Category: Private Investment Funds

The Family Office Exemption under the Investment Advisers Act

The Dodd-Frank Wall Street Reform and Consumer Protection Act wiped out the exemption enjoyed by most private funds. I’m still waiting to see how the SEC will define a “venture capital fund manager.” In the meantime, the SEC has published its proposed rule defining a “family office” and its exemption from registration under the Investment Advisers Act.

Historically, family offices have not been required to register with the SEC under the Advisers Act because of the same exemption used by private funds. The Dodd-Frank Act removed that “small adviser” exemption under section 203(b)(3) to enable the SEC to regulate hedge fund and other private fund advisers, but includes a new provision requiring the SEC to define family offices in order to exempt them from regulation under the Advisers Act.

“Family offices” are established by wealthy families to manage their wealth and provide other services to family members. That leaves the fabulously wealthy time to go yachting and leaves others to manage their securities portfolios, plan for taxes, worry about accounting services, and to directing charitable giving. The issue is the the family office management of securities.

In the past, the SEC has issued dozens of exemptive orders for family offices who requested them, removing them from the registration and supervision of the SEC. The proposed rule 202(a)(11)(G)-1 would largely codify the exemptive orders. Most of the conditions of the proposed rule are designed to restrict the structure and operation of a family office relying on the exemption to activities unlikely to involve commercial advisory activities, while still allowing family office activities involving charities, tax planning, and pooled investing.

(b) Family office. A family office is a company (including its directors, partners, trustees, and employees acting within the scope of their position or employment) that:

(1) Has no clients other than family clients; provided that if a person that is not a family client becomes a client of the family office as a result of the death of a family member or key employee or other involuntary transfer from a family member or key employee, that person shall be deemed to be a family client for purposes of this section 275.202(a)(11)(G)-1 for four months following the transfer of assets resulting from the involuntary event;

(2) Is wholly owned and controlled (directly or indirectly) by family members; and

(3) Does not hold itself out to the public as an investment adviser.

The key is how the SEC defines a family member:

(d) (3) Family member means:

(i) the founders, their lineal descendants (including by adoption and stepchildren), and such lineal descendants’ spouses or spousal equivalents;

(ii) the parents of the founders; and

(iii) the siblings of the founders and such siblings’ spouses or spousal equivalents and their lineal descendants (including by adoption and stepchildren) and such lineal descendants’ spouses or spousal equivalents.

I guess that some family offices will be cutting off some distant relations to get under this definition. For “less-beloved” family members, the family office management can use SEC regulation as an excuse to kick them out.  Of course, they can still seek and exemptive order from the SEC if they don’t fit under this definition.

The comments should involve a whole new area for the SEC: family law.

As I expected, this exemption is of no value to private funds look for a safe harbor from SEC registration.

Sources:

Revoking a Subscription Agreement

Private equity funds investors sign a subscription agreement, promising to deliver cash when the fund makes a capital call. In a recent Delaware case, investors sought to revoke their subscription agreements and recover their capital contribution. They were investors in a Lehman Brothers sponsored investment fund.

In 2007 the three plaintiffs became limited partners in Lehman Brothers Merchant Banking Partners IV L.P. After Lehman declared bankruptcy, the the Fund’s management team bought out Lehman, took over the Fund’s general partner and investment advisor, and changed the Fund’s name to Trilantic Capital Partners IV, L.P.

Among the other investors in the fund was Lehman Brothers itself. The company had made a $250 million capital commitment. The fund itself was not part of the Lehman bankruptcy estate, but the general partner’s interest, the investment advisor and the $250 capital commitment were involved.

The plaintiffs told the fund they would not make any capital calls after they heard of the Lehman bankruptcy. That was probably a sensible position to take initially.

But the fund emerged from the Lehman bankruptcy proceedings. The existing fund management team would stay in place. A third party capital source funded their purchase of Lehman’s general partner interest and investment adviser. The investor also agreed to assume the unfunded and uncommitted portion of the Lehman’s capital commitment. The management team offered all the limited partners a chance to reduce their capital commitments. Ultimately, the fund reduced in size from $3.3 billion to $2.6 billion.

These three plaintiffs sought a rescission based on three counts: supervening frustration, mutual mistake and violations of the Texas Securities Act.

Supervening frustration

“The doctrine of supervening frustration can be invoked ‘[w]here, after a contract is made, a party’s principal purpose is substantially frustrated without his fault by the occurrence of an event the non-occurrence of which was a basic assumption on which the contract was made.’ … The doctrine does not apply if the supervening events were “reasonably foreseeable, and could (and should) have been anticipated by the parties” at the time of contracting.”

The limited partnership agreement contemplated that Lehman might transfer its general partnership interest and the fund would continue to operate. The LP Agreement also contemplated the potential bankruptcy of Lehman.

This claim did not even come close to working.

Mutual mistake

“Under this doctrine, a party can rescind an agreement if (i) both parties were mistaken as to a basic assumption underlying the agreement; (ii) the mistake materially affects the agreed-upon exchange of performances; and (iii) the party adversely affected did not assume the risk of the mistake.”

The plaintiffs claimed they were mistaken about Lehman’s financial condition and the continued presence of Lehman was one of their basic assumptions. The LP agreement contemplated the removal of Lehman. The private placement memorandum made not representations about Lehman’s financial health. The subscription agreement stated that the investors were not relying on any other representations.

This claim did not even come close to working.

Texas Securities Act

“This statute prohibits the soliciting of an investment ‘by means of an untrue statement of a material fact or an omission to state a material fact necessary in order to make the statements made, in the light of the circumstances in which they are made, not misleading.’”

The plaintiffs claimed that Lehman failed to disclose its financial instability. Given this instability, its unlikely Lehman could continue its sponsorship of the fund.

But the false statements were in Lehman’s public filings, not the fund documents. They failed to show that the subscription agreement, the limited partnership agreement or the PPM contained any representation about Lehman’s financial health. They merely pointed to general statements in the PPM about how the fund would benefit in the future from its affiliation with Lehman.

The plaintiffs also failed to allege that the fund knew its representations about Lehman were “false when made.” It failed the scienter requirement under the Texas Securities Act.

It’s tough for a fund to get in a fight with its investors. Here, it was the investors who filed suit. it was probably sensible to resist making capital calls when Lehman filed bankruptcy. Once the fund survived and was spun out with the existing management team, the investors should have re-thought their position.

Sources:

Europe’s Approach to Derivatives Regulation

With this summer’s passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act, it’s Europe’s turn to address financial regulation. This morning, the European Commission released its Proposal for Regulation on OTC Derivatives, central counterparties and trade repositories.

The proposal seems to look a lot like the Dodd-Frank’s approach by creating a central trade repository, required margins, and required collateral. The proposal follows the commitment from the G-20 that

“All standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.”

The proposal excludes non-financial firms who use derivatives to mitigate risk in their core business from the central clearing requirements.

More analysis to come.

Sources:

I’m reading through the proposal and the supporting documents.

Dealing with Losses From the Madoff Fraud

Charles Ponzi

One of the many repercussions of the Madoff fraud is how to treat investors who had money in his Ponzi scheme.

There has been plenty written about how the trustee is treating the direct investors. He is only treating net cash. If you took out more cash than you put in, you are on the hook. That is regardless of how massive your paper losses may be. This clearly hurts the early investors with Madoff.

The other aspect is how the feeder funds or other investment funds treat the losses and pass them through to their investors. The case of Beacon Associates caught my eye when it popped up. (There is no connection to my employer.)

Beacon Associates had placed a big chunk of its assets with Mr. Madoff. That has lead to a class actions suit by its investors and ERISA lawsuits.

The losses have also left the fund in the lurch as to how to treat the losses and which period to attribute the losses. Between 1995 and December 2008, Beacon issued monthly financial statements reporting substantial gains on Beacon’s investments. Beacon allocated those gains to its members in proportion to each member’s interest in Beacon and reflected those gains in its financial statements. As we have now discovered, Madoff never invested the capital and those gains allocated by Beacon never existed.

As a result, Beacon ended up commencing liquidation and needed to figure out how to distribute its remaining assets to its investors. Beacon lost approximately $358,000,000 through investments with Madoff and had just $113,283,785 of remaining assets.

One way to treat the loss is the valuation method. You treat the losses to have occurred on December 2008 when the Madoff fraud was uncovered. Any investor who was fully redeemed before then would not be allocated any loss.

An alternative treatment would be the restatement method. They would treat the losses to have occurred when Beacon made each of its investments with Madoff. That would allocate the Madoff losses over a much longer period of time.

Not surprisingly, the different methodologies “provided dramatically different results.” While the capital account of one member was calculated at $4,750,866 using the Valuation method, it had a balance of $2,735,636 under a Restatement method. Another member’s capital account was valued at $1,815,576 under the Valuation method, but exceeded $3,000,000 under a Restatement method. Beacon polled its investors. Eight-two percent preferred the Valuation Method, 10% preferred a Restatement Method, and twenty-five (8%) did not make a selection.

The court ended up ruling:

“Because Beacon’s Operating Agreement requires that capital accounts be maintained in accordance with Federal Treasury rules, and because the IRS has ruled that losses attributable to Ponzi schemes be reported in the year they are discovered, Beacon’s Operating Agreement must be read as requiring that Madoff theft losses, including those losses owing to “fictitious profits,” be allocated among its members’ capital accounts in proportion to their interest in Beacon as recorded in December 2008, when Madoff’s fraud was discovered.”

The net investment method is similar to the one being used by the Madoff and is appropriate for Ponzi scheme cases. Here, the court points out that Beacon itself was not a Ponzi scheme. The valuation method is the proper choice.

Sources:

The First Attack on the Accredited Investor Standard

Many of the provisions in the merely provide for future regulatory framework. That it is in part true for the changing definition of “accredited investor” under the Securities Act. The other part is that the definition changed once President Obama signed the bill into law ten days ago.

The definition of accredited investor now excludes the value of the primary residence from the calculation of net worth. Angel investors who poured too much of their wealth into a new swimming pool and cabana may get excluded from future private placements.

The SEC has also shown that it intends to be aggressive in setting the new accredited investor definition through the rule-making called for in Section 413 of Dodd-Frank. Last week, as part of their regular Compliance and Disclosure Interpretations the SEC gave an opinion on valuing the primary residence.

Question 179.01

Section 413(a) of the Dodd-Frank Act does not define the term “value,” nor does it address the treatment of mortgage and other indebtedness secured by the residence for purposes of the net worth calculation. As required by Section 413(a) of the Dodd-Frank Act, the Commission will issue amendments to its rules to conform them to the adjustment to the accredited investor net worth standard made by the Act. However, Section 413(a) provides that the adjustment is effective upon enactment of the Act. When determining net worth for purposes of Securities Act Rules 215 and 501(a)(5), the value of the person’s primary residence must be excluded. Pending implementation of the changes to the Commission’s rules required by the Act, the related amount of indebtedness secured by the primary residence up to its fair market value may also be excluded. Indebtedness secured by the residence in excess of the value of the home should be considered a liability and deducted from the investor’s net worth. [July 23, 2010]

So you get no benefit to your net worth calculation for your home. Even worse, if you are underwater on your home then that excess debt is eating into your net worth calculation.

I think it’s easy to argue with this interpretation. By excluding “value” you can argue that it should exclude positive value as well as negative value. You could also argue that in some states (and some loan documents) the mortgage is non-recourse so the excess of debt over the value of the home should be excluded.

You can make those arguments when the SEC begins its rule-making to create a new definition for “accredited investor.” For now, you need to live by this interpretation while you are privately raising capital.

I expect the SEC is going to continue to be aggressive in establishing the new standards. As I said early this month:

Looking into my crystal ball, I expect the SEC to adjust the income standards based on inflation. That would put them at around $459,000 if single and $688,000 if married. I would also expect the standard to include some sort investment expertise and knowledge standard. Having a big pile of cash or a big paycheck will likely no longer be the only standard.  At least that’s my guess.

Now you will need a bigger pile of cash if your home mortgage is underwater.

Sources:

The Changing Standard for an Accredited Investor

As financial reform has made its way through Congress there have been several proposed changes to the standard of what it takes to be an accredited investor.

In 1982, the SEC prescribed the standard in Rule 501 of Regulation D:

5. Any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of his purchase exceeds $1,000,000;

6. Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;

The Senate version of the bill would have increased both amounts. If you use the CPI index, the amounts would more than double.

Although the bill has not passed yet, but it looks like the accredited investor standard is going to change. Section 413 of the bill is Adjusting the Accredited Investor Standard.

The net worth standard will stay at $1 million for at least the next four years, but the value of the primary residence will be excluded from net worth. Otherwise the SEC will be tasked with a review of the definition of “accredited investor” and has a clean slate to develop its own definition. The SEC can revisit the definition every four years. The only standard is that the definition be “appropriate for the protection of investors, in the public interest, and in light of the economy.”

Looking into my crystal ball, I expect the SEC to adjust the income standards based on inflation. That would put them at around $459,000 if single and $688,000 if married. I would also expect the standard to include some sort investment expertise and knowledge standard. Having a big pile of cash or a big paycheck will likely no longer be the only standard.  At least that’s my guess.

Sources:

Updated pdf file with text of the Private Fund Investment Advisers Registration Act of 2010

Image: three horsemen of the apocalypse, greenspan, et al by daveeza

Chief Compliance Officers and Private Investment Funds

If you are running a private investment fund, do you need a chief compliance officer?

If you are not registered with the SEC, it’s a gray area. If you are registered with SEC, then “yes.”

Rule 206(4)-7 requires a registered investment adviser to “[d]esignate an individual (who is a supervised person) responsible for administering the policies and procedures that you adopt under paragraph (a) of this section.”

Since the financial reform bill is going to remove the small adviser exemption from registration, hundreds (thousands?) of private fund managers will need to register with the SEC once the bill is finalized and signed by the president.

Do you need to hire a new person to serve as CCO? The rule does not require advisers to hire an additional executive to serve as compliance officer. [See Footnote 74 of SEC Release No. IA-2204] You merely have to designate someone to serve in the role.

What are the requirements for a CCO for private equity fund?

  • Must be competent and knowledgeable regarding the Advisers Act.
  • Must be empowered with full responsibility and authority to develop and enforce appropriate policies and procedures for the firm.
  • Must have sufficient seniority and authority within the organization to compel others to adhere to the compliance policies and procedures.

Having the knowledge about the act is going have many firms look toward their general counsel to act as CCO.

A dual role of general counsel and CCO may put the individual into conflict with their obligations to maintain attorney-client privilege.

Sources:

Image is Yes from Administration by Ranken Jordan

Private Investment Funds and Reporting Requirements Under the Ethics Code Rule

As I wrote about yesterday on the code of ethics for an investment adviser, one of the requirements of registering with SEC as an investment adviser is implementing a code of ethics. The most involved part of the code is the extensive reporting requirement on securities activities to the chief compliance officer.

Rule 204A-1 under the Investment Advisers Act of 1940 takes the approach that extensive reporting of trading activities by employees of an investment adviser will been a strong deterrent from getting involved in insider trading.The rule breaks the reporting into two baskets: holdings report and transaction report.

Holding Report Under Rule 204A-1

Annually, each access person needs to submit a report of their securities holdings. The report needs to include the following:

  • title of the security;
  • type of security
  • as applicable, the exchange ticker symbol or CUSIP number
  • number of shares
  • principal amount of each reportable security
  • The name of any broker, dealer or bank
  • The date of the report

The rule does not require this to be a calendar year.

Transactions Report Under Rule 204A-1

Quarterly, each access person needs to submit a report of their securities trading activity. The report needs to include the following:

  • date of the transaction
  • title of the security
  • as applicable the exchange ticker symbol or CUSIP number
  • interest rate and maturity date for bonds and debt instruments
  • number of shares
  • principal amount
  • nature of the transaction (i.e., purchase, sale or any other type of acquisition or disposition)
  • price of the security
  • name of the broker, dealer or bank who effected the trade
  • submission date of the report

The report is due within 30 days after the end of the calendar quarter.

Access Person Under Rule 204A-1

The reporting obligations are limited to “access persons” at the investment adviser. These are every employee that

  1. has access to nonpublic information regarding any clients’ purchase or sale of securities
  2. has access to nonpublic information regarding the portfolio holdings of any reportable fund
  3. is involved in making securities recommendations to clients
  4. has access to securities recommendations that are nonpublic

Those are some very broad categories. For most private funds, I would guess that most of their employees could be considered “access persons.” It’s probably easier and less likely to get you in trouble if you consider all employees to be access persons and require all employees to submit reports. Not easier on the compliance officers, but easier on employee understanding.

Exceptions From Reporting Requirements

Rule 204A-1 has some exceptions to personal securities reporting. No reports are required:

  • With respect to transactions effected pursuant to an automatic investment plan.
  • With respect to securities held in accounts over which the access person had no direct or indirect influence or control.

Plus there is also a group securities that are not reportable:

  • Direct obligations of the Government of the United States;
  • Bankers’ acceptances, bank certificates of deposit, commercial paper and high quality short-term debt instruments, including repurchase agreements;
  • Shares issued by money market funds;
  • Shares issued by open-end funds other than reportable funds; and
  • Shares issued by unit investment trusts that are invested exclusively in one or more open-end funds, none of which are reportable funds

Preclearance for IPOs and Limited Offerings

Rule 204a-1 requires an access person to obtain approval before they any security in an initial public offering or in a limited offering. A “limited offering” is a private placement and would include the purchase of an interest in a private investment fund.

What About Alternative Investment Fund Advisers?

These rules make sense for an adviser focusing on tradable securities, but make much less sense for advisers to funds that focus on alternative investments. Venture capital is an obvious example, but it seems they have escaped from the registration requirement imposed on other private equity firms under the financial reform bills.

Sources:

Image of 100 dollar bill is by mokra from RGBstock.com

It Will be up to the SEC to Define Venture Capital

With the financial reform bill set to eliminate the 15 client rule exemption for registration under the Investment Advisers Act, the only remaining exemption for fund companies with over $150 million in assets under management will be for venture capital. The Congressional conference decided to not include the Senate’s exemption for private equity.

The bill would leave it up to the Securities and Exchange Commission to define “venture capital.” So what do you think that definition will be?

Wikipedia provides a nice overview, but lacks much in the way of a definition for regulators.

Venture capital is provided as seed funding to early-stage, high-potential, growth companies and more often after the seed funding round as growth funding round in the interest of generating a return through an eventual realization event such as an IPO or trade sale of the company. Venture capital investments are generally made in cash in exchange for shares in the invested company.

Next I turned to a trade group’s definition of venture capital. So I went to the website for the National Venture Capital Association. I had a hard time finding a comprehensive definition. Although I’m sure that they are working on some proposals for the SEC. Here are some tidbits:

Venture capitalists invest mostly in young, private companies that have great potential for innovation and growth.

Venture capitalists are long-term investors who take a very active role in their portfolio companies. When a venture capitalist makes an investment he/she does not expect a return on that investment for 7-10 years, on average.

