Category: Private Investment Funds

Report on Self-Regulatory Org. for Private Fund Advisers

Section 416 of the Dodd-Frank Act require the Government Accountability Office to study the feasibility of forming a Self-Regulatory Organization to oversee private funds. With the removal of the 15 clients exemption, many private fund managers will have to register for the first time by March 30, 2011. The GAO beat Congress’s deadline by 10 days when it released the report on July 11.

In Private Fund Advisers: Although a Self-Regulatory Organization Could Supplement SEC Oversight, It Would Present Challenges and Trade-offs (.pdf), the GAO does not break any new ground. The big problem is obvious: the SEC lacks the resources to examine advisory firms on a regular basis. Congress seems to be willing to put a chokehold on funding as a way of limiting the effectiveness of the Securities and Exchange Commission.

Of the 11,505 investment advisers registered with the SEC on April 1, 2011, 2,761 advisers had private funds. But only 863 of those exclusively had private fund clients.  These numbers will change dramatically on April 1, 2012 when mid-sized advisers get kicked out of SEC registration and private fund advisers are dragged in.

Challenges

Legislation would be needed to create an SRO for advisers. I think most players are unsure whether it would be a good thing or a bad thing. Given that the SRO has no form, functions, membership or governance, it’s hard to have an opinion. Private fund advisers may not like registration with the SEC, but at least it’s a known regulatory regime.

“Some of the challenges of forming a private fund adviser SRO may be mitigated if the SRO were formed by an existing SRO, such as FINRA, but other challenges could remain,” the GAO states. As for FINRA, no private fund adviser I’ve spoken to wants to be under their oversight. They don’t like the overly rule-based approach.

Rules versus principles

The GAO report highlights one of the big differences between FINRA’s approach and the SEC’s approach. SROs, like FINRA, traditionally use a rules-based approach, in part, to address the inherent conflicts of interest that exist when an industry regulates itself by minimizing the degree of judgment an SRO needs to use when enforcing its rules. The SEC regime for investment advisers is primarily principles-based, focusing on the fiduciary duty that advisers owe to their clients. That fiduciary duty has been interpreted through case law and enforcement actions. Given the diverse business models among private funds, adopting detailed or prescriptive rules to capture every fact and circumstance possible under the fiduciary duty would be difficult.

Advantages of private fund adviser-only SRO

Through its membership fees, a private fund adviser SRO could have “scalable and stable resources for funding oversight” of its members. That would mean it could conduct earlier examinations of newly registered advisers and more frequent examinations of seasoned advisers than SEC could do with its current funding levels. With improved resources, an SRO could better technology to strengthen the examination program, provide the examination program with increased flexibility to address emerging risks associated with advisers, and direct staffing and strategic responses that may help address critical areas or issues.

Theoretically, the SRO could impose higher standards of conduct and ethical behavior on its members than are required by law.  It could also provide expertise and knowledge than SEC, given the industry’s participation in the SRO.

Disadvantages of private fund adviser-only SRO

The GAO listed these disadvantages:

  1. An increase the overall cost of regulation by adding another layer of oversight.
  2. Conflicts of interest because of the possibility for self-regulation to favor the interests of the industry over the interests of investors and the public.
  3. Limited transparency and accountability, as the SRO would be accountable primarily to its members rather than to Congress or the public.

Although the formation of an SRO could increase demand for CCOs, making it potentially good for me personally, I think it would be a terrible idea for the industry.

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Will Private Equity Fund Managers Register or be Exempt?

The SEC extended the deadline for private fund managers to register with the Securities and Exchange Commission as investment advisers from July 21, 2011 to March 30, 2012. That’s a long enough period of time for legislation to intervene and grant a new exemption for private equity fund managers.

Dodd-Frank has a new exemption for venture capital fund managers.  There was an exemption for private equity fund managers in early drafts of the legislation, but that exemption never made it into the final law.

Now the Republican-controlled House is trying to re-create the exemption.

The Small Business Capital Access and Job Preservation Act was approved by a House Committee on Financial Services.

“Given the costs of registration and compliance, subjecting private equity advisers to this regulation diverts capital, time, talent and effort from activities that result in job creation. By tailoring registration requirements to exempt advisers to private equity funds, the bill strikes a better balance between the benefits of adviser registration and its costs.”

The bill is not without its critics. The North American Securities Administrators Association sent a comment letter to the committee.

First, NASAA attacks the failure to define the term “private equity fund.” The bill delegates this task to the SEC. This was the same approach used for venture capital fund managers in Dodd-Frank. However that common label is better understand than the broad range of investment strategies and risks that fall under the private equity label.

