Category: Private Investment Funds

Private Funds Rule is Vacated

We consider a challenge to the Final Rule by petitioners National Association of Private Fund Managers, Alternative Investment Management Association, Ltd., American Investment Council, Loan Syndications and Trading Association, Managed Funds Association, and the National Venture Capital Association collectively “Private Fund Managers”). For the following reasons, we VACATE the Final Rule.

The central focus is thus on whether the Dodd-Frank Act expanded the Commission’s rulemaking authority to cover private fund advisers and investors under section 211(h) of the Advisers Act, see Part III.B.1., and whether section 206(4) authorizes the Commission to adopt the Final Rule, see Part III.B.2. We hold neither section grants the Commission such authority

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The Court found that the language in Section 211(h) applies to retail customers and therefore the SEC exceeded its authority. It looks at Section 913 of Dodd-Frank and points out that it applies to the defined term “retail customers.” Section 211(h) was enacted under Section 913. Therefore, rules under 211(h) should only be for the protection of retail investors. Private fund investors are not “retail customers.”

As for enacting the Private Fund Rules under the anti-fraud provisions of Section 206, the Fifth Circuit found the SEC conflated “lack of disclosure” with fraud or deception.

The Fifth Circuit found the remedy to be vacating the entire Private Funds Rule.

I assume the SEC will appeal the decision to the Supreme Court. The reasoning of the Fifth Circuit is strong enough that it risks invalidated other SEC rules if left standing. I’m hoping that the SEC will formally announce the delay of the compliance deadlines under the Private Fund Rules. It looks like it is pencils down on these new requirements.

23-60471_Documents-SEC-Private-FUnds-CaseDownload

SEC Offers Up a Buffet of Private Fund Regulations

At its open meeting on February 9, the Securities and Exchange Commission offered up a buffet of proposed regulations of private funds. It’s really an all-you-can eat buffet with six proposed changes across a variety of areas.

The SEC wants private funds to send out quarterly statements to private fund investors. It doesn’t seem that the SEC would require them to be audited. It would have to provide a detailed accounting of all fees and expenses. It sounds like it would some form of standardized reporting. The quarterly reports would have to provide information on fund performance. For “liquid funds, the quarterly statement would provide annual net total returns since inception, average annual net total returns over prescribed time periods, and quarterly net total returns for the current calendar year. For “illiquid funds,” the statement would provide the gross and net internal rate of return and gross and net multiple of invested capital for the illiquid fund to capture performance from the fund’s inception through the end of the current calendar quarter. Not sure what is going to draw lines between “liquid” and “illiquid” funds.

The SEC is proposing that private funds have an annual audit. This seems odd to me. Private funds largely have to do this already under the Custody Rule. Not sure what this regulation would do beyond the Custody Rule, unless it will replace the Custody Rule for private funds.

Adviser-Led Secondaries Rule would require a fairness opinion in connection with an adviser led secondary transaction. This requirement would provide a check against an adviser’s conflicts of interest in structuring and leading a transaction from which it may stand to profit at the expense of private fund investors. Not sure how much this rule would help in already complex transactions

The preferential treatment rule would prohibit private fund advisers from providing preferential terms for redemptions and providing additional information about fund holdings.  The proposed rule would go further and prohibit private fund advisers from providing “other preferential treatment” unless disclosed to current and prospective investors. This proposed rule is designed to protect investors by prohibiting specific types of preferential treatment that have a material, negative effect on other investors. Is the SEC trying to kill side letters? This proposal could be a mess.

The prohibited activities rule is side table full of dishes cooked up by the SEC under the umbrella  that these practices are contrary to the public interest and the protection of investors

  • Charging certain fees and expenses to a private fund or its portfolio investments, such as fees for unperformed services (e.g., accelerated monitoring fees) and fees associated with an examination or investigation of the adviser;
  • Seeking reimbursement, indemnification, exculpation, or limitation of its liability for certain activity;
  • Reducing the amount of an adviser clawback by the amount of certain taxes;
  • Charging fees or expenses related to a portfolio investment on a non-pro rata basis; and
  • Borrowing or receiving an extension of credit from a private fund client.

