Category: Private Investment Funds

Publicly Traded Partnerships and a Qualified Matching Service

QMS

If a fund has frequent transfers by its limited partners, it risks being classified as a publicly traded partnership. That’s a bad result because the fund then becomes taxable as a corporation, subject to a qualifying income test. You might be surprised how low the threshold is for being treated as a publicly traded partnership.

A partnership is treated as a PTP if (i) interests in the partnership are traded on an established securities market, or (ii) interests in the partnership are readily tradable on a secondary market or the substantial equivalent thereof. The big problem is determining when you have a “substantial equivalent” of a secondary market. Under the regulations, the IRS uses a facts and circumstances test to determine if “partners are readily able to buy, sell, or exchange their partnership interests in a manner that is comparable, economically, to trading on an established securities market.” You hate to get into a facts and circumstances discussion with the IRS.

One safeguard in the implementing regulations at 26 C.F.R. § 1.7704-1 is a de minimis trading exception. 26 C.F.R. § 1.7704-1(j) provides for interests in a partnership to be deemed not readily tradable on a secondary market or the substantial equivalent thereof if the sum of the percentage interests in partnership capital or profits transferred during the taxable year of the partnership does not exceed 2 percent of the total interests in partnership capital or profits.

Two percent is a very low threshold.

If you get close to that number there are several transfers that are disregarded transfers for this safeharbor, including:

  • block transfers by a single partner of more than 2% of the total interests
  • intrafamily transfers
  • transfers at death
  • distributions from a qualified retirement plan
  • Transfers by one or more partners of interests representing  50 percent or more of the total interests in partnership

Another option is the use of a Qualified Matching Service (QMS).

If transfers are made through a “qualified matching service,” up to 10% of the interests in a partnership can be transferred during the partnership’s taxable year without resulting in the partnership being a PTP.

Under Section 1.7704.1(g) a a qualified matching service has to meet the following standards:

(i) The matching service consists of a computerized or printed listing system that lists customers’ bid and/or ask quotes in order to match partners who want to sell their interests in a partnership (the selling partner) with persons who want to buy those interests;

(ii) Matching occurs either by matching the list of interested buyers with the list of interested sellers or through a bid and ask process that allows interested buyers to bid on the listed interest;

(iii) The selling partner cannot enter into a binding agreement to sell the interest until the 15th calendar day after the date information regarding the offering of the interest for sale is made available to potential buyers and such time period is evidenced by contemporaneous records ordinarily maintained by the operator at a central location;

(iv) The closing of the sale effected by virtue of the matching service does not occur prior to the 45th calendar day after the date information regarding the offering of the interest for sale is made available to potential buyers and such time period is evidenced by contemporaneous records ordinarily maintained by the operator at a central location;

(v) The matching service displays only quotes that do not commit any person to buy or sell a partnership interest at the quoted price (nonfirm price quotes) or quotes that express interest in a partnership interest without an accompanying price (nonbinding indications of interest) and does not display quotes at which any person is committed to buy or sell a partnership interest at the quoted price (firm quotes);

(vi) The selling partner’s information is removed from the matching service within 120 calendar days after the date information regarding the offering of the interest for sale is made available to potential buyers and, following any removal (other than removal by reason of a sale of any part of such interest) of the selling partner’s information from the matching service, no offer to sell an interest in the partnership is entered into the matching service by the selling partner for at least 60 calendar days; and

(vii) The sum of the percentage interests in partnership capital or profits transferred during the taxable year of the partnership (other than in private transfers described in paragraph (e) of this section) does not exceed 10 percent of the total interests in partnership capital or profits.

A fund sponsor can theoretically set up its own QMS to allowing greater liquidity in interests in its partnerships than permitted by the 2% safe harbor.

Sources:

Are Your Private Fund Employees Licensed?

compliance and licensing

I think many real estate fund managers and private equity fund managers may be concerned that there are some additional licensing requirements now that they are registered with the Securities and Exchange Commission as an investment adviser. If you didn’t require licensing with your current business model before Dodd-Frank you likely don’t require licensing post-Dodd Frank. Obviously there are many business models and internal compensation structures and each changes the analysis. Of course, a fund manager may have missed the licensing requirement in the first place.

