Mitt Romney puts his business background at the front of his campaign message. As the current front-runner for the Republican nomination, his background is going under increased scrutiny. Since his business background is in private equity, the industry should stop and wonder whether all of this publicity will be good or bad for private equity.
Hopefully people will not be as confused by private equity as they are with whether “Mitt” is short for Mittens. In listening to hearings on private equity and venture capital, many congressmen seem to think that private equity is only about leveraging healthy companies with lots of debt, firing lots of the employees, then quickly ripping them apart, and selling the pieces. If successful. Otherwise, they fire most of the employees and merely plunge their portfolio companies them into bankruptcy.
Certainly, Bain Capital made money for its investors. The Wall Street Journal found that Bain produced about $2.5 billion in gains for its investors who had put in $1.1 billion in capital.
Even in the Walk Street Journal story, there is a disagreement about the right measuring stick and which failures should be attributed to Bain. In some cases, the failure came after a partial Bain exit.
Of course, the statistics can’t cover what would have happened to the business if Bain failed to step in or private equity failed to take an interest. They may have failed anyway.
I suspect the answer to whether private equity is good or bad will be twisted around Mitt Romney. His supporters will laud his business success and his detractors will attack his job cuts and business failures. (I lived with Mitt Romney as governor and don’t have a position on candidacy. He was mostly limited by the state legislature in what he could do, a similar position that Congress limits Presidential action. )
In the end, private equity will likely come out of the election cycle bruised and battered.
Private equity transactions are not outside the scope of enforcement by the Securities and Exchange Commission. The SEC filed a case against a former principal of an investment adviser that manages private equity funds. The charge is that he “usurped …[a] lucrative investment opportunity in a private company.” At this point, the SEC has only filed for a cease and desist order and has not proven the allegations against Matthew Crisp.
Crisp worked for Adams Street Partners, a private equity firm registered with the SEC as an investment adviser. In 2006 and 2007, Adams Street was looking at investing in TicketsNow. Crisp was assigned as the lead sponsor of the possible investment. They decided to go ahead, but the investment was greater that their typical investment amount so Crisp decided to syndicate a portion of the committed investment.
Crisp decided to create his own investment fund and take a portion of the syndication. Adams Street contends that Crisp was not authorized to syndicate the investment to his own fund. He also increased the size of his fund’s allocation.
The SEC contends that the resulting decrease in the size of the Adams Street’s collective investment in TicketsNow was a misappropriation of a lucrative investment opportunity that should have gone to Adams Street. The SEC alleges that Crisp did not disclose his involvement to Adams Street. That would include failing to report the involvement on his periodic compliance disclosures. Failure to disclose such information was a violation of the Adam Street’s fiduciary duties and of it’s policies.
It turned out to be a good investment because TicketsNow was sold to a competitor a year later.The investment tripled their invested capital.
The SEC alleges that this was not a single instance of malfeasance. They claim that Crisp tried again with an investment in Sherman’s Travel. He took a syndication in that investment in his own investment fund.
Adams Street discovered the problem and, after conducting an internal investigation, terminated Crisp. Thy also took the next step and self-reported the matter to the SEC.
The SEC alleges that Crisp violated Sections 206(1), 206(2), and 206(4) of the Advisers Act. They extend this through Rule 206(4)-8 which prohibits fraudulent activity by advisers to pooled investment vehicles with respect to investors or prospective investors.
In the alternative, the SEC contends that Crisp aided and abetted Adams Street’s violation of Sections 206(1), 206(2), and 206(4) of the Advisers Act, extended through Rule 206(4)-8.
Further, the SEC alleges that pursuant to the actions outlined above, Crisp willfully violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder.
The cease and desist proceeding is being instituted to determine whether the allegations noted are true and what remedial action is appropriate. Crisp already returned a large portion of his returns to Adams Street.
As more private equity fund managers are going to be registered with SEC in the next six months, I found this case to be an interesting example of SEC enforcement in the industry. Assuming that Crisp actually did what the SEC alleges, such activity should be a violation of the firm’s conduct policy and a violation of it’s funds’ partnership agreements. Investors generally will impose a contractual obligation on the fund manager to not divert investment opportunities to employees and principals of the fund manager.
