The Financial Accounting Standards Board (FASB), the self-regulatory body governing the accounting industry, has adopted a change in the accounting method closed-end fund advisers must use that will reduce these companies' profits. The rules apply to funds that lack 12b-1 or contingent deferred sales charges (fees paid when a shareholder redeems his shares). These include closed-end and privately-placed funds.
The new methodology, approved by FASB in late September, requires fund advisers that launch new closed-end funds to take an immediate charge to their balance sheets for commission payments they make to brokers during their initial public offerings as. When a closed-end fund is started, a fixed number of shares are sold by brokers to investors during the fund's initial public offering. Brokerage companies receive commissions for selling these shares.
For accounting purposes, these commission costs are considered "start up" costs for the adviser. The new rule requires these and other start-up costs be reported as expenses in advisers' financial statements in the fund's first year of operation.
Previously, closed-end advisers were allowed to report commissions as assets on their books. They then gradually wrote off these assets over a period of, frequently, five years, says Mari Ferris, partner with McGladrey & Pullen, an accounting firm in New York. The impetus for FASB's change is to rid balance sheets of "soft assets" (those that will eventually be written off) and more closely follow the accounting rules used by corporate America, she said.
The rule is effective for fiscal years beginning after December 15, 1998. Any fund advisers who have paid commissions for fund distribution since July 24, 1998 must write off the total value of those commissions this year. For closed-end funds already operating prior to July 24, fund advisers will be required to take a one-time charge to income for all commissions that have not yet been written off.
Commissions on closed-end IPOs within the last two years have run between three and five percent of the assets raised, says Chris Bouffard, a closed-end fund analyst with Lipper Analytical. At the low end is Merrill Lynch, which sells through its captive sales force and pays two percent.
While none of these numbers are huge, they can cause a significant dent in the profits of mid- to small-size advisers. Chartwell Investment Partners, for example, which launched its first closed-end fund this past June- the $231 million Chartwell Dividend and Income Fund- will have to write down $6.9 million in commissions this year. The company, based in Berwyn, Penna., manages a total of $1.7 billion for institutional and private investors. Prior to the rule change, Chartwell would probably have written off about $1.4 million a year for five years.
Some advisers, including Eaton Vance, may have to find ways to finance these commissions, says William M. Steul, chief financial officer of Eaton Vance. In January, Eaton Vance was among the first companies to announce it would take a one-time charge of between $36 million and $38 million as a result of the change in the accounting rule. That would wipe out its $35.9 million in profits for the first three quarters. The adviser, based in Boston, is expecting a further blow to its net income as a result of its planned offering later this month of a new fund which is a closed-end version of its Prime Rate Reserves Fund. A spokesperson for Eaton Vance said the company would not know exactly how much of an impact the new offering will have on its net income until commission costs are determined, after the IPO.