Venture capital is a subset of the larger private equity asset class. The private equity asset class includes venture capital, buyouts, and mezzanine investment activity. Venture capital focuses on investing in private, young, fast growing companies. Buyout and mezzanine investing focuses on investing in more mature companies. Venture capitalists also invest cash for equity. Other private equity investors tend to use debt as part of their transactions.

Venture capital is more like a different business model for investing than a legally definable industry. Since the SEC is going to come up with a definition, that means that there will be a legal definition.

That also means that the SEC definition will most likely affect the types of investments by venture capital firms, the nature of their capital investment, and the exit strategy from their investments.

Here are some guesses:

  • Prohibition or limitation on holding debt
  • Limitation on holding preferred shares
  • Restricted to holding common shares in operating companies
  • Prohibitions or limitations on holding publicly-traded securities
  • Limitations on holding shares in companies that have debt obligations
  • Restrictions on the type of operating companies they can invest in

They are just guesses. But the industry should be very worried about the eventual definition. The SEC has expressed a desire to regulate all private investment funds so I would expect their eventual definition to be very narrow.

I’m sure that the venture capital industry views the exemption as a victory. But the exemption could end up being a heavy weight around their necks. They may need to change their operating approach and investing style to stay within the boundaries of the definition and the exemption.

In the end, it may just be easier to register and regain the flexibility for a wider variety of investment approaches.

Sources:

You can get the “Trust Me, I’m a Venture Capitalist” hat at Cafe Press.

Private Equity and the Custody Rule

With the impending removal of the 15 Client Rule exemption from registration with the SEC, I was scratching my head trying to figure how to make the SEC’s new custody rule work for private equity.

The SEC recently updated its guidance on custody rule compliance truing to add clarity for advisers to pooled investment vehicles.

Here is one:

Question II.3

Q: If an adviser manages client assets that are not funds or securities, does the amended custody rule require the adviser to maintain these assets with a qualified custodian?

A: No. Rule 206(4)-2 applies only to clients’ funds and securities. (Posted 2003.)

Actually that does not help. A private equity fund will hold interests in private companies. Those interests may be stock, LLC interests or partnership interests.  Just because the company is private, those interests may still be securities.

For real estate private equity, the deeds to the underlying property would fall outside the custody rule. The intermediate entities, REITs and joint ventures may not fall outside the custody rule.

§ 275.206(4)-2(b)(2) has an exemption for certain privately offered securities, if the securities are:

(A) Acquired from the issuer in a transaction or chain of transactions not involving any public offering;
(B) Uncertificated, and ownership thereof is recorded only on the books of the issuer or its transfer agent in the name of the client;
and
(C) Transferable only with prior consent of the issuer or holders of the outstanding securities of the issuer.

This exemption is available only if the fund is audited, and the audited financial statements are distributed, as described in paragraph (b)(4) of this section.

The “uncertificated” requirement can be a problem. It is common practice for lenders relying on private company interests to require they be certificated to get better priority under the UCC.

The limits on transfer are a problem because as the holder of the interests, you want the flexibility to transfer interests.

The financial statements requirement is another extra burden, although may not be a problem for many funds. This requires:

  • annual audit
  • in accordance with GAAP
  • within 120 days of the end of the fiscal year
  • independent accountant registered and subject to inspection by PCAOB

(I’m not sure how quickly the SEC can change this rule if the Supreme Court rules PCAOB unconstitutional.)

In looking towards Capitol Hill, the Senate’s would exempt private equity firms from having to comply with the custody rule since they would not have to register. The House’s would not exempt private equity firms from registration and they would be subject to the custody rule.

One interesting aspect of the bills is that fund advisers that are currently registered because they have more than 15 clients/funds may no longer have to be registered if they fall under the venture capital fund advisers exemption or private equity fund advisers exemption. (Assuming those exemptions survive in the final bill.)

Sources:

Image of Old West Bank – It’s a beautiful bank is by oddsock