So how does SEC enforcement help in this area? I suppose it adds the scare factor of a government investigation on top of losing your job and professional reputation.
The Small Business Capital Access and Job Preservation Act, H.R. 1082, took another step forward this week when it was approved by the House Committee on Financial Services. It still has a long way to go before coming law so this is no time to stop getting your compliance infrastructure in place.
The bill still defers the definition of “private equity fund” to the Securities and Exchange Commission and gives the SEC six months to come up with that definition. Even assuming the bill passes and passes quickly, you would not know if you fit into this exemption until very close to the March 30, 2011 filing deadline under the Investment Advisers Act.
The bill has been revised and now imposes a leverage limitation.
“provided that each such fund has not borrowed and does not have outstanding a principal amount in excess of twice its invested capital commitments.”
I think that limitation would prohibit the use of a subscription secured credit facility by a private equity fund if they wanted to take advantage of this exemption. That borrowing is used prior to calling capital and to provide liquidity without calling capital. It makes it easier for the fund manager to smooth out capital calls to investors.
Beyond that facility, It’s not clear to me whether that limitation would include debt at the portfolio level. In reading the minority view at the end of the committee report (.pdf), they think the leverage limitation excludes leverage in the portfolio companies.
Unfortunately, the committee report comes across as very partisan and attacks Dodd-Frank as a whole. To me that would only seem to decrease the likelihood that the House as a whole will take the bill seriously.
Dodd-Frank set a July 21 deadline for changes to the Investment Advisers Act in Title IV: The Private Fund Investment Advisers Registration Act. This included the expiration of the private adviser exemption from registration under the Investment Advisers Act, the addition of an new exemption for “venture capital fund advisers” and the increase in the threshold for registration with the SEC to $100 million.
With the increase in the registration threshold to $100 million, about 4,000 investment advisers will be moved to the state authorities for supervision. Many states are still in the middle of revising their statutes and regulations to deal with the changes.
Since the SEC has a 45 day review period on the Form ADV, the filing deadline in June 6. That’s just two weeks away. Throw in Memorial Day weekend in the middle of that to lose a few more days.
In April, the SEC hinted that they would extend the July 21 deadline. The IARD registration system would not be ready for the new Form ADV until the end of 2011. It sounded like the SEC is not ready.
I think it’s unrealistic for the SEC to release the new regulations and forms in the next two weeks and expect their regulated constituents to be able to pull the pieces together. Actually, it’s probably unrealistic to expect that the SEC will be ready in the next two weeks. They keep talking about have the regulations in place by July 21. That’s 45 days too late. Looking at this week’s SEC meeting, the subject is not on the agenda.
This week, I’m sitting down to start registering on the old Form ADV. The boxes don’t fit very well and some of the dollar amounts are wrong. It may be a waste of time, but we are out of time.
To entertain myself in the face of this deadline, I present the deadline post-it video
In earlier versions of Dodd-Frank, when it was being formulated in the House committee, there was an exemption for private equity fund managers from registration under the Investment Advisers Act. It also had an exemption for venture capital fund managers. Only the venture capital exemption managed to survive.
Of the many attempts to cut back on Dodd-Frank, at least one bill is slowly moving forward. The Small Business Capital Access and Job Preservation Act, H.R. 1082, would exempt advisers to private equity funds from SEC registration under the Investment Advisers Act.
The bill is straightforward:
Except as provided in this subsection, no investment adviser shall be subject to the registration or reporting requirements of this title with respect to the provision of investment advice relating to a private equity fund or funds.
It still leaves you with issue of how to define “private equity fund or funds.” The SEC would have 6 months to define the term. Even if the SEC extends the deadline for registration and even if this bill gets passed quickly, that would leave a very narrow window for a private equity fund manager to determine if they need to register.
The first contingency seems destined. Most fund manager CCOs that I’ve talked to are not expecting the July 21 deadline to be in place. Everyone is expecting the deadline to be extended into the first quarter of 2012. They’re just wondering what is taking the SEC so long to make it official.
The bigger question is whether this bill be passed quickly and whether it will be passed at all. Certainly there is some legislative support for the exemption. It had been in earlier versions of Dodd-Frank. The risks of private equity are not the same risks as hedge funds. On the other hand, the some Congressional testimony about the bill focused on the leverage buyout sector of private equity. Many associate this high leverage business model with all of private equity.
The bill was forwarded by the Subcommittee on Capital Markets and Government Sponsored Enterprises to the full House Committee on Financial Services. It still has a long way to go and its future is uncertain. Continue moving forward with implementing your compliance program.
For those of you who need a brush-up on the legislative process, Schoolhouse Rocks still tells it best:
The U.S. is investigating Allianz SE, for possible bribery by a German printing press company in which it holds a majority stake according to a story by Joe Palazzolo in WSJ.com’s Corruption Currents.
The Foreign Corrupt Practices Act bars US companies from paying bribes to foreign officials to keep or obtain business. The SEC claims jurisdiction over Allianz under the FCPA because it was listed on the New York Stock Exchange until October 2009.
FCPA investigations are a dime a dozen, so I didn’t pay much attention to this one a first. But then I noticed something different about this one. The company accused of bribery is Manroland AG a private equity portfolio company of Allianz.
This raises the specter that federal regulators are looking at the private equity industry as the next area for increased enforcement under the FCPA. At least, Tom Fox raises that possibility.
The additional FCPA challenge in the private equity industry is what level of control and ownership will be required to pass the liability up to the parent. Past actions have shown that when you purchase a company, you purchase the FCPA liabilities. Will other forms of acquisitions continue FCPA liability and pass it up the ownership chain? What if a transaction is structured as a purchase of a company’s assets instead of the ownership of the company? That traditionally severs most liabilities. What if ownership is just a minority interest? How much of a say over management will trigger FCPA liability being passed to a minority owner? One board seat? A majority of board seats?
The hard work has begun as federal regulators are trying to implement the provisions of Dodd-Frank. The law pushed lots of the detail out to the agencies so there are lots of unanswered questions.
One of the hot button issues was what to do with financial institutions that were too big to fail. Dodd-Frank came up with the concept of “systemically important.” They created a new entity, the Financial Stability Oversight Council to come up with a definition, figure who should get that designation and design safeguards for those designees.
Private equity lost the battle to get an exemption from registration under the Investment Advisers Act. It may have to fight another battle to avoid the “systemically important” label.
The Independent Community Bankers of America, a major trade group for community banks, said General Electric Co.’s GE Capital and private-equity firms Carlyle Group, KKR & Co.’s Kohlberg Kravis Roberts & Co. and Blackstone Group LP should be tagged as systemically important.
Private equity doesn’t belong in that group, shot back Blackstone spokesman Peter Rose. “We do not trade, we have no leverage at the parent-company level, our investments are clearly disclosed and transparent, our investors are with us for the long term,” he said. “Therefore there is no possibility of a, quote, ‘run on the bank.’ ”
may determine that a U.S. nonbank financial company shall be supervised by the Board of Governors and shall be subject to prudential standards, in accordance with this title, if the Council determines that material financial distress at the U.S. nonbank financial company, or the nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the U.S. nonbank financial company, could pose a threat to the financial stability of the United States.
The term “U.S. nonbank financial company” means
a company (other than a bank holding company, a Farm Credit System institution chartered and subject to the provisions of the Farm Credit Act of 1971 (12 U.S.C. 2001 et seq.), or a national securities exchange (or parent thereof), clearing agency (or parent thereof, unless the parent is a bank holding company), security-based swap execution facility, or security-based swap data repository registered with the Commission, or a board of trade designated as a contract market (or parent thereof), or a derivatives clearing organization (or parent thereof, unless the parent is a bank holding company), swap execution facility or a swap data depository registered with the Commodity Futures Trading Commission), that is–
(i) incorporated or organized under the laws of the United States or any State; and
(ii) predominantly engaged in financial activities, as defined in paragraph (6).
[102(a)[4)]
A company is “predominantly engaged in financial activities” if–
(A) the annual gross revenues derived by the company and all of its subsidiaries from activities that are financial in nature (as defined in section 4(k) of the Bank Holding Company Act of 1956) and, if applicable, from the ownership or control of one or more insured depository institutions, represents 85 percent or more of the consolidated annual gross revenues of the company; or
(B) the consolidated assets of the company and all of its subsidiaries related to activities that are financial in nature (as defined in section 4(k) of the Bank Holding Company Act of 1956) and, if applicable, related to the ownership or control of one or more insured depository institutions, represents 85 percent or more of the consolidated assets of the company.