David W. Blass Chief Counsel, Division of Trading and Markets U.S. Securities and Exchange Commission mentioned in a speech earlier this month that the SEC is focusing on this issue. Absent an available exemption or other relief, a person engaged in the business of effecting transactions in securities for the account of others must generally register under Section 15(a) of the Exchange Act as a broker.

A firm needs to be very focused on this issue if it is paying compensation to its employees that depends on the outcome or size of the securities transaction:  transaction-based compensation. The SEC views the receipt of transaction-based compensation is a hallmark of being a broker.

There is an “issuer exemption” in Exchange Act Rule 3a4-1 that provides a non-exclusive safe harbor under which associated persons of certain issuers can participate in the sale of an issuer’s securities in certain limited circumstances without being considered a broker. One key aspect of that rule is that the employee

Is not compensated in connection with his participation by the payment of commissions or other remuneration based either directly or indirectly on transactions in securities. Rule 3a4-1 (a)(3)

Beyond that threshold requirement, there are several other hurdles under the rule.  Blass summarizes those hurdles:

A person must satisfy one of three conditions to claim the issuer exemption from broker-dealer registration:

  • the person limits the offering and selling of the issuer’s securities only to broker-dealers and other specified types of financial institutions;
  • the person performs substantial duties for the issuer other than in connection with transactions in securities, was not a broker-dealer or an associated person of a broker-dealer within the preceding 12 months, and does not participate in selling an offering of securities for any issuer more than once every 12 months; or
  • the person limits activities to delivering written communication by means that do not involve oral solicitation by the associated person of a potential purchaser.

On the bright side, Blass indicates that the he would consider a rule providing a broker-dealer registration exemption written specifically for private fund advisers.

Sources:

Private Equity Funds in the Hot Seat

Debevoise & Plimpton LLP

Debevoise & Plimpton LLP put on an excellent seminar focused on enforcement actions against private equity funds.

Moderator:
Kenneth J. Berman

Speakers:
Eric R. Dinallo
Robert B. Kaplan
Shannon Rose Selden

Each fund manager is designated with a risk rating by the Securities and Exchange Commission. The Form ADV filing gives the SEC the background to assign that rating for a likelihood to be in compliance or out-of-compliance with regulatory requirements.

Registration gives the SEC the ability to just show up and ask for information. Prior to registration, the SEC would have needed a subpoena. The goal of the presence exams is to visit 25% – 50% of the new registrants over the next 2 years. The exams seems to more heavily weighted towards private equity than hedge funds. Perhaps because many hedge funds had been registered before and the SEC is more familiar with the risks with hedge funds.

Examination Priorities:

Exam Priorities in 2013 for Investment Advisers
– Conflicts of Interest Related to Compensation Arrangements
– Conflicts of Interest Related to Allocation of Investment Opportunities
– Marketing/Performance

“Presence” Exam Priorities
– Marketing
– Portfolio Management
– Conflicts of Interest
– Safety of Client Assets
– Valuation

Enforcement Priorities
• Marketing/Performance
• Valuation
• Conflicts of Interest
• Allocation of Expenses
• Fee Arrangements & Calculations
• Waterfall & Carry Distribution Calculations
• “Zombie Funds”

Marketing Cases:

• In re Oppenheimer Asset Mgmt. Inc., et al, (March 11, 2013)
• In re Ranieri Partners LLC and Donald W. Phillips (March 8, 2013) and In re Stephens (March 8, 2013)
• In re Advanced Equities, Inc. (Sept. 18, 2012)

Valuation
• In re Oppenheimer Asset Mgmt. Inc. (March 11, 2013)
• SEC v. Brantley Capital Mgmt., LLC et al. (Sep. 28, 2010)
• In re KCAP Financial, Inc., (Nov. 28, 2012)
• SEC v. Yorkville Advisors (Oct. 17, 2012)

Conflicts of Interest
• In re Crisp (Aug. 30, 2012) (Self-Dealing)
• SEC v. Resources Planning Group Inc. (Nov. 23, 2012) (Misuse of Client Funds)

Fees & Expenses

• In re Pinkas (Feb. 15, 2012) (Allocation of expenses)
• SEC v. Onyx Capital Advisors, LLC (April 22, 2010) (Improper Fee Arrangements)

State versus Federal Enforcement

States still have the ability to enforce anti-fraud laws against investment advisers and private funds. Just because you are exempt from state registration, you are not exempt from state enforcement.