The desert is that all registered investment advisers, not just private funds, have to document their annual review in writing.

Commissioner Peirce, as expected, was against the rule. She sees it as a diversion of resources by the SEC away from retail investor protection. Further she says that maybe the SEC needs to re-think whether there is any reason to keep private placements away from retail investors if the SEC is going to impose retail-like requirements on private investments.

Chair Gensler along with Commissioner Lee and Crenshaw were all in favor of the proposed rule. They all piled on the idea that private funds are a large and growing segment of the investment industry. Of course if investors were unhappy with private funds they would not be investing in private funds and they would not be a large and growing segment of the investment industry.

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Compliance for 401k and a Recent Supreme Court Case

I assume some compliance officers often get involved in their firm’s retirement plans. If so, you may want to take a look at a decision last week by the US Supreme Court: Hughes v. Northwestern University. The case is a lawsuit by employees of Northwestern against the school and trustees of the school’s retirement plans. This is one of hundreds of lawsuits against big retirement plans for being mis-managed.  Since it’s a non-profit, Northwestern’s plans are not traditional 401ks, but the same standards apply to its plans as to Beacon’s 401k.

The employees claimed that Northwestern and the plan fiduciaries violated their duty of prudence by, among other things, offering needlessly expensive investment options and paying excessive recordkeeping fees.

The Northwestern plans have many options for employees to chose among. Many, many, many options. The plans had over 400 investment options during the time period. Some of those 400 investment options were low-cost index funds. Some were high-cost retail class funds.

The plan used revenue-sharing to plan expense, a completely acceptable way to pay record-keeping expenses and other costs. The funds pay some of the management fee back to the plan and the plan pays the fund administration costs with those fees. As you might expect, low cost index funds usually don’t pay a fee back to the plan and the higher cost funds pay more back to the plan.

Northwestern’s defense was that it “had provided an adequate array of choices, including the types of funds plaintiffs wanted (low-cost index funds).”

The Supreme Court ruled for the employees

“[E]ven in a defined-contribution plan where participants choose their investments, plan fiduciaries are required to conduct their own independent evaluation to determine which investments may be prudently included in the plan’s menu of options. If the fiduciaries fail to remove an imprudent investment from the plan within a reasonable time, they breach their duty.”

The case makes it clear that retirement plan sponsors have a duty to protect employees from making poor investment choices by monitoring and removing those poor choices from the plan menu. Just adding more good options does not make up for leaving bad options in the plan.

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The SEC Has Observed Your Private Funds and the SEC Is Not Happy

On January 27, the SEC’s Division of Examinations published a Risk Alert on the EXAMS staff Observations from Examinations of Private Fund Advisers. The Risk Alert is labeled as a follow up to the 2020 Observations from Examinations of Investment Advisers Managing Private Funds and the 2017 The Five Most Frequent Compliance Topics.

The EXAMS staff breaks their problematic observations into four broad categories:

  1. failure to act consistently with disclosures;
  2. use of misleading disclosures regarding performance and marketing;
  3. due diligence failures relating to investments or service providers; and
  4. use of potentially misleading “hedge clauses

Disclosures

The staff found fund managers not getting consent from their LPACs when required by the fund documents. That seems like a poor choice by those fund managers.

Fund managers were not getting the management fee calculations right during the post-commitment period. Sure, commitment period is easy, just the percentage against the commitment. Post-commitment you typically have to deal with equity invested calculations, impairments and partial sales.

Some funds were diverting from their designated strategy. I see this issue pop up during long term funds. The world ends up in a different place than when the fund originated. You still need to stay within the guard rails.

Marketing Performance

Fund managers like to think they are a unique flower and benchmarks don’t apply to them and their performance needs to be shown in a special way. (That is true.) The problem is stepping over the line and showing it in a misleading way. The Risk Alert points out failures in calculations by using the wrong dates, cherry picking, omitting information on leverage, and not including fees. This is a continuing problem with private funds. It’s been raised by the SEC many times and the SEC is raising the issue again. I don’t think the new Marketing Rule went into enough detail on what the SEC wants.

