Category: Private Investment Funds

Umbrella Registration

Continuing with my look at the changes to Form ADV, I spent some time looking at the new umbrella registration.

Umbrellas_at_Caudan_Waterfront_Mall

One investment adviser (“Filing Adviser”) will be able to file a single Form ADV on behalf of itself and other investment advisers (“Relying Advisers”). This tackles the problem fund managers had when the manager was a collection of separate fund advisers.

For a variety of tax, legal and regulatory reasons, private fund managers are often carved into separate legal entities even though they operate together. There may just be a collection of fund general partners, even it looks like a single adviser to the outside.

Form ADV is based on the legal entity and therefore skews the information since the separate legal entities would have to file separate Form ADVs (or is it Forms ADV?). The SEC had provided some guidance for umbrella registrations in 2012, but there were complications around ownership on Schedules A and B.

For a group of private fund advisers that operate as a single advisory business to qualify for Umbrella Registration, they must meet these five requirements:

  1. The Filing Adviser and each Relying Adviser advise only private funds and/or “qualified clients” in separately managed accounts that are otherwise eligible to invest in the private funds advised by the Filing Adviser or a Relying Adviser and whose accounts pursue investment objectives and strategies that are substantially similar or otherwise related to those private funds.
  2. The Filing Adviser’s principal office and place of business is in the United States, and all of the substantive provisions of the Advisers Act and rules apply to the Filing Adviser and each Relying Adviser.
  3. Each Relying Adviser, its employees, and persons acting on its behalf are subject to the Filing Adviser’s supervision and control.
  4. Each Relying Adviser’s advisory activities are subject to the Advisers Act and rules, and subject to SEC examination.
  5. The Filing Adviser and each Relying Adviser operate under a single code of ethics and written policies and procedures adopted and implemented in accordance with rule 206(4)-7 of the Advisers Act and administered by a single chief compliance officer in accordance with the rule.

There is a new Schedule R for information on the Relying Advisers.

Sources:

Umbrellas at Caudan Waterfront Mall by Martin Falbisoner CC BY SA

Don’t Charge Your Examination and Investigation Expenses to Your Funds

Most private fund documents allow the manager to charge the funds for expenses incurred in the operation of the funds. Most investors expect and most managers charge the funds for some of the legal expenses and consulting expenses. The Securities and Exchange Commission though Cherokee went too far in charging the funds for expenses related to registration with the SEC.

money

Like many private fund managers, Cherokee spent a great deal of time, money and energy in 2011 in preparing to register with the SEC as an investment adviser. According to the SEC order, Cherokee charged $171,000 of those expenses to the funds it managed. The expenses were for a third-party consultant and outside counsel, as well as registration fees.

Cherokee was subject to an exam in 2013 and incurred $239,362 of expenses that it charged back to the funds. In 2014, Cherokee got notice of an impending enforcement action and charged $45,000 to the funds for legal services incurred during the investigation.

The SEC takes the position in the enforcement action that the disclosure would need to specifically state that funds would be charged for a portion of the adviser’s own legal and compliance expenses. Cherokee’s partnership provided that the funds would be charged for expenses that in the good faith judgment of the general partner arose out of the operation and activities of the funds. That was not good enough for the SEC.
Sources:

Another Private Equity Fee Case from the SEC

When the Securities and Exchange Commission announced last year that it was not happy with the fees private equity funds were charging and how they were disclosed (or not disclosed) to investors, we expected enforcement cases to follow. They are here. The latest is against Fenway Partners for failing to disclose conflicts of interest to a fund client and investors when fund and portfolio company assets were used for payments to former firm employees and an affiliated entity.

fenway

According to the SEC order, Fenway had management service agreements with the portfolio companies which were partially offset against the fund management fee charged to investors.

In 2011, Fenway cancelled those agreements and entered into similar agreements with a new consultant firm largely owned and operated by the principals of Fenway. Fenway did not offset these consulting fees against the fund management fee.

The SEC found several faults with the change. The SEC found the disclosure to the fund’s advisory board to be lacking in detail. The SEC also challenged the fund’s financial statements for failing to be GAAP compliant and disclose the payments to affiliates, the new Fenway consultant firm.

