Category: Investment Advisers Act

ILPA Asks for Regulatory Changes for Private Equity

The Institutional Limited Partners Association and 35 of its member institutions sent a letter to the Securities and Exchange Commission pushing for stronger regulations on private equity advisory firms.  

ILPA is asking the SEC to make 7 changes.

  1. Rescind the Heitman Capital Management No-Action Letter, issued in 2007.
  2. SEC enforcement settlements with private fund advisers should not be conditional on them not seeking indemnification from their investors.
  3. Require private fund advisers to explicitly and clearly disclose the standard of care owed to investors and the fund.
  4. Set that the standard of care owed to clients of private fund advisers under the Advisers Act as a “negligence” standard.
  5. Limit the ability for private fund adviser to “pre-clear” conflicts of interest to ensure informed consent by investors.
  6. Private fund advisers should have a limited partner advisory committee as best practice, and all conflicts should be presented to the LPAC for resolution.
  7. Provide more clarity surrounding hedge clauses, including the limits of their scope and the facts and circumstances in which they can be used.

This most recent letter is a follow-up to letter requests in August 6, 2018 and November 21, 2018 that raised similar concerns.

One focus is the standard of care owed to investors. ILPA’s letter raises concerns about eliminating or significantly modifying fiduciary requirements under Delaware state law. This practice was permitted under the Heitman Capital Management No-Action Letter.

This comes into play under the fund’s indemnification provisions which may require LPs to indemnify the fund manager to a “gross negligence” standard. The Advisers Act standard is a lower simple “negligence” standard. A hedge clauses may effectively raise the Advisers Act fiduciary standard to “gross negligence.” If the SEC brings an enforcement action and settles with the fund manager, LPs may be required to indemnify the fund manager for a fine under the fund’s indemnification provision.

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The Pay to Play Rule and Political Endorsements

It’s not often that I open The Boston Globe and see a front page story about compliance with Security and Exchange Commission’s Rule 206(4)-5: Patrick stays quiet as his former aide runs for governor. Jay Gonzalez was the former Secretary of Administration and Finance for the state of Massachusetts under Governor Deval Patrick. Mr. Gonzalez is now running for governor.

Former Massachusetts Governor Deval Patrick states that he is barred under federal “pay-to-play” rules from saying anything about any candidates for state or local office because he now works a firm that is registered with the Securities and Exchange Commission as a registered investment adviser. I’m sure the firm has many investors that are state or local pension funds. That makes the firm subject to the pay-to-play rule.

Rule 206(4)-5 was put in place to prevent political support from driving investment choices made by government investors. In that article, the reporter cites a lawyer and professor that both take a much tighter interpretation of the rule. They both say that the rule is limited to monetary contributions. They both say that the rule should not prohibit the ability of someone to voice his or her preference for a candidate.

In the release for Rule 206(4)-5, the SEC states in footnote 154 that:

“it is our intent that, under the rule, advisers and their covered associates ‘are not in any way restricted from engaging in the vast majority of political activities, including making direct expenditures for the expression of their views, giving speeches, soliciting votes, writing books, or appearing at fundraising events.'”

That would seem to fall in favor of the legal experts and conclude that Mr. Patrick and his firm are being too conservative in their interpretation of the rule.

But let’s take a closer look at the rule. A contribution is defined to include a “gift, subscription, loan, advance, deposit of money, or anything of value made for the purpose of influencing an election for a federal, state or local office…” Contributions are limited to the de minimis amounts of $150, or $350 if you can vote for the candidate.

Certainly, my endorsement of a candidate has little to no value. I don’t have a following of political supporters and campaign backers. But Deval Patrick does. I don’t know the value of his endorsement. But I would say that it is worth much more than $350. The SEC rule does not anticipate a high profile person like Deval Patrick at a firm subject to the pay-to-play rule.

You can also credit the “further prohibition” section of the rule that prohibits a covered associate from doing “anything indirectly which, if done directly, would result in a violation of” the rule. Would Deval Patrick’s endorsement be an indirect call for giving campaign contributions to Jay Gonzalez?

I have heard an SEC official state that putting a yard sale on your lawn is a violation of the pay-to-play rule. She was wrong and other senior SEC officials emphatically stated that she was wrong. But we all heard that there is a willingness of the SEC to take a hard position under the pay-to-play rule.

