Category: Private Investment Funds

Private Fund Manager Registration Status

Shearman & Sterling put together a great client publication on private fund manager registration requirements being considered by Congress: Private Fund Manager Registration as U.S. Financial Reform Legislation Approaches the Finish Line.

Among the many provisions to be reconciled in the 1,600+ pages of each bill are those that would require private fund managers to register as investment advisers with the U.S. Securities and Exchange Commission. The registration provisions would strike the existing registration exemption on which many fund managers now rely, that being the so-called “private adviser” or “fourteen or fewer clients” exemption. The result is that many fund managers that are currently exempt from SEC investment adviser registration will be forced to register in due course. With that background, this alert highlights differences between the Senate and House treatment of these registration requirements.

Dodd Bill, Private Placements and Accredited Investors

I previously wrote about how the Restoring American Financial Stability Act being tossed around in the Senate could affect private investment funds by changing the definition of accredited investor and altering the process for a Regulation D private placement.

It looks like much of that is going to be wiped out of the bill. Senate Amendment 4056, proposed by Senator Bond, was passed by a voice vote.

The amendment directs the SEC to adjust the net worth needed to attain accredited investor status to $1,000,000, excluding the value of the primary residence. Within the period of four years after enactment, however, the net worth standard must be $1,000,000, excluding the value of the primary residence. The proposal would give the SEC the power to adjust the the definition of “accredited investor” every four years.

Senate Amendment 4056 also removed the 120 review period for private placements.

I have found Senate process for dealing with financial reform bill to be incredibly opaque and fast moving. There have been almost 400 amendments proposed since the bill was submitted last month, with the text of most of the amendments not being available until after vote has taken place.

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Private Investment Funds and Form 5500 Schedule C

If you have ERISA plan investors in your private investment fund you should know that they have new reporting requirements this year.

There is a new rule that requires greatly expanded disclosure of monetary and non-monetary compensation paid by the ERISA plan. On Schedule C to Form 5500, the plan will need to identify any service provider who received more than $5,000 in compensation. In prior years, ERISA plan administrators were only required to identify the plan’s 40 most highly compensated service providers who received at least $5,000.

Mutual funds, hedge funds, private equity funds and funds of funds are all considered service providers. If you have an ERISA plan invested in your fund, expect a request for information on fees.

In the case of registered mutual funds, compensation paid to persons who rendered services to the plans investing in the fund is reportable. These expenses include investment management fees and fees related to the purchase or sale of interests in the fund. Amounts charged against the fund for “other ordinary operating expenses,” such as brokerage commissions paid to a broker in connection with a securities transaction within the fund’s portfolio, would not be deemed indirect compensation to a service provider and would not be reportable.

Fees received by third parties from an operating company in which a plan invests, including a venture capital operating company (VCOC) or a real estate operating company (REOC), generally would not be reportable indirect compensation according to the DOL’s FAQ on Form 5500 Schedule C:

Q7: Is compensation received in connection with the management and operation of venture capital operating companies (VCOCs), real estate operating companies (REOCs), and other operating companies reportable indirect compensation?

No. Although the requirement to report indirect compensation is not limited to fees received by persons managing plan assets, unlike investment funds (e.g., mutual funds, collective investment funds), fees received by third parties from operating companies, including real estate operating companies (REOC) or venture capital operating companies (VCOC), in connection with managing or operating the operating company, generally would not be reportable indirect compensation. Fees or commissions received by an investment manager or investment adviser in connection with a plan investment in a VCOC, REOC, or other operating company would, however, be reportable indirect compensation. This answer would not be affected by whether the VCOC, REOC, or other operating company were wholly owned by a plan such that the assets of the entity would be deemed to be plan assets.

ERISA is a complicated law. Make sure you find someone to help you answer these questions.
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SEC Censure for Failing to Conduct Due Diligence

sec-seal

The SEC censured and fined an investment adviser for due diligence lapses. Yosemite Capital Management, LLC and its managing director, Paul H. Heckler, got a wrist slap for failing to disclose to clients that they had encountered substantial problems when attempting to perform the due diligence.

The big problem is that Yosemite had made a promise to at least two clients prior to placing his clients into the investment. They had promised to conduct due diligence. We saw a similar action by the SEC against the Hennessee Group for their failure to conduct their promised due diligence.