I assume Fenway was taking the position that the new consultant firm did not meet the definition of “affiliate” under the fund documents and could be carved out separately. Clearly, the SEC does not like this approach. KKR was challenged on taking this position last year by the SEC.

Sources:

Private Fund Statistics

If you manage a private fund and are registered with the Securities and Exchange Commission, you spend a good chunk of April (and maybe more) filling out Form PF. Ever wonder what the SEC does with all that data? They publish an annual report on fund statistics, which was recently released.

Form PF

Form PF implemented Section 404 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which directed the SEC to establish reporting requirements for advisers to private funds. That reported information was to be sent on for use by the Financial Stability Oversight Council in monitoring risk to the U.S. financial system. The SEC also purports to use information obtained from Form PF in its regulatory programs and investor protection efforts relating to private fund advisers.

As of the end of 2014, there were 24,725 private fund reporting to the SEC. About 1/3 were labeled hedge funds and another 1/3 were private equity funds. There were 1,789 real estate funds.

Managing those funds were 2,694 advisers. Of those, 260 were real estate fund managers.

Gross assets for all private funds just missed the $10 trillion mark of gross value. ($9.956 trillion to be more exact). Real estate funds comprised $350 billion of that total.

One surprise is that the biggest owner of private funds is other private funds. (see Table 10) Private funds hold 20% of all private funds, with government pension plans holding 12.8% and private pension plans holding 12.5%.

There is some other interesting data in the report. It’s worth spending a few minutes flipping through it.

Sources:

Why I think the Accredited Investor Standard Should Not Change

rich accredited investor

The SEC Investor Advisory Committee is scheduled to vote on a reform plan from a subcommittee at its Oct. 9 meeting. That plan calls for the SEC to rethink the income and net-worth minimums used to define an “accredited investor.”

Much of the concern about private placements is about risk. They seem to be universally labeled as the most risky of investments. The accredited investor definition is categorized as the class of individuals who do not need the ’33 Act protections in order to be able to make an informed investment decision and protect their own interests. They get to pass the red velvet rope and buy securities through a private placement

It’s not that the ’33 Act protections remove risk. There are plenty of people who have lost money in the stock markets. Prices can fluctuate wildly, fraud exists, the markets get manipulated and we are all being fleeced by high-speed traders.

It’s too easy to label private placements as risky. They cover a broad swath of investments with different levels of risk. Public companies may raise capital through a private placement because its quicker, easier and less expensive than through a public offering. Hedge funds are sold through private placements, but they can be anywhere on the risk spectrum. Of course there are start-ups and crowdfunded firms that are the most risky of investments. This would be true if the capital were raised through a public offering or a private offering.

The risk is incredibly varied for private placements. So labeling them as risky investments is an incorrect categorization.

In my view, it’s not the risk of loss that is the main problem with private placements.

It’s the loss of liquidity.

Whether the investment ends up being a bad one or a wildly successful one, the investor will have limited ability to access that gain or loss and limited ability to time the realization of that gain or loss.

With an investment in the public markets, the investor can sell at any time. With a private placement, the investor may have no ability to sell.

The net worth prong of the accredited investor definition is key because it shows that the individual has other resources and is not reliant on the private placement. Excluding the primary residence was a good change for the definition. Someone who is house rich and cash poor is less likely to be able to deal with the liquidity problem.

Excluding retirement accounts is exactly the wrong thing to do with the net worth requirement. That money is already relatively illiquid. An investor can access it, but is subject to penalty. Retirement money is long term money that will not be subject to liquidity demands and can be invested over the long term.

The current income test is a useful measure of liquidity demands of an investor. A higher income indicates that the investor is more likely to be able to absorb the loss in liquidity from a private placement.

I’m all for expanding the definition to more individuals who can prove their financial sophistication. One recommendation from the sub-committee is to have a test for financial sophistication. That’s a great idea to expand the base, but I’m skeptical that there would be many people lining up to take the test.

Another recommendation is that private placement investments be limited to a portion of income or net worth. That is better aligned with the liquidity risk. However, it would impossible to verify and incredibly intrusive to implement.

That comes back to the compliance aspect. The more complicated the method for determining whether an investor is an accredited investor that harder it is for a company to use private placements or to open them to individuals. Removing the primary residence from the net worth definition was a good idea to address the liquidity risk, but it makes the confirmation more difficult.