Second, NASAA is concerned that the bill is unclear as to what, if any, reporting requirements would be required for this new defined group of private equity fund advisers. The bill exempts “private equity” from the registration and reporting requirements. That means venture capital would have some reporting obligations, but private equity would not. NASAA believes that the proposed exemption contained in Section 203(o)(1) would likely have the unintended consequence of depriving the SEC of regulatory information critical for assessing risk and protecting investors.

Third, NASAA observed that the bill’s scope appears to cover all investment advisers who advise “private equity funds.” The exemption is not limited to those who solely advise private equity funds. Theoretically, an adviser could set up a private equity fund and cover all of its operations that would otherwise be exempt.

I have an interest in this bill so my opinion is biased. I think many private equity fund managers are a poor fit under the requirements of the Investment Advisers Act. Registration and reporting will impose a regulatory burden that will do little to reduce risk or protect investors.

However, the bill is taking such a blatantly partisan and over-broad approach to a sensible exemption. It also seems to be packaged with the Small Company Capital Formation Act (H.R. 1010) and the Burdensome Data Collection Relief Act (H.R. 1062). The Small Company Capital Formation Act would raise the regulatory thresholds for exemption for registration with the SEC from $5 million to $50 million. The Burdensome Data Collection Relief Act repeals the obligations under Section 953(b) of Dodd-Frank for public companies to disclose the ratio of executive compensation to the median compensation of all corporate employees.

Two other bills, the Asset-Backed Market Stabilization Act and the Business Risk Mitigation and Price Stabilization Act were originally introduced with these three, but I haven’t seen any further action of those two.

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Image of Washington DC – Capitol Hill: United States Capitol is by Wally Gobetz
CC BY-NC-ND 2.0

The Monstrous Size of Dodd-Frank

“What is 20 times taller than the Statue of Liberty, 15 times longer than “Moby Dick” and would take the average reader more than a month to read, even if you hunkered down with it for 40 hours a week?”

If you’ve been Dodd-Frank’ed, you know the answer.

The last round of financial overhaul was the Sarbanes-Oxley Act that came out of the Enron scandal. SOx weighs in at 66 pages. Dodd-Frank eats that for breakfast; It’s in heavyweight class at 849 pages.

That is just the legislation. Dodd-Frank put a big burden on financial regulators to work out the details to implement their vision (as myopic as it may be at times).

“In addition to the 30 rule-making procedures that already have missed the deadline set by Congress, 145 are supposed to be completed by year end…. Officials at the SEC, on the hook for more Dodd-Frank-related regulations than any other U.S. agency, have finished six rules, proposed 28 additional rules, missed deadlines on 11—and still have 50 to go, on which they have yet to issue any proposals.”

So far the regulatory “process has produced more than three million words in the Federal Register—or more than 3,500 11-inch-high pages.” And almost 2/3 of the rules required by Dodd-Frank have not even been proposed.

Congressman Barney Frank thinks missing the deadlines is no a big deal. “There is no penalty for not meeting the deadline,” Mr. Frank said during a webinar sponsored by the National LGBT Bar Association. “There’s no gun at their heads. Nobody gets fired.”

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Pay for Performance from Future Fund Flows

Michael Weisbach Professor and Ralph W. Kurtz Chair in Finance at The Ohio State University, and his colleagues, Ji-Woong Chung, Berk A. Sensoy and Léa H. Stern, are looking a the effect of the pay for performance at private equity funds. One hand, there is the current income from management fees and a percentage of the profit earned by the fund. On the other hand, there is the potential future income from future funds.

A fund sponsor’s lifetime income can be as dependent on the ability to raise capital in the future as it is for the income on capital currently under management. A fund sponsor’s “total pay for performance equals the sum of pay for performance features of the explicit compensation contract and the implicit, market-based pay for performance caused by the relation between today’s performance and future fundraising.”

Weisbach takes a closer look at the magnitude of pay for performance for private equity fund managers.

  • For every extra percentage point of returns (or every extra dollar) earned for the current fund’s investors, how much, in expectation, does the lifetime revenue to the fund’s general partners change?
  • How strong is this implicit pay for performance sensitivity relative to the much-discussed explicit one?
  • Theoretically, how should implicit pay for performance vary across different types of partnerships and over time within a partnership? Do these predicted patterns appear true in the data?
  • More generally, how do today’s returns affect the ability of partnerships to raise capital subsequently? How important is future fundraising to the total (explicit plus implicit) pay-performance relation facing private equity general partners, and for what types of partnerships and at what point in a partnership’s lifecycle is it most important?