I think the position of Deval Patrick and his firm is correct under the rule. It’s the rule that has problems.

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Proposed Enhanced Investment Adviser Regulation

Yesterday I pointed out the fiduciary duty obligations laid out in the SEC’s new release. The other half of the release is a request for comment on three new proposals to enhance investment adviser regulation.

  • Federal Licensing and Continuing Education
  • Provision of Account Statements
  • Financial Responsibility

The SEC notes these as areas where the broker-dealer framework provides investor protections that do not have counterparts in the registered investment adviser framework.

Federal Licensing and Continuing Education

The federal securities laws do not impose licensing or qualification requirements on investment advisers. Broker-dealers, through FINRA, are subject to licensing, qualification, and continuing education requirements. The first question of should RIA reps be licensed seems like a done deal. I believe the SEC is looking for comments on the requirements, avoiding duplication for dual-registered personnel and the exam process. I assume that FINRA is going to step in and take over this process.

Provision of Account Statements

I found this request to be a bit strange. Broker-dealers have to send account statements and transaction confirmations. Registered investment advisers rely on the custodian to do this.

From my perspective, the SEC also needs to focus on how these additional deliveries would work for non-retail investment adviser clients, like private funds.

Financial Responsibility

Broker-dealers are subject to capital requirements. The firms need to have minimum levels of net capital and liquidity. Of course, broker-dealers are holding customer assets directly while investment advisers have the client assets with a qualified custodian.

I suspect any of these proposals would have a big impact on smaller registered investment advisers. I thought the Custody Rule was supposed to address these concerns.

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All of Your Fiduciary Duty in One Place

Of the trio of regulatory releases from the Securities and Exchange Commission last week, the one targeted at registered investment advisers is a little weird. It sets out the fiduciary duty of investment advisers, sort of, and proposes some new regulations.

One of the problems with the fiduciary duty is that it is not explicitly written into the statutes or regulations of the Investment Advisers Act. The SEC latched on to Section 206 and court cases have followed along. But if you look through the Act or the regulations you will not find a fiduciary duty stated.  Last week’s regulatory release, at least in part, was to “reaffirm – and in some cases clarify – certain aspects of the fiduciary duty that an investment adviser owes to its clients under section 206 of the Advisers Act.”

Of course, if this reaffirmation and clarification don’t get codified in the regulations, they are just a secondary source and will stay harder to find. The SEC did ask for comment on whether it would be beneficial to codify this interpretation. I would give that a resounding “yes.”

What does the SEC think are the obligations of an investment adviser’s fiduciary duty?

The Duty of Care and the Duty of Loyalty.

The release draws heavily from the 1963 Supreme Court case SEC v. Capital Gains Research Bureau, Inc. that was the landmark case holding that the Investment Advisers Act imposes a fiduciary standard on registered investment advisers.

Duty of Care

The SEC breaks down the duty of care into three prongs.

  1. the duty to act and to provide advice that is in the best interest of the client,
  2. the duty to seek best execution of a client’s transactions where the adviser has the responsibility to select broker-dealers to execute client trades, and
  3. the duty to provide advice and monitoring over the course of the relationship.

Acting in the best interest of the client is the big prong and the SEC gives lots of examples of what advisers should be doing.

  • duty to make a reasonable inquiry into a client’s financial situation, level of financial sophistication, experience, and investment objectives
  • duty to provide personalized advice that is suitable for and in the best interest of the client based on the client’s investment profile
  • update a client’s investment profile in order to adjust its advice to reflect any changed circumstances
  • have a reasonable belief that the personalized advice is suitable for and in the best interest of the client based on the client’s investment profile.
  • Take into account the costs of an investment strategy
  • Take into account the liquidity, risks and benefits, volatility and likely performance in determining if the strategy is in the best interest
  • Conduct a reasonable investigation into the investment sufficient to not base its advice on materially inaccurate or incomplete information.
  • Independently or reasonably investigate securities before recommending them to clients

Duty of Loyalty

“The duty of loyalty requires an investment adviser to put its client’s interests first. An investment adviser must not favor its own interests over those of a client or unfairly favor one
client over another.”

The SEC makes a point that in not unfairly favoring one client over another, an adviser is not locked into making pro rata allocations of opportunities.

An adviser has to try to avoid conflicts of interest with its clients, and make full and fair disclosure to its clients of all material conflicts of interest that could affect the investment advisory relationship. But disclosure of a conflict alone is not always sufficient to satisfy the adviser’s duty of loyalty. The disclosure must be clear and detailed enough for the client to understand and make an informed decision.

Commentary

What do I see as the problems with these standards?

The first is its application to private funds and private fund advisers. The proposal is targeted at retail investors and separately-managed accounts. It skips any mention of the issues related to pooled investment vehicles like private funds. In those cases the client is the fund. For some advisers, there may also be a client that invests in the fund. The needs of the various investors in a fund may vary. The fund is a client and the fund investors may not be clients.

The SEC has danced around the private fund issues of the fiduciary duty and registration requirements for a decade. With the passage of Dodd-Frank, a bigger portion of the SEC’s registered investment advisers are private funds. It seems strange to have omitted them from this release.

I also think this release fails to clarify issues around the disclosure of conflicts in dealing with the duty of loyalty. The SEC hedges its statements. I expect we will see a fair amount of comments on this issue.

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Private Real Estate and Regulatory Assets Under Management

It’s that time of the year again. Real estate fund managers registered with the Securities and Exchange Commission are working on their Form ADV filings. I’m hearing a few questions about the right way to calculate Regulatory Assets Under Management.

The instructions to Form ADV Part 1 Appendix B provide three steps on page 9:

First, is the account a securities portfolio?
Second, does the account receive continuous and regular supervisory or management services?
Third, what is the entire value of the account?

Form ADV deems a “private fund” to be a “securities portfolio.” If you’ve gotten this far you’ve already given up on dealing with subtleties of the “private fund” definition and accepted that your real estate fund is a private fund. That gets you past the first step.

For fund managers, the second question is relatively easy since fund management falls squarely into management services.

That leaves us with the third step. The instructions provide:

In the case of a private fund, determine the current market value (or fair value) of the private fund’s assets and the contractual amount of any uncalled commitment pursuant to which a person is obligated to acquire an interest in, or make a capital contribution to, the private fund.

The first question is what to do about the subscription credit facility. As far I can tell: nothing. That leaves the likelihood that the fund RAUM is slightly high. Draws from the credit facility will be repaid with capital calls. So any investments still financed by the facility will be double counted. The value of the investment is in the value of the fund assets, but the capital has not been called to fund the investment and will be added as part of the uncalled capital.

The second question is what portion of the value of the real estate should be included as a fund asset. Some fund managers are using the gross value of all of the real estate. Others are using the net value after deducting the mortgage debt.

I’ve heard mixed messages from the SEC on which is the preferred method. One thing is clear is that the SEC wants consistency on how you come to the value and that you don’t act in a way that is deceptive.

The argument on using the net is that it better equates to the true fund value. The mortgage debt is generally isolated to the investment, so it is not fund-level debt. The fund is not leveraged.

As a comparison, it would seem strange for a private equity firm to use the gross value of a portfolio company in its fund valuation. I have not heard from any private equity fund managers that are adding the portfolio company level debt into the firm’s RAUM.

Many funds use the Investment Company Guidelines for real estate fund accounting. Those Guidelines call for the net value to be shown on the fund’s balance sheet. The Form ADV instructions say that if you calculate fair value in accordance with GAAP or another international accounting standard for financial reporting purposes you are expected to use that same basis for purposes of determining the fair value of your assets under management.

The SEC wants the registered adviser to use the same method in calculating assets under management that it uses to report its assets to clients or to calculate fees for investment advisory services. That would all seem to lead back to the equity capital in the real estate investments and not the gross value of all of the real estate investments. Investors generally look to the return on equity and capital, not the gross value of the real estate assets.

The third question is what to do about non-fund real estate investments, like direct investments,  separate accounts and joint ventures.  The general consensus seems to be that can they fall outside the scope of RAUM.

While there is still debate over whether a real estate fund is a “private fund”, these type of dirt investments generally seem to fall far away from that definition. There are few, if any, structural entities that would make one think that it is investing in a securities. There is little in the way of cash holding that may end up in a money market fund or other security investment. That means these “dirt” investments would not be a securities portfolio and don’t make it past step one in the RAUM analysis.

I’ve seen a few real estate managers address the RAUM mismatch in Form ADV Part 2. Item 5 states RAUM, then add in other measures of assets under management and how they got to those amounts. That extended assets under management would include the “dirt” investments.

I’m curious to heard what methods you are using.

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Publicity for Private Equity Funds

While looking through the various restrictions on advertising for investment advisers, I was  struck by how they fail to address the operations of private equity funds. The Securities and Exchange Commission effectively banned advertising by investment advisers for decades. As reality came, the SEC relented, subject to strict restrictions. In this post-Dodd-Frank world with private equity funds, the advertising restrictions are tough to navigate for private equity funds and their portfolio companies.

half-price advertisement

Private equity funds are dealing with two different regulatory schemes. The restrictions under the Investment Advisers Act apply all the time, while the restrictions under the Securities Act will apply during fundraising.

The issue is drawing the line between advertising for the fund manager and advertising for the portfolio company. The same is true for private equity real estate funds, in which case the real estate asset is the portfolio company.

A soup company should be able to advertise its soup. This should be true regardless of its ownership structure, whether it is a public company, a private company, or owned by a private equity fund. The soup company can only advertise securities issued by the company in accordance with the securities laws.

I have not found much in the Investment Advisers Act to address this circumstance. That the ownership of the soup company is controlled by an firm regulated under the Investment Advisers Act should not affect its ability to advertise soup.

If the soup is real estate, the firm should be able to advertise its buildings. The ownership structure of real estate should not affect its ability to let the general public that the building is for sale, that space is available or that some new renovations have transformed the building.

The problem begins when you try to draw the line between an advertising for the soup and an advertising for the securities. It’s not a bright line. I’m sure you can imagine ads all along the line going from soup to securities.

That has lead me to look at the SEC limitations around gun-jumping. Under Section 5(c) of the Securities Act, it’s unlawful to make solicitations or offers for the sale of securities prior to the filing of a registration statement. There is a large body of law on what constitutes pre-filing publicity. This is a large body of law in which I have no expertise.

I plan to spend the next few days exploring the area of gun-jumping to see if I can find some ways to determine when a private equity firm is advertising the soup or advertising the securities.

The Wild West of Wyoming

I run across compliance stories that make me scratch my head when I find something odd.  I just came across another that made me remember one of the quirks of registration with the Securities and Exchange Commission as an investment adviser.

Crossing_Deloney_and_Center,_Jackson,_WY_20110818_1

The SEC was after Timothy Sexton and his advisory firm, Bantry Bay Capital. Examiners showed up at Bantry Bays offices and were surprised to find no office. The address was listed at 3465 N Pines Way in Jackson, Wyoming in its Form ADV filing as its principal place of business. The examiners found a UPS Store instead of an operating office.

One aspect of registration between state and SEC registration is that investment advisers in Wyoming register with the SEC, regardless of the amount of assets under management. Some advisers try to sneak into Wyoming. It looks like Bantry Bay had rented a post office box at that UPS Store. That is not enough for a principal place of business.

Wyoming does not have a state level regulator of investment advisers so all Wyoming investment advisers are under SEC jurisdiction.

That will change next year. Wyoming passed a securities law and is implement a regulatory regime for investment advisers. On June 1, 2017, those 21 investment advisers in Wyoming will be required to state registration.

Wyoming will no longer be the wild, wild west for investment advisory firms.

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Buildings in Jackson, Wyoming, located at the crossing of Deloney Avenue and Center Street
By DXR
CC BY SA

Increasing the Threshold for Qualified Clients and Performance Fees

The U.S. Securities and Exchange Commission proposed to increase the net worth threshold for “Qualified Clients” from $2 million to $2.1 million.

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Rule 205-3 currently requires “qualified clients” to have at least $1 million of assets under management with the adviser or a net worth of at least $2 million.

Under the Investment Advisers Act, an adviser can only charge a performance fee if the client is a “qualified client”. The SEC equates net worth with sophistication, so a “qualified client” had to have a level assets to prove their financial sophistication.