Due Diligence

“A reasonable belief that investment advice is in the best interest of a client also requires that an adviser conduct a reasonable investigation into the investment that is sufficient to ensure that the adviser is not basing its advice on materially inaccurate or incomplete information.”

Hedge Clauses

The EXAMS staff observed private fund advisers that had included hedge clauses in fund documents that waive or limit the Advisers Act fiduciary duty except for certain exceptions, such as a non-appealable judicial finding of gross negligence, willful misconduct, or fraud. That could violate Section 206(1) and section 206(2) of the Advisers Act. You can’t contract away your fiduciary obligations.

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SEC Chairman Gensler Talks About Private Funds

Last week, Securities and Exchange Commission Chair Gary Gensler, made a speech at the Institutional Limited Partners Association Summit. The topic? (You can guess by the title.) Private Funds. In particular, potential new regulatory requirements around private fund.

I think it’s time we take stock of the rapid growth and changes in this field, as well as that decade of learning, and bring more sunshine and competition to the private funds space.

Fees and expenses – These are always at the top of the list when talking about private funds. The industry had a long history of not being completely transparent about fees. His spin is that competition and transparency about fees should lower costs, which would raise the returns for limited partner investors, who are pensions and endowments, ultimately helping workers prepare for retirement and families pay for their college educations.

Side letters – Chair Gensler is concerned that side letters may create “uneven playing field” by giving some investors preferred liquidity terms or disclosures or different fees. I’m less concerned about fees. That’s a point of bargaining. Bigger investors get fee breaks. That’s true for mutual funds as well as private funds. The difference is that private funds can give bigger breaks to attract key investors, which reduces their costs. If its public, the fund can just stick to its schedule. Preferred liquidity can be more of a problem.

Performance metrics – Chair Gensler is concerned with the transparency of performance metrics for private funds. It is hard to compare apples-to-apples with private funds because many do things differently. The new Marketing Rule requires private fund managers (at least those that are registered investment advisers) to provide net returns in performance metrics.  That would seem to provide a pretty good method to compare fund returns and to compare against other benchmarks.

Fiduciary duties and conflicts of interest – Chair Gensler expressed concerns about the modification and reduction of fiduciary duties by general partners. Of course, that only applies to fund managers that are not registered investment advisers. Once you’re registered, you’re subject to the fiduciary requirements of the Investment Advisers Act. As for conflicts, Chair Gensler raises the possibility of the SEC prohibiting certain conflicts and practices. No more information on what those conflicts or practices may be for private funds.

Form PF – Chair Gensler is looking to revise the Form PF filing information. “I think we ought to consider whether more granular or timelier information would be useful in these circumstances.”

It sounds like there is some future rulemaking in the works that will directly affect private funds,

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Changing the Definition of “Covered Funds” under the Volker Rule

The rule that the late Paul Volker wanted to impose on banks was to stop them from engaging in proprietary trading. If the government was going to provide a back stop, then the banks should not be engaged in risky trading behavior with the protection of the federal government.

Although the Volker Rule sounds easy in concept, it’s been tough to implement and prove compliance. Even harder now that the line between investment bank and commercial bank largely does not exist.

One aspect of the Volker was to also get banks out of the business of sponsoring investment funds. Section 13 of the Bank Holding Company Act of 1956 generally prohibits any banking entity from engaging in proprietary trading or from acquiring or retaining an ownership interest in, sponsoring, or having certain relationships with covered funds.

The definition of “covered fund” covered fund covered a hedge fund or private equity fund. For compliance, you need to dive into the definition:

“The terms “hedge fund” and “private equity fund” mean an issuer that would be an investment company, as defined in the Investment Company Act of 1940 (15 U.S.C. 80a–1 et seq.), but for section 3(c)(1) or 3(c)(7) of that Act “

So it’s the same definition of private fund from the Investment Advisers Act.

What’s proposed to be changed?

  1. Revise certain restrictions in the foreign public funds exclusion to more closely align the provision with the exclusion for similarly situated U.S. registered investment companies.
  2. Permit loan securitizations excluded from the rule to hold a small amount of non-loan assets, consistent with past industry practice, and codify existing staff-level guidance regarding this exclusion.
  3. Be able to invest in and have certain relationships with credit funds that extend the type of credit that a banking entity may provide directly
  4. Exclude venture capital funds from the definition of covered fund
  5. Exclude an entity created and used to facilitate a customer’s exposures to a transaction, investment strategy, or other service.
  6. Exclude wealth management vehicles that manage the investment portfolio of a family, and certain other persons, allowing a banking entity to provide integrated private wealth management services.
  7. Make clear that an “ownership interest” in a fund does not include bona fide senior loans or senior debt instruments interests in the fund

The proposal to exclude venture capital funds sticks out from the others. It may even be the riskiest of these.

The argument for venture capital funds is that they “promote growth, capital formation, and competitiveness.” (See page 60) With the lack of leverage and reliance on other securities, venture capital funds are less interconnected with the broader markets. ” Banking entity investments in qualifying venture capital funds may benefit the broader financial system by improving the flow of financing to small businesses and start-ups and thus may promote and protect the financial stability of the United States.” (see page 60)

For the definition of “venture capital fund” the proposal refers to the SEC’s definition in 203(l)-1, with the limitations on holdings and debt.

This seems like good lobbying by venture capital. Comment period is open for the proposals. Let’s see if sticks.

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Credit Lines and Fund Performance

Dr. Christoph Jäckel, a Director of Montana Capital Partners AG, wades into the discussions about fund credit facilities with some new research he published in Private Funds CFO. His findings? A credit line increases IRR for most funds by only one percentage point.

Of course, it’s a bit more complicated than that. The average in his findings was 4%, but that was inflated by a few, very well-performing funds. The study looks at funds from 1990 to 2007 using quarterly cash flow data from Prequin. As for the equity multiple, he only found a small effect.

This is all against the back-drop of the ILPA guidance encouraging more disclosure on the use of credit lines. Around the same time, Howard Marks of Oaktree Capital took a deep but practical dive into the use of lines.

Another research study in the works by James Albertus and Matthew Denes found that use of credit lines increased performance by 6.1%. They used a different data set with a focus on data from 2014 to 2018. Unlike the Jäckel study, they only report the average effect, so it could be skewed by highly successful funds, similar to his report. As with Jäckel, they found an effect on the equity multiple, but it was small. They also note that younger funds skewed the data, presumably since the short time frame would have relatively more on the credit line and less returned to investors.

What about compliance? It has become an industry best practice to disclose in performance marketing that the fund used a credit line and the performance would be different without use of the line.

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Enforcement Actions for Failure to File Form PF

A mentioned two weeks ago that the Securities and Exchange Commission was looking at private fund managers who failed to Form PF. That is now official and the SEC announced enforcement actions against 13 private fund managers.

The SEC’s orders are against:

Each of the enforcement orders are cookie cutter and straight-forward:

  1. The private fund manager is registered with the SEC and manages private funds.
  2. Rule 204(b)-1 applies to the manager, requiring it file Form PF.
  3. The manager failed to file Form PF.
  4. The manager willful violated Rule 204(b)-1.
  5. The manager has to pay the SEC $75,000.

In each of the orders, the manager is noted as failing to file Form PF in multiple years.

As I said earlier, this is an easy violation for the SEC to catch. When filing Form ADV and listing a private fund, it gets a private fund identification number. It should be fairly easy for the SEC to search its database to see which funds in Form ADV filings were not in Form PF filings.

If you don’t want to file Form PF, you now know the result. You get subject to cease and desist, you get censured, and you pay $75,000. Since you get a cease and desist, you have to file Form PF or face even more serious consequences.