The results are not particularly surprising:

For all types of funds, both the probability of raising a follow-on fund and the size of the follow-on conditional on raising one are significantly positively related to the performance of the current fund. The magnitude of these relations varies with the scalability of the investments. Buyout funds, which are the most scalable, have the strongest relation, while venture capital funds, which are the least scalable, have the weakest relation.

We also find that these relations are stronger for funds that are earlier in a partnership’s sequence of funds, that is, younger partnerships have stronger relations between future fundraising and current fund returns than older partnerships. This suggests that fund flows in the private equity industry reflect learning about ability over time, and that the strength of the market-based, implicit pay for performance facing a private equity partnership depends on the extent of its prior track record.

The paper does have some interesting data on private equity funds and their operations:

  • The mean (median) preceding fund size is $497.9 ($210.0) million for all funds taken together,
    • $866.4 ($380.0) million for buyout funds,
    • $217.7 ($125.0) million for venture capital funds, and
    • $501.0 ($314.9) million for real estate funds.
  • The mean (median) preceding fund performance is 15.1% (10.6%) for all funds taken together,
    • 16.5% (14.3%) for buyout funds,
    • 14.1% (5.8%) for venture capital funds, and
    • 14.6% (14.1%) for real estate funds.
  • The mean (median) follow-on fund size, conditional on raising one, is $792.2 ($314.0) million for all funds taken together,
    • $1,465.3 ($632.6) million for buyout funds,
    • $283.9 ($181.0) million for venture capital funds, and
    • $694.2 ($425.0) million for real estate funds.
  • The time between successive fundraisings averages 3.3 years for the entire sample,
    • 3.8 years for buyout funds,
    • 3.3 years for venture capital funds, and
    • 2.4 years for real estate funds.

In the end, they conclude that the implicit component of pay for future performance from future funds is on the same order of magnitude as the explicit component of compensation in the carried interest of the current fund. That sounds like a fund manager’s interests are well aligned with the long term interest of the investors in its funds. That’s something that public companies continue to struggle with.

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The SEC Wants to Know if You Are Systemically Important

The Securities and Exchange Commission proposed a new rule that would require advisers to private funds to report information for use by the Financial Stability Oversight Council in monitoring risk to the U.S. financial system. Sections 404 and 406 of the Dodd-Frank Wall Street Reform and Consumer Protection Act requires the SEC to gather this information.

The SEC is proposing a new Rule 204(b)-1 under the Investment Advisers Act that would require SEC-registered investment advisers to report systemic risk information on Form PF if they advise one or more private funds.

Each private fund adviser would report basic information about the operations of its private funds on Form PF once each year. Large Private Fund Advisers would be required to submit this basic information each quarter along with additional systemic risk related information required by Form PF concerning certain of their private funds.

“Large Private Fund Advisers” would be

  • Advisers managing hedge funds that collectively have at least $1 billion in assets as of the close of business on any day during the reporting period for the required report;
  • Advisers managing a liquidity fund and having combined liquidity fund and registered money market fund assets of at least $1 billion as of the close of business on any day during the reporting period for the required report; and
  • Advisers managing private equity funds that collectively have at least $1 billion in assets as of the close of business on the last day of the quarterly reporting period for the required report.

The SEC estimates that approximately 4,450 advisers would be required to file Form PF. Of those, approximately 3,920 would be smaller private fund advisers not meeting the thresholds for reporting as Large Private Fund Advisers.

It looks like the definition of private equity fund for purposes of the Large Private Fund Adviser reporting requirements will exclude real estate funds.

Private equity fund:

Any private fund that is not a hedge fund, liquidity fund, real estate fund, securitized asset fund or venture capital fund and does not provide investors with redemption rights in the ordinary course.

Under the proposed rule, real estate private equity funds will be subject to the annual reporting, but not subject to the more detailed quarterly reporting. This is just a proposed rule, so the final requirements and definitions may change in the final rule when it is issued. In the meantime, you can make comments.

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Proposed “New” Standard for Accredited Investor

If you are involved in the private placement of securities, then you have been waiting to hear how the SEC was going to change the definition of “accredited investor.”

Section 413(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act requires the definitions of “accredited investor” to exclude the value of a person’s primary residence for purposes of determining whether the person qualifies as an “accredited investor” on the basis of having a net worth in excess of $1 million. Previously, the standards required a minimum net worth of more than $1,000,000, but permitted the primary residence to be included in the calculation.