The failure to ensure that all investors in a private placement are accredited investors can lead to very bad results. Complicating the definition will lead to a reduction in the usefulness of this fundraising regime.

Sources:

Group Purchasing Programs and Compliance

group purchase and compliance

Can a fund manager save the investors money, but still be doing the wrong thing? That’s the issue presented by the Securities and Exchange Commission’s look at group purchasing programs for private equity firms.

Buying in bulk usually results in cost savings. A private equity firm, with a collection of companies in its portfolios, should be able to save money by pooling the purchasing power of the combined companies.

That’s savings to the portfolio companies and savings to the investors in the funds. But the fund manager may be earning fees from the group purchasing program. That’s good for the fund manager and does not affect the investors.

A recent article in the Wall Street Journal highlights the SEC’s Concern: Buyout Firms’ Fees Come Under Review. A group purchasing provider charges a fee to vendors and may share a portion of the fee with the private equity firms. According to the article, Blackstone saved over $700 million for its portfolio companies over the last seven years. Blackstone between 2011 and 2013 received roughly $7 million in fees from a company that negotiates those discounts for its portfolio companies.

The first problem is one of disclosure. If the extra fee income is disclosed to investors in the funds, then the problem largely goes away. If the extra income to the fund manager is not disclosed, then there is a potential problem. But just a potential problem. The SEC needs to prove that the fee violated the Investment Advisers Act or is somehow fraudulent, deceptive or manipulative. Earning money from investors that is not disclosed is a problem. Even if it saves investors money.

The other group purchasing issue is having the portfolio companies buy products and services from each other. The bigger problem there may be companies selling across funds managed by the private equity firm. That’s moving money from fund to fund.

The second prong after disclosure (or lack thereof) is putting a control in place to ensure each company is getting the best product at the best price. If the portfolio company is forced to buy an improper product at an inflated price, that’s a problem.

Proving cost savings will make the fund manager look better in the eyes of its investors and regulators. But update the documents to disclose the extra fee income.

Sources:

Guidance on Accredited Investor Verification

The Securities and Exchange Commission revised the private placement rules last year to permit public private-placements. Of course it took some prodding from Congress in the JOBS Act to get that change. The law and the new regulation require the issuer to take “reasonable steps” to determine that the investor is an “accredited investor.”

The SEC rule has four non-exclusive safe harbor methods which meet the verification requirement. One of those methods is to rely on the written confirmation of accredited investor status issued by a registered broker-dealer or investment adviser. The Securities Industry and Financial Markets Association has put together guidance on that verification method.

For individuals, SIFMA recommends that the investor have been a client for at least six months so the firm has sufficient knowledge. Second, SIFMA recommends that the broker or adviser obtain a representation from the investor that he or she is not borrowing money to make the investment.

To make the determination, SIFMA has two methods. In the account balance method, the investor must have at least $2 million with the broker or adviser. This assumes $1 million liabilities. If the investor discloses debt greater than this, obviously the account balance threshold will increase.

The second method is the investment amount method. In this situation, the investor must commit at least $250,000 to the investment and represent that it is less than 25% of the investor’s net worth.

I’m not sure the guidance breaks new ground, but its good to see some filling in the holes. The SEC safe harbor also permits CPAs and lawyers to issue the accredited investor verification. It will be interesting to see if the bar association and PCAOB offers any guidance to its members.

Sources:

Private Equity Real Estate Top 50 – 2014 Edition of Who Is Registered

PERE 50 long

Private Equity Real Estate has released its ranking of the top 50 real estate private equity fund managers. As I have done in the past, I parsed the list to see which managers are registered with the Securities and Exchange Commission as investment advisers. (Disclosure: my company is on the list.)