The Dodd-Frank Wall Street Reform and Consumer Protection Act required a change for Section 205(e) of the Advisers Act by adjusting the levels for inflation and to re-adjust the levels every five years. The SEC also tossed out the value of a person’s primary residence, just as they did with the accredited investor standards.

The last inflation adjusted increase was in 2011, so it’s time to adjust again.

Inflation has been low, so the increase is small. So small that the inflation increase for the $1 million assets under management prong is below the rounding amount specified in Rule 205-3.

So it’s time to revise you client intake / investor subscription documents.

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Can a Real Estate Fund Manager Be a Venture Capital Fund Manager?

The Dodd-Frank Wall Street Reform and Consumer Protection Act split the world of fund managers into a few groups. One group that was able to grab a limited exemption from the Investment Advisers Act registration was venture capital fund managers. What does it take to be a venture capital fund manager? And could a real estate fund manager take advantage of it? I ask because I came across a real estate crowdfunding platform that took this choice.

Venture Capital - Inscription on Red Road Sign on Sky Background.

Under Rule 203(l)-1, a venture capital fund is any private fund that:

(1) Represents to investors and potential investors that it pursues a venture capital strategy;

(2) Immediately after the acquisition of any asset, other than qualifying investments or short-term holdings, holds no more than 20 percent of the amount of the fund‘s aggregate capital contributions and uncalled committed capital in assets (other than short-term holdings) that are not qualifying investments, valued at cost or fair value, consistently applied by the fund;

(3) Does not borrow…… in excess of 15 percent of the private fund‘s aggregate capital contributions and uncalled committed capital, and any such borrowing, indebtedness, guarantee or leverage is for a non-renewable term of no longer than 120 calendar day….;

(4) Only issues securities the terms of which do not provide a holder with any right, except in extraordinary circumstances, to withdraw, redeem or require the repurchase of such securities but may entitle holders to receive distributions made to all holders pro rata; and

(5) Is not registered under section 8 of the Investment Company Act of 1940 (15 U.S.C. 80a-8), and has not elected to be treated as a business development company pursuant to section 54 of that Act (15 U.S.C. 80a-53).

I gave up on this treatment because the debt limitation in (3) makes it hard to use a subscription secured credit facility. But if you’re not using a credit facility, the other provisions seem achievable for private equity funds or other funds investing in private securities, including real estate.

The big limitation would be that the fund “pursues a venture capital strategy.”

So I poked around looking for a definition of “venture capital” or “venture capital strategy” in the SEC’s rule release.

The rule and its release never bother to define “venture capital” or “venture capital strategy.” The rule merely states that the fund manager has to represent that it pursues a venture capital strategy. I found no color on what is and what is not “venture capital” or “venture capital strategy.”

I poked around on the National Venture Capital Association website. I thought the big trade association would have an easy to find definition. I was wrong. I could not find a meaningful definition of “venture capital.”

At the end of 2013, the SEC issued a guidance update on the exemption for advisers to venture capital funds. This guidance helped with some of the legal structures and the terms “qualifying investments” in part (2) of the definition. It does not discuss “venture capital strategy.”

I looked at some of the real estate crowdfunding platform’s documents and found these provisions:

In addition, the Subscriber understands that the Manager is not registered as an investment adviser under the Investment Advisers Act of 1940, as amended. The Manager is expected to be treated as an investment adviser exempt from federal or state registration under the venture capital strategy being pursued by the Company….

The Company is pursuing a venture capital strategy through investments in operating companies that manage and develop real estate.

I think it’s a bold approach to call itself a venture capital fund manager. But it kind of works. It may not make sense from a common sense perspective or a common expectation of what “venture capital strategy” is. But it’s a term that is not well defined in common practice. The SEC did not even try to define it.

The big problem is the consequences. The release for Rule 203(l)-1 says that you can’t merely state that you are pursuing a venture capital strategy; You have to actually pursue that strategy. (Again, without defining it.)

In the rule release, the SEC also states that it is a violation of the anti-fraud provisions if you merely state that you are pursuing a venture capital strategy when you are not actually engaged in that strategy.

A real estate fund with an opportunity investing style or value-add investing style could argue that it is a “venture capital strategy.” Those fund types are looking to invest in companies and get them to grow. Of course, each investment is likely a single-asset real estate company.

I would not sleep well at night, worrying that the SEC was going to challenge that regulatory choice.

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