Municipalities and nonprofit organizations looking for ways to reduce volatile and expensive variable-rate debt payments may soon have another solution.
Fairmount Capital Advisors, a Philadelphia-based financial advisory firm, is in the process of forming a pair of investment funds to buy auction-rate securities and insured variable-rate demand obligations. The tandem funds will work so that issuers who are investors in one of the funds will be able to sell their securities to the other fund, without worrying about Securities and Exchange Commission rules or other potential conflicts of interest.
The idea of the fund came to Richard Stys, managing director and principal at Fairmount, and others at the firm as a way to help out their clients who were looking for ways to reduce borrowing costs and bring added liquidity to the market. As the credit crunch deepened earlier this year, banks began to withdraw from auctions, causing them to fail and rates to skyrocket.
In searching for solutions, Fairmount considered the idea of pooling funds to bid on auction-rate securities. Having another capitalized investor in the auction process could help the functioning of auctions, bring down rates, and help their clients at the same time as providing an attractive return for investors.
"We didn't just wake up one day and say let's create an unregulated fund," Stys said. "Our idea came relatively early but the legal execution of this took longer."
The fund will be structured without leverage as a limited partnership, Stys said, with Fairmount as the general manager in charge of fund activities. Fund documents say the minimum investment of the Regulation D investment fund is $5 million, with incremental investments of $1 million after that. It is not a hedge fund, Stys said.
Management fees include a seven basis point one-time commitment fee, an annual fund management fee of 25 basis points, and any ongoing expenses of the fund, estimated at about 10 basis points a year. An investor cannot withdraw pledged funds any earlier than 180 days, according to the documents.
Some market sources have questioned the firm's timing, saying that it would have been much more successful if it had come in February. Since the crisis began, a number of viable solutions have surfaced, including SEC guidance that allows issuers to bid on their own ARS.
"Any of our clients who have wanted to bid on their own auctions have been able to successfully do it," said Kenneth Kaufman, managing partner at Kaufman, Hall & Associates Inc.
Stys said some lawyers have said the SEC guidance may eventually be overturned, because state law dictates the type of debt instrument that can be held, and this may be a case where "state law trumps federal law."
"Issuers who are considering bidding on their own securities should consider the fund," Stys said.
The duration of the crisis - which market participants estimate could range from 45 days to one year - remains to be seen, and rates have fallen, calling into question the profit potential of the fund. The Securities Industry and Financial Markets Association auction-rate 7-day index reset last Wednesday at 4.34%, after reaching a high of 6.89% on Feb. 20.
"I don't think this market opportunity is going to last a period of six months," said Bob Millikan, director of fixed income at BB&T Asset Management.
If the market recovers before the 180-day period is over, the fund would be wound down and closed.
"As the general partner we will use our discretion," Stys said. "If we are not providing the service, we will not simply hold onto the money just to get a fee."
To date, not a single dollar has been collected but Stys said about 150 organizations have seen the private placement memorandum, and many have shown interest. Health care and higher education issuers are best suited to invest in this fund, but many of them take their time in deciding the timing and size of their investment.
"My big questions are the timing and the size," Stys said. "I wish I knew."