Yosemite ended up putting their clients’ money into a Ponzi scheme. Yosemite placed $3.25 million of four clients’ funds through a feeder fund, Ashton Investments LLC which was supposed to make bridge loans arranged by Norman Hsu and Next Components, Ltd. Heckler’s clients’ funds became part of a Hsu’s $60 million Ponzi scheme.

Yosemite missed some bright red flags:

  • The business cards from Ashton’s representatives that listed their position as “Represenative” [sic].
  • Ashton gave Yosemite a brochure riddled with spelling errors and mostly general, unverified information.
  • In addition to the business cards and the brochure, the only other written information concerning Ashton and Hsu that Yosemite received were emails, without any identifying information, that summarized a few of the loans.
  • Heckler was told that he could not contact Hsu’s lawyers or accountants because Hsu was a  private person.
  • Heckler was told that the bridge loans were safer than stocks or bonds.
  • When Heckler requested a disclaimer in the loan agreement, he was told that it was unnecessary because the investment was not risky.
  • Because Ashton had no offices, Heckler met the Ashton representatives at local restaurants to discuss the investment.

Heckler and Yosemite willfully violated Section 206(2) of the Advisers Act, which prohibits any investment adviser from engaging in any transaction, practice, or course of business, which operates as a fraud or deceit on any client or prospective client, and Heckler caused Yosemite’s violations of Section 206(2) of the Advisers Act.

The “wrist slap” was a disgorgement of the fee earned ($26,000), prejudgment interest and a $50,000 fine. Heckler invested $275,000 of his own money in the scheme and lost $150,000 of it.

Of the $3.25 million of the clients’ money invested, they lost $1.95 million when Hsu’s Ponzi scheme collapsed.

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SEC is Probing Hedge Funds

They’re looking at you.

Rob Kaplan and Bruce Karpati, co-chiefs of the Asset Management Unit of the SEC enforcement division, held their first full staff meeting last week. This new unit will be focusing on misbehavior by private-equity funds, hedge funds, buyout firms, mutual funds and other asset managers. The unit is one of the five specialty units the SEC formed earlier this year.

Side Pockets

Hedge funds use side pockets to protect new investments, long term investments and other assets that they do not want to liquidate in the face of redemptions in the fund. In the Great Panic of 2008 funds used side pockets to limit redemption.

Valuations

One issue related to the side pocket is valuation of the assets. One reason for keeping the assets is because the fund managers feel the assets are not being properly valued in the market. On the bad side, the fund may be charging fees against the inflated value of those side pockets assets. Most side pocket assets are illiquid, which makes valuations difficult to determine.

Management Investment

One surprising priority for the unit is evaluating whether fund managers really have their own wealth invested in the fund when they are saying so in the prospectus and marketing materials.

It sounds like some enforcement proceedings are likely to appear in this area in the next few months.

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Picture is by Daniel Rosenbaum for The New York Times

The Knowledgeable Employee Exemption for Private Funds

UPDATE: See More Guidance on Knowledgeable Employee Exemption for Private Funds

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 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.)

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.

You will still need to determine if the employee’s acquisition of the interest is exempt from the registration requirements of the Securities Act. Most likely that will mean that the knowledgeable employee will need to be an accredited investor. Meeting that $200,000 per year / $300,000 per year if married income (and a reasonable expectation of that income continuing) threshold may be the biggest impediment to offering equity interests further down the company ladder.

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.

The 12 month limit is not limited to 12 months at the employee’s current company. The SEC concluded that it is not necessary to require that an employee work for the particular fund or management affiliate for the entire 12-month period as long as the employee has the requisite experience to appreciate the risks of investing in the fund and performed substantially similar functions or duties for another company during that 12 month period.

Whether an employee actively “participates in the investment activities” of a private fund will be a factual determination made on a case-by-case basis.  In a 1999 No Action letter sent to the ABA the SEC said the following would NOT be knowledge employees:

  • Marketing and investor relations professionals who explain potential and actual portfolio investments of a fund and the investment decision-making process and strategy being followed to clients and prospective investors and interface among the fund, the portfolio mangers and the fund’s clients.
  • Attorneys who
    • provide advice in the preparation of offering documents and the negotiation of related agreements,
    • who also are familiar with investment company management issues, and
    • respond to questions or give advice concerning ongoing fund investments, operations and compliance matters.
  • Brokers and traders of a broker-dealer related to the Fund who are Series 7 registered.
  • Financial, compliance, operational and accounting officers of a fund who have management responsibilities for compliance, accounting and auditing functions of funds.