Other than changing the calculation of net worth change mandated by Dodd-Frank, the SEC has declined to change the definition.

The other test for determining qualification was an individual income in excess of $200,000 in each of the two most recent years (or joint income with a spouse in excess of $300,000). I expected those number to nearly double to keep pace with inflation.

Section 415 of the Dodd-Frank Act requires the Comptroller General of the United States to conduct a “Study and Report on Accredited Investors” examining “the appropriate criteria for determining the financial thresholds or other criteria needed to qualify for accredited investor status and eligibility to invest in private funds.” That study is not due for three years. The SEC indicated that they will likely use the results of that study when they once again address the accredited investor standard in 4 years, as allowed under Dodd-Frank.

It seems to me that the SEC found an opportunity to reduce its rulemaking agenda, by not significantly changing a rule. Maybe this is the first sign of the SEC creaking under the weight of the Dodd-Frank mandates.

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Pay to Play Rules for Placement Agents

The SEC imposed strict limitations on the ability of investment advisers to make political contributions when their clients include government bodies when it issued Rule 206(4)-5. They don’t want government investment decisions decided campaign contributions. This limitation also applies to private investment funds under the language of the rule and the changes to the Investment Advisers Act made by the Dodd-Frank Wall Street Reform and Consumer Protection Act.

The SEC carried this limitation over to placement agents used by investment advisers. The placement agent needs to be subject to similar limitations. That means the placement agent would need to be a registered investment adviser or otherwise regulated. At first the SEC expected FINRA to create a new rule to govern pay-to play. Instead, Section 975 of Dodd-Frank Wall Street Reform and Consumer Protection Act created a new category of regulated persons called a “municipal adviser.” This new category will regulated by the Municipal Securities Rulemaking Board.

The MSRB has issued a proposed draft of new Rule G-42 that would limit a placement agent’s ability to make political contributions.

One major difference between this draft of Rule G-42 and SEC Rule 206(4)-5 is the definition of de minimis political contribution. The SEC allows a contribution of $350 per election cycle for candidate you can vote for or $150 for a candidate you can’t vote for. The MSRB definition would be $250 for candidate that you can vote for.

Violating the rule means you are banned from

  • engaging in municipal advisory business with a municipal entity for compensation,
  • soliciting third-party business from a municipal entity for compensation, or
  • receiving compensation for the solicitation of third-party business from a municipal entity,

for two years after any contribution to an official of such municipal entity in excess of the de minimis amount.

Proposed Rule G-42 for municipal advisers is similar to Rule G-37 for those in the municipal securities business. I expect that comments will argue that the de minimis amount should match up with the SEC’s de minimis amount.

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Regulation of Private Fund Advisers at the State Level

The Dodd-Frank Wall Street Reform and Consumer Protection Act raised the level for registration with the SEC and removed the commonly used exemption from registration used by private fund advisers. That means smaller traditional investment advisers will be kicked out of the SEC registration and into the state registration systems. That also means that advisers to funds with less than $150 million are potentially subject to state-level registration and regulation.

In general, advisers to private funds with less than $150 million in assets under management will be exempt from SEC registration but still must submit reports to the SEC and maintain certain books and records. This, along with venture capital fund advisers are the new “exempt reporting advisers” category. They are not excluded from the definition of “investment adviser” under the Investment Advisers Act and are not required to register under the Investment Advisers Act.

That means states are not preempted by Section 203A of the Investment Advisers Act from requiring “exempt reporting advisers” to register.

Advisers to private funds with more than $150 million under management are federal covered advisers and merely have to notice file in the states in which they maintain a place of business. (Investment adviser representatives for private fund advisers are required to register with the states if they meet the definition of investment adviser representative under SEC Rule 203A-3.)

The North American Securities Administrators Association has begun looking at the issue of how states with regulate private fund advisers under the $150 million level. They have issued their Proposed NASAA Model Rule on Private Fund Adviser Registration and Exemption.

The model rule would provide the basis for an exemption from state registration only for advisers only to 3(c)(7) funds, including venture capital funds formed under 3(c)(7). Presumably funds falling under the 3(c)(1) exemption would be subject to state registration.

Under the proposed model rule, an investment adviser solely to one or more private funds will be exempt from state registration requirements if the adviser satisfies certain specified conditions:

  • The adviser cannot be subject to a disqualification under 230.262 of title 17, Code of Federal Regulations.
  • The adviser’s clients must be limited to private funds that that qualify for the exclusion from the definition of “investment company” under Section 3(c)(7) of the Investment Company Act of 1940.
  • The adviser must file with the state the report required by the SEC for exempt reporting advisers.
  • The adviser must pay the fees specified by the state.

