ORLANDO - Merging mutual funds typically takes six months, primarily due to requirements of both the IRS and the SEC, but this has not discouraged deals - one in six funds was merged out of existence from 1962 to 1999.
And $13.5 billion of fund assets have been have been moved so far this year, more than in all of 2005.
Foremost among the challenges to executing 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, experts said at the Investment Company Institute's Tax and Accounting Conference here recently.
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 managers want to show shareholders how a merger will benefit both partners, said Mark Bradley, the deputy treasurer at Pioneer Investment Management in Boston.
The SEC's application form for merger approval requires the values, share prices, and net assets of each fund to be specified, along with projections of how a post-merger company would look. Both funds must also submit balance sheets reflecting operations for the preceding 12 months or, should that not be possible, matching time frames, said Donna McManus, a vice president at Bank of New York Co.
The application form must also list all major shareholders, such as 401(k) plans, since those parties are likely to make redemptions before the merger, thereby eroding the value of the target or acquiring fund.
If, however, 30 days before the application to merge, 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, Ms. McManus advised. If the balance sheet shows that the smaller fund might absorb more costs than the larger one, or if the target fund's portfolio fails to satisfy the acquiring fund's investment protocols, regulators will ask questions, she said. Satiate them from the start with ample footnoted explanations, she suggested.
"If there is any unusual situation that does not follow the rules, you need to talk to the SEC during the process," she said.
William Ying, a tax director at Wells Fargo & Co. in San Francisco, said many fund companies find themselves talking to the SEC about whether they can clear the requisite IRS hurdle to ensure that the merger is tax-free.
Despite an absence of clear guidance from the IRS on the "continuity of business enterprise" rule, or COBE, funds generally have two options. First, they can prove historic assets in common. In most cases, this means the buyer takes and freezes about one-third of the target's portfolio. How long those assets must remain locked up is a "squirrelly" issue, Mr. Ying said. Portfolio managers generally object to this potentially performance-impairing option.
The second - more popular, and more complicated - option is a historic-business test, through which managers prove their funds share certain goals and methods. This path requires the buyer to request a private-letter ruling from the IRS. "If we're going to go that route, we really need to get our lawyers on board," Mr. Ying said.
This can be tricky. Though the combination, say, of an industry-specific portfolio and a dividend-income fund might be deemed to demonstrate COBE-compliance this year, the merger of a tax-free state bond fund with a national tax-free fund might not be deemed compliant at a later time.
The Investment Company Institute has pushed for clear guidance to investment companies on COBE, since the rules governing tax-free mergers were written with operating companies, not investment companies, in mind, Mr. Ying noted. Meanwhile, the IRS has agreed to fast-track, 10-day letters, shaving a lot of delay off what can be a five-month process.
Once shareholders approve a merger and the SEC has granted permission, funds must choose a date on which all activity stops so that both the target and acquiring funds can settle any issues and distributions before merging. "It's the fair thing to do," said Mr. Rein. "You don't want to submit your shareholders to additional taxes."
And Larry Depp, a partner at Deloitte in New York, said there are the funds' operations to consider.
Before the merger, the funds should determine the transfer agent, distributor, and pricing formula for the combined product, he said, and address any accounting differences. Mergers should close on Fridays, allowing the weekend to prepare to support the new product. Finally, the companies must delegate the post-merger cleanup of tax reports, target-fund deregistration, and any other corporate housekeeping matter.