Rank Name of institution SEC Registered?
1 The Blackstone Group Registered
2 Lone Star Funds (Hudson Advisors) Registered
3 Starwood Capital Group Registered
4 Colony Capital Registered
5 Brookfield Asset Management Registered
6 Tishman Speyer Registered
7 Angelo Gordon Registered
8 Westbrook Partners Registered
9 Oaktree Capital Management Registered
10 Global Logistic Properties  Overseas
11 Walton Street Capital Registered
12 GI Partners Registered
13 Orion Capital Managers Registered (overseas)
14 The Carlyle Group Registered
15 Fortress Investment Group Registered
16 TA Associates Realty Registered
17 CapitaLand  Overseas
18 Cerberus Capital Management Registered
19 LaSalle Investment Management Registered
20 Beacon Capital Partners Registered
21 Hines Registered
22 Northwood Investors Registered
23 Rockpoint Group Registered
24 Prudential Real Estate Investors Registered
25 GTIS Partners Registered
26 Ares Management (formerly AREA Property) Registered
27 KSL Capital Partners Registered
28 Secured Capital (Exempt Reporting)
29 Rialto Capital Management Registered
30 DRA Advisors LLC Registered
31 Merlone Geier Partners
32 Paramount Group Registered
33 CBRE Group Registered
34 Perella Weinberg Partners Registered
35 Hemisferio Sul Investimentos Overseas
36 Alpha Investment Partners Exempt Reporting
37 Gaw Capital Partners Exempt Reporting
38 Harrison Street Real Estate Capital Registered
39 Kayne Anderson Capital Advisors Registered
40 Phoenix Property Investors Registered
41 Kildare Partners Registered
42 DivcoWest Registered
43 Patron Capital Exempt Reporting
44 Mapletree Investments Overseas
45 GreenOak Real Estate (TFG) Registered
46 Heitman Registered
47 GE Capital Real Estate
48 The JBG Companies
49 Related Companies Registered
50 Tristan Capital Partners Overseas

 

Last year, PERE expanded the list from 30 to 50.  On this year’s list, 38 of the top 50 are registered with the SEC as investment advisers. Of those not registered, 9 are overseas, some of which filed as exempt reporting advisers and the rest are likely to be outside the scope of SEC registration requirements. That leaves 3 firms that are not registered or overseas.

There are good arguments to be made on both sides of the registration debate for real estate funds. The core requirement under the Investment Advisers Act is that the manager is giving investment advice about “securities.” Most of these real estate fund managers are truly focused on real estate and not securities. However, the discussion between what is and is not a security may be fun for the first week of your securities law class in law school. It’s not a fun discussion when trying to comply with regulatory requirements.

The PERE 50 measures capital raised for direct real estate investment through commingled vehicles, together with co-investment capital, over the past five years. This edition measures from January 1, 2009 to March 2014 for direct investment through closed-end commingled real estate funds. It excludes core and core-plus funds.

Sources:

 

SEC Charges Private Equity Fund Manager with Misallocation of Expenses

clean energy capital

In the presence exam initiative, the Securities and Exchange Commission identified conflicts of interest as a high risk area. Included in that high risk area is the allocation of fees and expenses. The SEC just brought charges against a private equity fund manager for the improper allocation of fees and expenses.

The SEC charged Scott A. Brittenham and his company, Clean Energy Capital LLC, with paying more than $3 million of the firm’s expenses from its funds. Brittenham did not consent to the order, so I can only rely on the SEC’s view of the facts.

The SEC order states that the $3 million in expenses was primarily employee compensation and office expenses for Clean Energy Capital. That includes executive bonuses, health benefits, retirement benefits and rent. The SEC goes for the kitchen sink when it also mentions “group photos, legal fees for estate planning maintenance costs on CEC’s offices, CEC checks and letterheads, office and mobile telephone, bottled water, office lunches, car washes and insurance, holiday cards, CEC’s registration expenses, and business cards, and charges relating to transporting Brittenham’s daughter to and from school.”

Theoretically, a fund manager could charge these expenses to the fund if properly disclosed. (I doubt investors would line up to invest in such a fund.) But the Clean Energy Capital funds did not disclose these expenses. The limited partnership agreements described the expenses to be borne by the funds as “reasonable” partnership expenses “related to the acquisition or disposition of securities.”

The SEC charges that CEC treated all of its funds equally when it came to the expense reimbursement. However, that means that CEC did not make an effort to allocate the actual expense to the fund that benefited.

On top of the alleged improper allocation, CEC was making loans to the funds because they had insufficient cash reserves to pay their expenses. The SEC claims the interest rate on these internal loans ranged from 11.86% to 17.38%. That’s a high rate in this low interest rate environment.