Ranieri

Highlighted the Ranieri case where a finder stepped over the line and acted as a placement agent. The SEC not only brought an action against the finder, but also against the fund firm and its principal. The SEC seemed especially annoyed that the finder had been barred from acting as a broker.

Don’t Secretly Change Your Fund Structure

new stream capital logo

New Stream Capital took the unusual step or restructuring its fund structure in secret. The restructuring put its biggest investor into a preferred position, to the disadvantage of its other investors. At least according to the complaint filed by the Securities and Exchange Commission.

The SEC alleges that New Stream’s co-owners David Bryson and Bart Gutekunst secretly revised the fund’s capital structure to placate its largest investor. Secretly changing the priority structure is bad for your existing investors. The firm took it a step further and continued marketing the fund as though all investors were on the same footing when that was not true. New Stream raised an additional $50 million after the restructuring and received additional management fees, but left the investors with nearly worthless holdings when the fund failed.

New Stream had a structure that bifurcated investors, with US investors investing directly in the master fund and offshore investors contributing capital through a Bermuda feeder fund. The Bermuda moved capital into the master fund in the form of secured notes. In 2007, New Stream proposed a restructuring with a new onshore feeder fund for US Investors and new Cayman feeder fund for offshore investors.

The trick was moving the offshore investors out of the old Bermuda note feeder into the new Cayman feeder. As an incentive, New Stream gave equal priority to new Cayman feeder and the old Bermuda note feeder.

Gottex Fund Management had $300 million in the old Bermuda note feeder, which represented almost 40% of the capital in the entire fund structure. Gottex did not like the new structure and I assume was upset that New Stream made the change without their consent.

According to the complaint, New Stream lied to Gottex and told them that the Bermuda Feeder was senior to the new feeders. Then New Stream defrauded the other investors by actually making the Bermuda feeder senior. The marketing of the fund failed to disclose the structure to new investors. Also, the debt appears to have been mischaracterized in the fund’s financial reports.

On top of the misleading statements to new investors, the new structure also dramatically increased the management fees charged to the funds. The structure allowed for a management fee to be charged against the gross amount invested, including the loans. In November 2007, the management fee was $34,643, which increased to $318,561 in April of 2008 after the initial restructuring.

Then the financial crisis devastated the fund and it was hit hard with redemption requests. Many of those apparently came from investors in the old Bermuda feeder. By September 30, 2008, investor redemption requests totaled approximately $545 million. The fund managed stop many redemptions, but it was too late. The fund was in a death spiral, as redemption requests increased and the fund’s assets continued to decrease as the financial crisis of 2008 continued to devastate the economy and the fund’s investments.

New Stream sent one letter to Bermuda investors assuring them that their priority position would be maintained, and a different letter to the remaining investors that failed to mentioned the priority.

An initial fund restructuring/bankruptcy was rejected in Bermuda. Then a 2011 Delaware bankruptcy filing was finalized in April 2012 with the US and Cayman investors recovering only $9.7 million for their $182 million in claims. The old Bermuda investors are expected to recover much more.

The SEC additionally charged New Stream’s former head of investor relations Tara Bryson, who is David Bryson’s sister. She agreed to settle the SEC’s charges. It’s not her first scrape with the law. According to another story, she was busted in 2010 for turning her goat farm into a marijuana farm.

Sources:

California Redefines “Private Fund”

I’ve spent a great deal of brain power on the definition of “private fund” under the Investment Advisers Act. California has added its own twist on the definition. It’s a twist that is very important to real estate fund managers.

Working through the definition of “private fund” requires wading through the Investment Company Act. Congress chose to define it as a “an issuer that would be an investment company, as defined in section 3 of the Investment Company Act of 1940 (15 U.S.C. 80a-3), but for sec­tion 3(c)(1) or 3(c)(7) of that Act”. Then it requires a re-visit to the first week of discussion in a securities law class over what is a security.

Most private funds, including real estate funds, have looked at the exclusions under sec­tion 3(c)(1) or 3(c)(7) as safe harbors from registration under the Investment Company Act. They have very clear requirements fro compliance. With the new definition of “private fund” under the Investment Advisers Act, many real estate fund managers have looked at the exclusion under Section 3(c)(5) and wondered if that will work as an exclusion.

California is the first state to recognize the loophole and proposed changes to its definition of private fund in the proposed changes to Rule 260.204.9:

“Qualifying private fund” means an issuer that qualifies for the exclusion from the definition of an investment company under section 3(c)(1), 3(c)(5), or 3(c)(7) (or any combination thereof) of the Investment Company Act of 1940, as amended….[my emphasis]

Given the twisted definitions under the Investment Advisers Act, fund managers could classify themselves out of the federal level of registration and into the state level. At the state level, a fund manager could find other exemptions and exclusions from registration. Although, the state level definitions are continuing to change and catch up to the changes brought by Dodd-Frank.

I have not worked through the implications of this new definition of “private fund”. I decided I’d rather deal with the Securities and Exchange Commission than a collection of state regulators. For a real estate fund manager with operations in California who didn’t register with the SEC, you may need to re-visit the analysis for your exemption.

Sources:

Preliminary Results of Dodd-Frank Act Changes to Investment Adviser Registration Requirements

The Securities and Exchange Commission has released some statistics on the effect of Dodd-Frank on the registration of investment advisers (.pdf). March 30, 2012 was the compliance date for several provisions of the Dodd-Frank Act that amended the registration provisions of the Investment Advisers Act.

Registered private fund advisers advise 30,617 private funds with total assets of $8 trillion, which is 16% of total assets managed by all registered advisers. Approximately 31% of private fund total assets are attributable to advisers that registered since the effective date of the Dodd-Frank Act. Hedge funds (53%) and private equity funds (24%) comprised the majority of private fund assets managed by registered advisers. Real estate funds are in the other 23% along with liquidity funds and venture capital funds.

A total of 1,950 exempt reporting advisers filed Form ADVs with the SEC. 41% are foreign advisers. Exempt reporting advisers account for 6,702 private funds with total assets of $1.5 trillion. Of that mix, 17% are venture capital funds.

There are currently 12,623 advisers registered with the SEC with total assets under management of $48.8 trillion. The SEC expects expects that 2,400 mid-sized advisers will switch to state registration by June 28, 2012, resulting in approximately 10,000 advisers with $48.6 trillion in assets under management registered with the SEC.

Using these projections, the SEC anticipates that the cumulative impact of the Dodd-Frank Act registration changes will be a 25% decrease in the number of advisers registered with the Commission, but a 12% increase in the total assets under management of those registered advisers.

Dawn of the Zombie Funds

The Securities and Exchange Commission has a shotgun in its hand and is looking for zombies. “We are going to take a close look at that and see whether or not there’s a problem,” said Robert Khuzami, the SEC’s enforcement director. Khuzami is the one pointing the shotgun.

Many private investment funds either prevent redemptions or have some limit on redemptions. That gives the fund manager a better ability to make a long term investment. Otherwise, the fund manager’s ability to invest will be subject to the short term withdrawals of its limited partners. A typical equity mutual fund can allow broader redemption rights because its investments in the stock market are very liquid and easy to value. At the other extreme is a real estate fund. Buying and selling real estate takes weeks and often months to settle. The business plan for a private equity fund or venture capital fund investment may run for a decade.

Private investment funds will typically have a lifespan of many years with the ability of the fund manager to extend that lifespan. During the lifespan, the investor/limited partner has no contractual right to get its money back. This limitation is magnified for investors in a fund of funds. The fund of funds manager is stuck with whatever the underlying fund manager is doing.

Although the limits on redemption are needed, that doesn’t mean that there is no abuse. A few fund managers may have let the fund turn into a zombie and merely sit back and collect management fees.

“We’re looking at zombielike funds that potentially have stale valuations,” says Bruce Karpati, co-head of the SEC’s asset-management enforcement unit. “The investigation into zombie funds is an important effort being driven across the country.”

From a compliance perspective, improper valuations are the most likely source of trouble. Overvaluing assets will increase management fees. An examination by the investors or the SEC will be a problem if the fund manager cannot document and justify the valuations. The SEC has made many public statements that it will take a close look at the valuation practices of private investment funds.

If you’re a zombie fund manager, lookout. The SEC is hunting the walking dead.

Sources:

>Letter from the Illinois State Board of Retirement to Invesco

      (.pdf) from the

Wall Street Journal

Comments on Advertising Restrictions for Private Funds

Section 201 of the recently passed Jumpstart Our Business Startups Act will change the advertising limits on private funds and any other company that raises capital through the private placement safe harbor in Rule 506 of Regulation D. That rule has historically prevented the use of general solicitation and advertising in selling private fund interests. Section 201 requires the SEC to lift the ban through a new rulemaking and gave the SEC 90 days (July 4) to do so.

I still find it strange that Congress did not just create revise the underlying statutes to allow solicitation and advertising in private offerings not registered with the SEC. Instead, Congress took the convoluted route of requiring the SEC to change a rule that interprets a statutory provision of the Securities Act. That injects some uncertainty into what limitations, if any, the SEC will continue to require after July 4 (or whenever the new rule goes into effect).

There are a few other points in Section 201 that concern me and make me worry about fundraising in the post JOBS Act regulatory world.

First, Section 201 limits sales only to accredited investors when using general advertising or solicitation. Currently, a Rule 506 offering can have up to 35 non-accredited investors. That would typically include friends and family investors. It would also include employees.

Second, Section 201 requires the SEC to include a requirement that the issuer take reasonable steps to determine accredited investor status using methods determined by the SEC. That could radically change the current practice and safeguards in the fundraising process.

Third, I’m concerned what the effect will be for a fund or other issuer that ends up selling to a non-accredited investor. A fund can take reasonable steps to determine if a potential investor is accredited. But the investor could be deceptive. That would leave the fund in violation even though it reasonably believed the investor was accredited.

Fourth, Section 201 purports to lift the ban across all federal securities law. In particular, I’d prefer clarification that the advertising and solicitation applies to the Section 3(c)(1) and 3(c)(7) of the Investment Company Act that permits most private funds to avoid regulation under that law.

In looking through the comments letters to Section 201, I see that I am not alone in these concerns.

The American Bar Association’s Federal Regulation of Securities Committee does a a great job of focusing on my fourth concern and asks for a clear statement that “an offering of fund shares pursuant to Rule 506 or Rule 144A utilizing general solicitation or general advertising will not be a ‘public offering’ for the purposes of Section 3(c)(1) or 3(c)(7) of the Investment Company Act.”

The letter also requests clarification of the reasonable belief standard in the Rule 501 definition of accredited investor.

“any person who comes within any of the following categories, or who the issuer reasonably believes comes within any of the following categories, at the time of the sale of the securities to that person…”

The letter falls short in its comments to the verification practice. It merely asks the SEC to have the rule reflect “current custom and practice” without letting the SEC what the customs and practice is. (It’s asking the investor to fill out a questionnaire.)

In it’s comment letter, the Managed Fund Association focuses on reasonable steps for the verification process.

In general, each potential hedge fund investor must complete a subscription document provided by the fund’s manager that provides a detailed description of, among other things, the qualification standards that a purchaser must meet under the federal securities laws. In completing the subscription materials, each investor must identify which applicable qualification standard it meets. In addition to these procedures, many hedge funds managed by MFA members obtain further assurance of the qualification of their investors by virtue of minimum investment thresholds that meet or exceed the net worth requirement in the definition of accredited investor.

The Managed Fund Association also asks that the knowledgeable employee exemption be extended to Rule 506. With private funds, investors prefer (demand?) that senior management have a significant investment in the fund. This aligns interests among the investors and management. When operating under the Section 3(c)(7) exemption from the Investment Company Act, the issue then becomes how a private investment fund can provide an equity ownership to key employee when it’s unlikely that your key employees will have the $5 million in investments needed to qualify as  a Qualified Purchaser. 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. The Managed Fund Association recommends

that as part of the implementation of Section 201, the SEC amend the definition of “accredited investor” to include those individuals who meet the definition of “knowledgeable employee” in Rule 3c-5 under the Investment Company Act.

The New York City Bar splits the verification process by asking for a principle-based approach with a non-exclusive safe harbor. Their comment letter points out the body of existing practice and asks the SEC to build on it, rather than replace it.

The clock is ticking and the SEC has very little time to produce a proposed rule for comment. I wouldn’t be surprised to see the SEC miss the deadline given all of the other rule making piled up in front of them. That means the advertising may have to wait that much longer.

Sources – Comment letter from:

Private Equity Real Estate Top 30 – 2012 Edition

Private Equity Real Estate just released its ranking of the top 30 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.)

1 The Blackstone Group Registered
2 Morgan Stanley Real Estate Investing Registered
3 Goldman Sachs Real Estate Principal Investment Area Registered
4 Tishman Speyer Registered
5 Colony Capital Registered
6 The Carlyle Group Registered
7 Lone Star Funds (Hudson Advisors) Registered
8 Beacon Capital Partners Registered
9 Westbrook Partners Registered
10 LaSalle Investment Management Registered
11 MGPA Registered
12 Starwood Capital Group Registered
13 CBRE Global Investors Registered
14 AREA Property Partners Registered
15 Prudential Real Estate Investors Registered
16 TA Associates Realty Registered
17 Angelo, Gordon & Co Registered
18 Rockpoint Group Registered
19 Shorenstein Properties
20 Bank of America Merrill Lynch Global Principal Investments Registered
21 AEW Global Registered
22 Hines Registered
23 Brookfield Asset Management Registered
24 Lubert-Adler Real Estate Registered
25 JER Partners Registered
26 Grove International Partners Registered
27 CIM Group
28 Northwood Investors Registered
29 DRA Advisors Registered
30 Walton Street Capital Registered
Other Real Estate Fund Managers  —
GI Partners Registered
KSL Capital Registered
Aetos Capital Registered
Citi Property Investors Registered
Lehman Brothers Real Estate Private Equity Registered
Crow Family Registered
Jamestown, LP Registered
KK daVinci Advisers
Rockwood Capital Registered
RREEF Alternative Investments Registered
Rockefeller Group Registered

 

It still stands that 28 of the top 30 are registered with the SEC as Investment Advisers.

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 30 measures capital raised for direct real estate investment through commingled vehicles, together with co-investment capital, over the past five years.

Sources:

More Private Fund Advisers Register than SEC Expected

From the great sources at IA Watch:

The numbers may not be final, but they’re close. Some 1,400 private fund advisers registered with the SEC by the first week of April, sources tell IA Watch. Owing for some stragglers, these appear to be what Dodd-Frank wrought by way of new advisers. They join some 2,600 private fund advisers that had elected to register long before the congressional mandate.

By last week, an additional 1,968 so-called exempt-reporting advisers had filed (IA Watch, June 27, 2011). These private fund advisers will have to update their subset of Form ADV questions annually. The agency expects more ERAs to file this month, bringing the total to about 2,000 by May.

The additional reporting growing out of Dodd-Frank and the financial crisis means the agency now has data on about 38,000 private funds, including feeder funds, the source states.

There are now more than 12,600 RIAs, although the agency expects about 2,600 of these to shimmy over to state registration by July (IA Watch, Dec. 12, 2011).