The SEC also said that research analysts who investigate the potential investments for the fund may not be knowledgeable employees unless they research all potential portfolio investments and provide recommendations to the portfolio manager.

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Photo is of the Board of Directors and Officers of the Industrial Exhibition Association of Toronto 1930 used under Creative Commons License from the Toronto Public Library Special Collections

Qualified Purchasers under the Investment Company Act

In a private fund exempt under 3(c)(1) investors only generally need to be accredited investors (and “qualified clients” if the fund manager is SEC registered. If you have more than 100 investors in the fund you will need to fall under the 3(c)(7) exemption. That means all of your investors must be “qualified purchasers.” A qualified purchaser is a much greater requirement than an accredited investor and a qualified client.

To paraphrase the requirements under Section 2(a)(51) of the Investment Company Act, a “qualified purchaser” means:

  • a person not less than $5 million in investments
  • a company with not less than $5 million in investments owned by close family members
  • a trust, not formed for the investment, with not less than $5 million in investments
  • an investment manager with not less than $25 million under management
  • a company with not less than $25 million of investments

To that list you can also add:

  • A company (regardless of the amount of such company’s Investments) beneficially owned exclusively by Qualified Purchasers.
  • A “Qualified Institutional Buyer” under Rule 144A of the 33 Act (except that “dealers” under Rule 144 must meet the $25 million standard of the 1940 Act, rather than the $10 million standard of Rule 144A). Rule 144A generally defines a “Qualified Institutional Buyer” as institutions, including registered Investment Companies, that own and invest on a discretionary basis $100 million of securities that are affiliated with the institution, banks that own and invest on a discretionary basis $100 million in  securities and have an audited net worth of $25 million, and certain registered dealers.

“Investments” generally means the following:

  1. Securities, including stocks, bonds and notes, other than securities of an issuer that  is under common control with the qualified purchaser.
  2. Real estate held for investment purposes.
  3. Commodity futures contracts, options or commodity futures and options on physical commodities traded on a contract market or board of trade, held for investment purposes.
  4. Physical commodities (e.g., gold and silver), with respect to which futures contracts are traded on a contract market or board of trade, held for investment purposes.
  5. Financial contracts (e.g., swaps and similar individually negotiated financial transactions), other than securities, held for investment purposes.
  6. For an investment company or a commodity pool, any binding capital commitments.
  7. Cash and cash equivalents held for investment purposes. Neither cash used by an individual to meet everyday expenses nor working capital used by a business is considered cash held for investment purposes.

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Image of Coin Stacks is by Darren Hester under a creative commons license.

Private Fund Exemptions under the Investment Company Act

Private investment funds primarily use two exemptions to avoid being defined as an “investment company” under the Investment Company Act of 1940: Section 3(c)(1) or Section 3(c)(7).

Less than 100 Investors

Section 3(c)(1) of the Investment Company Act excludes from being an investment company any issuer whose outstanding securities are beneficially owned by not more than 100 persons and that is not making and does not presently propose to make a public offering of its securities. The benefit of Section 3(c)(1) is that there is no additional status requirement for the investor, such as net worth, total assets, or total investments owned beyond the “accredited investor” standard.

There are some catches in trying to count the number of investors. There are several types of investors that result in a look through their ownership.

More than 100 Investors

If your private fund will have more than 100 investors, either directly or because of a look-through, then the fund will need to fit under the Section 3(c)(7) exemption. As with Section 3(c)(1) you cannot anticipate making a public offering. Investors in 3(c)(1) fund need only be accredited investors, but investors in a 3(c)(7) fund must be “qualified purchasers.”

The higher standard of qualified purchaser limits potential investors to institutional investors, investment managers and high net worth individuals. (More on the “qualified purchaser” definition in my next post.)

Contacting lots of investors may be viewed as general solicitation so you need to pay attention to the prohibition on general solicitation or advertisement under .

You will also need to be careful in limiting future transfers of interest in the private investment funds. With more than 100 investors, you will no longer be in the safe harbor exemption from being a publicly traded partnership.

500 or more Investors

Once you have 500 or more investors and more than $10 million in assets you are subject to the reporting requirements of the Exchange Act. Effectively you are no longer a private fund.

I believe something analogous happened to Google. They had gotten so big and their shares ended up in the hands of more than 500 people. Since they would have to begin complying with the reporting requirements, they may as well let the shares trade publicly.

So if you are going to end up with more than 500 investors in a private fund, you are better off having several smaller funds to avoid the public reporting requirements under the Exchange Act.

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Image of the Twenty Dollar Bill is by Darren Hester under a Creative Commons License.

Are Private Equity-Backed Companies More Likely to Default?

During the Great Panic, there was some grumbling that private equity-backed companies were posing a great risk to the economy.

The Private Equity Council has done some research and came to the conclusion that the opposite is true. They are less likely to default.

Of course, there are lots of caveats and distinctions in the report. Of course, there is my own disclosure since I work in private equity.

One issue is how you define a “default.” The Private Equity Council use the the ISDA’s definition in credit default swap contracts: (1) a missed payment or (2) a bankruptcy filing.

They exclude exchanges where the borrower buys back debt at a discount or swap the debt for equity. You can make an argument that these types of exchanges are opportunistic, and not a genuine attempt to avoid a bankruptcy filing. After all, if the company were really in such bad shape, why would the private-equity backers pour more money into the deal by buying the debt or diluting their equity.

The Private Equity Report was largely in response to a report from the Boston Consulting Group and a second report from Moody’s Investor Service.

Get Ready for the Private Equity Shakeout

The problem with the Boston Consulting Group’s study, Get Ready for the Private Equity Shakeout, is that they used the credit spreads in November 2008. They found that 60% of the private equity portfolio companies had their debt trading at distressed levels.

I have to agree with the Private Equity Council when they find fault with that calculation. Credit spreads were huge for every company in November 2008. The economy was in the grips of the Great Panic for liquidity.

The PEC’s chart shows that the default rates have not held up to the BCG estimate.

$640 Billion & 640 Days Later

The big issue with the Moody’s report is that it includes “distressed exchanges” in their definition of default. More than half of the defaults in the Moody’s study fell into this category. Of those, about 70% were exchanges at less 15¢ on the $1. I would be hard-pressed to say at debt purchase at 90% of par should be considered a default. At 15% you are looking more like a default.

However, the Moody’s report ended up concluding that the 186 LBO deals in the study had roughly the same default rate as similarly rated companies.  Where Moody’s found the biggest problem was the biggest LBO deals from January 2008 to September 2009. Six of the ten were considered distressed or defaulted.

On the other hand, the study’s time frame was during the most tumultuous period in the financial markets for decades. Things are much calmer now than they were in September 2009.

What’s Ahead

How should I know? I’m just a compliance guy banging away on his keyboard. But it is hard to ignore upcoming debt maturities. Even though companies may be current on their debt service, all of that cheap debt is going to be hard to replace when it matures.

It is clear to me that we should be skeptical about statements that private equity transactions pose an exceptional risk to the financial system. Those statements are not backed up by the data.

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Accredited Investors under the Restoring American Financial Stability Act

Senator Dodd

One of the surprises in the Restoring American Financial Stability Act of 2010 is that it proposes to raise the standard for being an accredited investor. Section 412 of the bill would require the SEC to increase the dollar thresholds to be qualified as an accredited investor. Section 413 would require the GAO to study the appropriate criteria.

The current standards come from Section 2(a)15 of the Securities Act of 1933

ii. any person who, on the basis of such factors as financial sophistication, net worth, knowledge, and experience in financial matters, or amount of assets under management qualifies as an accredited investor under rules and regulations which the Commission shall prescribe.

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;

If you adjust for inflation from 1982, those levels could increase to $459,000 if single and $688,000 if married, with the net worth requirement becoming $2.29 million. The bill is not clear on what to use as an inflation index. I used the Consumer Price Index for All Urban Consumers (CPI-U) comparing March 1981 (94.5) to February 2010 (216.741).

The Private Fund Investment Advisers Registration Act passed by the House in the Wall Street Reform and Consumer Protection Act of 2009 (H.R.4173) required the SEC to start increasing the asset levels. The Dodd bill (still not in the Thomas system) takes the issue on more forcefully.

The result is that there will be fewer investors for private investment funds. Under and , you are limited to 35 non-accredited investors in a private fund offering, with an unlimited number of accredited investors.

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