I’m not sure if the 13 orders surprises me because it’s a mistake that nobody should make (or that it’s too high and that there are many other firms out there not doing the filing). I know that there was a great deal of uncertainty about the definitions in Form PF with many funds being advised to file as hedge fund because of the poorly written definitions of the different fund types. These cases are all wholesale failures to file, not for filing the wrong form.

If you’re a private fund manager and haven’t filed a Form PF for one or more of your funds, the SEC has fired this shot across the bow. You’ve been warned. Be prepared to pay your $75,000.

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Private Funds and the Economic Growth, Regulatory Relief, and Consumer Protection Act

Last week, the Economic Growth, Regulatory Relief, and Consumer Protection Act became law,  providing some revisions to Dodd-Frank and some new regulatory wrinkles. Some of those revisions apply to private funds.

Section 203 exempts Banks and Bank Holding Companies with (1) $10 billion or less in total consolidated assets and (2) total trading assets and trading liabilities of 5% or less of total consolidated assets from the Volcker Rule.

Section 204 allows hedge funds and private equity funds to share the name with a banking entity acting as its investment adviser provided that the investment adviser is not an insured depositary institution and the name does not contain the word “bank.” Interestingly, that new exemption would seem to apply to real estate funds or venture capital funds.

Section 504 Revises the exemption in 3(c)(1) of the Investment Company Act. it adds a new exemption for “qualifying venture capital funds” to have up to 250 investors instead of the 100 investors limit for other types of funds. A “qualifying venture capital funds” is a venture capital fund that has not more than $10 million in aggregate capital contributions and uncalled committed capital.

I suppose this allows venture capital fund managers to create a pool with a larger number of less wealthy investors that are making smaller commitments. Otherwise, to exceed 100 investors, a fund manager would have to use the 3(c)(7) exemption that requires investors to be Qualified Purchasers. This was a Senate amendment sponsored by Senator Heitkamp as the “Supporting America’s Innovators Act.”

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Analysis of a 3(c)5 Fund

Dodd-Frank created a new legal definition for a “private fund” as pooled investment vehicles that are excluded from the definition of “investment company” under the Investment Company Act of 1940 by section 3(c)(1) or 3(c)(7) of that Act.

Under 3(c)(1), the main limitations are that you have one hundred or fewer holders of beneficial interest in the fund and that you do not propose to sell them in a public offering. Under 3(c)(7) you can go beyond the 100 owners, but they need to be “qualified purchasers.” That means they need to have a bigger wallet.

Real estate funds managers have used these standards because they are bright-line tests. It also skirts around the issue of whether the fund is investing in “securities” and “what is a security”. The SEC has taken a broad view on what could considered a security.

Real estate fund managers have also looked at 3(c)5 and wondered if they can rely it as an exclusion under the Investment Company Act:

(5) Any person who is not engaged in the business of issuing redeemable securities, face-amount certificates of the installment type or periodic payment plan certificates, and who
is primarily engaged in one or more of the following businesses:
… (C) purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.

The SEC issued a new no-action letter to Redwood Trust that takes a deep look at some features of this exclusion. Although the credit risk transfer certificates at issue in the letter are not widely applicable to real estate fund managers, the discussion around the exclusion is useful:

We have taken the position that the exclusion in Section 3(c)(5)(C) may be available to an issuer if: at least 55% of its assets consist of “mortgages and other liens on and interests in real estate” (called “qualifying interests”) and the remaining 45% of its assets consist primarily of “real estate-type interests;” at least 80% of its total assets consist of qualifying interests and real estate-type interests; and no more than 20% of its total assets consist of assets that have no relationship to real estate (these factors together, the “Asset Composition Test”).[3]

We generally have taken the position that qualifying interests are assets that represent an actual interest in real estate or are loans or liens fully secured by real estate [4]

We generally also have taken the position that an asset is not a qualifying interest for purposes of Section 3(c)(5)(C) if it is an interest in the nature of a security in another issuer engaged in the real estate business.[5]

We have, however, indicated that certain mortgage-related instruments that may not be treated as qualifying interests may be treated as real estate-type interests.[6]

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