What is ‘new issue income’? Income earned due to participating in an IPO, typically the first day earnings when the stock is traded in the open market.
What is an IPO? When a privately owned company decides to become publicly owned, meaning anybody can eventually buy shares in the company. There are typically two stages: (1) the shares of the company are offered for purchase to selected buyers (typically big institutions or high net worth individuals) at a predetermined offering price, (2) the investor who purchased the shares in stage one decide to sell the shares to the general public (often referred to as the secondary market).
So, what exactly is ‘new issue income’? It’s the increase in value of a stock after buying it in ‘stage 1’ above and it becoming available to the general public in ‘stage 2’, the secondary market.
Example: A company Tree-For-Hire Inc. decides to go public at $100 per share. A couple of investors are lucky enough to buy these shares. Some of them decide to immediately sell on the open market at a price of $120 per share and make a profit of $20 per share. Conclusion, the $20 profit per share is new issue income.
Who cares? The
Why? This is a process that could easily be abused for a quick buck by the more criminally inclined person. So what the NASD has done is design a bunch of rules to restrict certain people to participate in IPOs. People who are not necessarily criminal but are very close to the process are restricted from participating in IPOs. The rules that apply are in section 2790, Restrictions on the Purchase and Sale of Initial Equity Public Offerings (http://www.finra.org/RulesRegulation/index.htm).
Which persons are restricted? NASD members or other broker/dealers, broker/dealer personnel, portfolio managers, certain accountants and lawyers involved in the process and immediate family members of the above.
How does this effect hedge funds? Well, the NASD rules refer to restricted members having a ‘beneficial interest’ in new issue income. That means if a restricted member invests in a fund which participates in new issue income the restricted member has a beneficial interest in new issue income. Income earned by the fund is of course allocated to its investors.How do hedge funds deal with this? Separate classes are typically created for restricted investors and non-restricted investors (i.e. Class A might be non-restricted and Class B might be restricted). This allows the fund to treat these two groups of investors differently in relation to new issue income.
Ok, now hit me with the accounting treatment of new issue income. It’s not that hard. The general principle is to allocate new income earned during the month to the class of investors who are non-restricted. BUT we have some options as provided by the regulations. If the restricted investors own less than 10% of the total value of the fund then new issue income can be allocated to all investors in the same way all other income and expenses are allocated – there is no need to split out the new issue income and only allocate to non-restricted investors. If restricted investors own more than 10% of the fund, they may participate up to 10% of the total new issue income with the remaining balance only allocated to non-restricted investors.
Are there any general exemptions for entities to be considered as non-restricted? Yes. Below is the list:
(1) An investment company registered under the Investment Company Act of 1940;
(2) A common trust fund or similar fund as described in Section 3(a)(12)(A)(iii) of the Act, provided that:
(A) the fund has investments from 1,000 or more accounts; and
(B) the fund does not limit beneficial interests in the fund principally to trust accounts of restricted persons;
(3) An insurance company general, separate or investment account, provided that:
(A) the account is funded by premiums from 1,000 or more policyholders, or, if a general account, the insurance company has 1,000 or more policyholders; and
(B) the insurance company does not limit the policyholders whose premiums are used to fund the account principally to restricted persons, or, if a general account, the insurance company does not limit its policyholders principally to restricted persons;
(4) An account if the beneficial interests of restricted persons do not exceed in the aggregate 10% of such account;
(5) A publicly traded entity (other than a broker/dealer or an affiliate of a broker/dealer where such broker/dealer is authorized to engage in the public offering of new issues either as a selling group member or underwriter) that:
(A) is listed on a national securities exchange;
(B) is traded on the Nasdaq Global Market; or
(C) is a foreign issuer whose securities meet the quantitative designation criteria for listing on a national securities exchange or trading on the Nasdaq Global Market;
(6) An investment company organized under the laws of a foreign jurisdiction, provided that:
(A) the investment company is listed on a foreign exchange for sale to the public or authorized for sale to the public by a foreign regulatory authority; and
(B) no person owning more than 5% of the shares of the investment company is a restricted person;
(7) An Employee Retirement Income Security Act benefits plan that is qualified under Section 401(a) of the Internal Revenue Code, provided that such plan is not sponsored solely by a broker/dealer;
(8) A state or municipal government benefits plan that is subject to state and/or municipal regulation;
(9) A tax exempt charitable organization under Section 501(c)(3) of the Internal Revenue Code; or
(10) A church plan under Section 414(e) of the Internal Revenue Code