The SEC order goes on to describe other alleged compliance failures, including violation of the custody rule, lying about the GP investment amount, and failure to disclose previous disciplinary actions.

References:

More Guidance on Knowledgeable Employee Exemption for Private Funds

Board of Directors and Officers of the Industrial Exhibition Association of Toronto 1930

A new no-action letter from the SEC’s Division of Investment Management should allow more employees of a fund manager to invest in their firm’s private funds under the Investment Company Act. Even better for the compliance department, compliance staff could fit the expanded definition of a “knowledgeable employee.”

When operating under the Section 3(c)(7) exemption from the Investment Company Act, the issue becomes how a private investment fund can provide an equity ownership to key employees. Its unlikely that your key employees will have the $5 million in investments needed to qualify as an investor. (Each investor in a 3(c)(7) private investment fund must be Qualified Purchaser.) When operating under the Section 3(c)(1) exemption, you need to worry about employee taken up one of those valuable 100 spots.

The SEC established Rule 3C-5 to allow “knowledgeable employees” to invest in their company’s private fund without having to be a qualified purchaser. The rule also exempts these knowledgeable employees from the 100 investor limit under the Section 3(c)(1) exemption from the Investment Company Act.

Rule 3C-5 creates two categories of “knowledgeable employees”. The first category of “knowledgeable employees” is the management of the covered company, which covers these positions:

  • director [see Section 2(a)(12)]
  • trustee
  • general partner
  • advisory board member [see Section 2(a)(1)]
  • “executive officer”

Executive Officer is defined in Rule 3C-5 as:

  • president
  • vice president in charge of a principal business unit, division or function
  • any other officer who performs a policy-making function
  • any other person who performs a similar policy-making function

The second group of knowledgeable employees are those who participate in the investment activities. Those employees need to meet these requirements:

  • Participate in the investment activities in connection with his or her regular functions or duties,
  • has been performing such functions and duties for at least 12 months, and
  • is not performing solely clerical, secretarial or administrative functions.

It’s a typically fuzzy definition. I expect most fund managers have people that clearly fit in the definition, some that are clearly outside the definition, and some that are in a gray area. It depends on how you define “principal business unit”, “policy-making function”, and “participates in the investment activities”. There was a 1999 American Bar Association SEC No Action Letter that provided some guidance. This no-action letter goes even further.

Your IT head is likely to be happy with the guidance on “principal business unit”:

“While the ultimate determination of whether any business unit, division, or function should be deemed principal is a factual determination that must be made on a case-by-case basis, we believe that an investment manager could determine that its IT and investor relations departments are principal business units, divisions, or functions under the circumstances described above and, accordingly, the individual in charge of each such department could be a knowledgeable employee.”

In particular, the guidance points out that unit need not be part of the investment activities to be considered principal.

The letter opens a bit wider the definition of “policy-making function”:

“Further, we agree that the rule does not require that the policy-making function be concentrated in one individual and that employees serving as active members of a group or committee that develop and adopt an investment manager’s policies, such as the valuation committee, could be executive officers under the rule. We do not believe that individuals who merely observe committee proceedings or merely provide information or analysis to the decision-makers of a committee or group would be engaged in making policy and, therefore, such individuals generally would not be executive officers under the rule.

On the “participate in investment activities” term, the SEC says each of these could fit in the definition, depending on the facts and circumstances:

  • member of the analytical or risk team who regularly develops models and systems to implement the Covered Fund’s trading strategies
  • trader who regularly is consulted for analysis or advice by a portfolio manager during the investment process
  • tax professional who is regularly consulted for analysis or advice by a portfolio manager
  • attorney who regularly analyzes legal terms and provisions of investments

The SEC steps away from creating a bright line and leaves it up to the private fund to address the particular facts and circumstances for each employee. But you will need to write down why you treated an employee as a “knowledgeable employee.”

“[I]nvestment managers should maintain in their books and records a written record of employees the investment manager has permitted to invest in a Covered Fund as knowledgeable employees and should be able to explain the basis in the rule pursuant to which the employee qualifies as a knowledgeable employee.”

References: