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Fund Mergers Take Time, Cooperation


ORLANDO, Fla.-Amid speculation about whether the potential sale of Putnam Investments and MFS Investments could provide an opportunity for their parent companies, Marsh & McLennan and Sun Life Financial, to shed themselves of struggling underlings, one thing is often overlooked.

The subsequent mergers between their fund families and those of the buyers won't be quick or easy.

Foremost among the challenges of fund mergers is fulfilling the requirements of both the Internal Revenue Service and the Securities and Exchange Commission, while navigating a set of rules that is not always clear, said experts during the Investment Company Institute's Tax & Accounting Conference here last week.

As a result, fund mergers take time-typically a minimum of six months.

Another thing about fund mergers is that they're pretty common. In fact, between 1962 and 1999, one in six funds was merged out of existence.

"If you haven't already been faced with a merger, chances are you will be," said Bud Rein, a director at Morgan Stanley of New York.

So far in 2006, $13.5 billion worth of fund assets-more than all of 2005-have been shifted into other funds. If the $3 billion in Putnam's funds and the $4 billion that MFS manages find new families soon, 2006 will mark the most assets ever merged.

In each case, boards must consider each other's management style and objectives, the costs and benefits of the merger and the expense ratios for the ultimate product.

Ultimately, fund management wants to show shareholders how the merger will improve both funds, said Mark Bradley, deputy treasurer for Pioneer Investment Management of Boston.

The SEC's application for merger, or N-14, requires the values, share prices and net assets of each fund, along with projections of how a combined version would look. Both funds must also submit balance sheets reflecting the operations for the past 12 months, or, should that not be possible, matching time frames, said Donna McManus, a vice president at The Bank of New York. It's also good practice to include information from semi-annual reports, she added.

The N-14 must also list all major shareholders, such as 401(k) plans, since those parties are likely to make redemptions prior to the merger, and thereby drop the value of the target or acquiring fund.

If, however, 30 days before the application for merger, assets in the target fund are less than 10% of those of the acquiring fund, no filing is required. SEC review usually takes about a month.

When it comes to fee tables: disclose, disclose, disclose, McManus advised. If the balance sheet shows that the smaller fund might absorb more costs than the larger fund, or the target fund's portfolio fails to meet the investment protocol of the acquiring fund's, regulators will ask questions, she said. Satiate them from the start with ample explanations in the footnotes, she suggested.

"If there is any unusual situation that does not follow the rules, you need to talk to the SEC during the process," McManus advised.

One rule that many fund companies find themselves talking to the SEC about is whether they can clear the requisite IRS hurdle to ensure the merger is tax-free, said William Ying, tax director at Wells Fargo of San Francisco.

Despite an absence of clear guidance from the IRS on the Continuity of Business Enterprise (COBE) rule, funds generally have two options. First, they can prove historic assets in common. In most cases, that means the acquiring fund takes and freezes about one-third of the target's portfolio. As for how long those funds must remain locked-up, "it's squirrelly," Ying said. Portfolio managers generally object to this potentially performance impairing method.

The second, more popular-and more complicated-method, is an historic business test, through which managers prove their funds share certain goals and methods, and request a private letter ruling (PLR) from the IRS. "If we're going to go that route, we really need to get our lawyers on board," Ying said.

That's tricky, because rulings vary from year to year. While the union of say, an industry-specific fund and a dividend income fund might be deemed to demonstrate COBE this year, the merger of a tax-free state bond fund and a national tax-free fund might not get the same treatment at a different time.

The Investment Company Institute has pushed for clear guidance on COBE for investment companies, since the rules governing tax-free mergers were written with operating companies, not investment companies, in mind, Ying noted. Meanwhile, the IRS has agreed to provide fast-track 10-day letters, shaving what was once a five-month-long process.

Once shareholders approve the merger and the N-14 is effective, funds must choose a date by which all activity stops, so that both the target and acquiring funds can settle any issues and distributions prior to the final merger. "It's the fair thing to do," said Rein. "You don't want to submit your shareholders to additional taxes," he said.

And then there are operations, said Larry Depp, a partner at Deloitte of New York.

Prior to the merger, funds should determine the transfer agent, distributor and pricing formula for the combined product, and address any accounting differences, Depp said. Mergers should close on Fridays, allowing the weekend to prepare to support the new product.

Finally, companies must delegate the post-merger clean-up of final tax reports, target fund deregistration and any other corporate issues that don't settle before the merger is complete.

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