The proposed rule could change depending on how the SEC changes its proposals for implementing the new registration and reporting requirements in Release No. IA-3110 and Release No. IA-3111. Once the NASAA finalizes the proposed rule, it would be up to the states to adopt the rule. They may not adopt it all or may change it significantly.

NASAA is seeking comments on their proposed rule. Comments should be submitted electronically to [email protected], but written comments may be mailed to NASAA, Attn. Joseph Brady, 750 First Street, NE, Suite 1140, Washington, DC, 20002. The deadline for submission of comments is January 24, 2011.

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More Information on the Custody Rule

With the removal of the 15 client rule exemption from registration with the SEC, many private funds are going to have to comply the custody rule Rule 206(4)-2. Private equity firms will have the most problems trying to meets the demands of the rule.

The SEC is trying to help. They updated the Staff Responses to Questions About the Custody Rule.

Apparently they have been getting lots of questions about how the surprise examination should work.

Question IV.4

Q: Is there an example of a report that may be issued by the independent public accountant performing a surprise examination of the adviser?

A: Yes. As stated within the Commission’s Guidance for Accountants (see Release No. IA 2969), the surprise examination is a compliance examination to be conducted in accordance with AICPA attestation standards. The AICPA has issued an illustrative surprise examination report to reflect the reporting specified in the Guidance for Accountants. The illustrative report is available on the AICPAs website at http://www.aicpa.org/InterestAreas/AccountingAndAuditing/Resources/
AudAttest/AudAttestGuidance/DownloadableDocuments/
FINAL_Surprise_Exam_Report_File_for_AICPA_org_REVISED_7.22.10.pdf.

Additionally, the AICPA published this illustrative surprise examination report in the May 2010 edition of the Audit and Accounting Guide — Investment Companies. (Posted September 9, 2010)

Question XIII.3

Q: Within the Guidance for Accountants contained in Release IA-2969, the Commission indicated that two types of reports issued under the AICPA professional standards (Type II SAS 70 or AT 601 compliance attestation) would be sufficient to satisfy the requirements of the internal control report. Are there other report formats that can be used to satisfy the Custody Rule?

A: Yes. The AICPA recently developed a report that under AT 101, Attest Engagements, of the AICPA’s professional standards that would be acceptable under the Custody Rule. An illustrative report is currently available on the AICPA’s website at http://www.aicpa.org/
InterestAreas/AccountingAndAuditing/Community/InvestmentCompanies/
DownloadableDocuments/Custody_report_September_1final.pdf. (Posted September 9, 2010)

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California’s New Placement Agent Law

California has become the latest state to regulate the use of placement agents who help investment managers secure government pension fund money. (Or is that placement agents who help government pension fund money find suitable investment managers?)

California Assembly Bill 1743 was backed by the California Public Employees’ Retirement System, the state treasurer and the state controller. Placement agents must register as lobbyists before they can pitch investment proposals to California government investors.

As Keith Paul Bishop notes in the California Corporate & Securities Law Blog

“the proposed rule does not appear to require disclosure of gifts and campaign contributions to losing candidates for positions that have the authority to appoint persons to the CalPERS Board.  This is not consistent with the Securities and Exchange Commission’s recently adopted “time out” Rule 206(4)-5 for investment advisers which appears to cover contributions to both successful and unsuccessful candidates.  Nor is this approach consistent with the Municipal Securities Rulemaking Board’s interpretation of Rule G-37 (See FAQ II.22)”

Meanwhile CalPERS is has its own rules which area bit stricter. Placement agents must report gifts and campaign contributions made to all Board members as well as to persons who have the authority to appoint persons to the CalPERS Board: the Governor, the Speaker of the Assembly, and the members of the Senate Rules Committee.

One point to focus is the definition of “Placement Agent.” An investment manager’s employees, officers, directors, and equityholders who solicit California public retirement systems for compensation may be placement agents under the definition, unless they spend more than one-third  of their time during the calendar year managing securities or assets of the manager. With respect to solicitation of CalPERS and CalSTRS only, if the manager is registered with the Securities and Exchange Commission as an investment adviser or broker-dealer, is selected through a competitive bidding process, and has agreed to a fiduciary standard of care applicable to the retirement board, then the employees, officers, and directors of a manager will not be a placement agent.

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