent, if an investor redeems within the first year, and declines by one percent per year until it falls to zero in the eighth year. After eight years, most fund advisers then convert those expired B shares automatically to A shares.
Fund advisers may choose to sell the rights to receive these future mutual fund fees, whether they are 12b-1 fees or contingent deferred sales charges, to third parties at a discounted rate.
Third party buyers have included commercial banks and finance companies. Buyers often finance the fee-purchase activities themselves by selling them as securities, sometimes bundled with other 12b-1 fee streams.
As with any other security, there are risks involved, including the risk that mutual fund investors will redeem their assets and so cut off the revenue streams. The net asset value of a fund or the assets held in B shares could also decline enough to significantly impact the asset-based fees being recouped over time.
There is also the chance that the board of directors of a fund, which is required to annually approve the continuation of a fund's 12b-1 plan, will terminate the plan. The board alternatively could decide to decrease or temporarily suspend the 12b-1 fee. Contingent deferred sales charges do not face this termination risk.