[102(a)[6)]
Those are some very wide open definitions for who could be considered “systemically important.”
(A) The extent of the leverage of the company;
(B) The extent and nature of the off-balance-sheet exposures of the company;
(C) The extent and nature of the transactions and relationships of the company with other significant nonbank financial companies and significant bank holding companies;
(D) The importance of the company as a source of credit for households, businesses, and State and local governments and as a source of liquidity for the United States financial system;
(E) The importance of the company as a source of credit for low-income, minority, or underserved communities, and the impact that the failure of such company would have on the availability of credit in such communities;
(F) The extent to which assets are managed rather than owned by the company, and the extent to which ownership of assets under management is diffuse;
(G) The nature, scope, size, scale, concentration, interconnectedness, and mix of the activities of the company;
(H)The degree to which the company is already regulated by 1 or more primary financial regulatory agencies;
(I) The amount and nature of the financial assets of the company;
(J) The amount and types of the liabilities of the company, including the degree of reliance on short-term funding; and
(K)Any other risk-related factors that the Council deems appropriate.
[113(a)(2)]
Hearing
Then it takes 2/3 of the voting members of the Council, including the Chairperson, to make the designation [113(a)(1)]. Then the financial company designated as systemically important has 30 days to request a hearing and another 30 days to submit material. [113(e)(2)] The Council has 60 days to make a final determination.
Too Big to Fail
This provision of Dodd-Frank is the Anti-AIG and to some extent the Anti-Lehman Brothers portion of the law.It is one of the many ways the law tries to address Too Big to Fail.
Capital has many forms and is made available in many ways. The U.S. government thought AIG was too big to fail because of its size and interconnectedness. They didn’t think Lehman Brothers was too big to fail, but I think they were wrong about that.
Back to the Finger Pointing
Now that the Financial Stability Oversight Council is trying to define Too Big to Fail as systemically important, the finger pointing has begun. Industries and companies are saying “not me” and saying that others should be included.
The problem is that once you are designated “systemically important” it’s not clear what additional burdens will be placed on you and whether there will be any benefit to the designation. It seems the Council has the flexibility to craft different requirements for different companies and different industries.
It may boost your ego to be considered “systemically important” but it will also lead to a regulatory headache. Private investment firms are not exempt from the designation and could be tagged.
If you do the math, 19 of the top 30 are already registered with the SEC as Investment Advisers. I expect to see several more in the “yes” column before July 21, 2011, the registration deadline under Dodd-Frank.
The PERE 30 measures capital raised for direct real estate investment through commingled vehicles, together with co-investment capital, over the past five years.
On Friday, The Securities and Exchange Commission will be considering rules that should be of interest to private investment fund managers.
It looks like we may have the first look at how the SEC will define a venture capital fund and who will fit into that new exemption to registration under the Investment Advisers Act. Section 407 of Dodd-Frank puts the onus on the SEC to define ‘venture capital fund.’
My guess is that the definition will be very narrow and many venture capital fund managers will not be happy with the definition.
Open Meeting – Friday, November 19, 2010 – 10:00 a.m.
The subject matter of the Open Meeting will be:
The Commission will consider whether to propose new rules and rule amendments under the Investment Advisers Act of 1940 to implement provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act. These rules and rule amendments are designed to give effect to provisions of Title IV of the Dodd-Frank Act that, among other things, increase the statutory threshold for registration by investment advisers with the Commission, require advisers to hedge funds and other private funds to register with the Commission, and address reporting by certain investment advisers that are exempt from registration.
The Commission will consider whether to propose rules that would implement new exemptions from the registration requirements of the Investment Advisers Act of 1940 for advisers to venture capital funds and advisers with less than $150 million in private fund assets under management in the United States. These exemptions were enacted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The proposed rules also would clarify the meaning of certain terms included in a new exemption for foreign private advisers.
The Commission will consider whether to propose new rules under Section 763(i) of the Dodd-Frank Wall Street Reform and Consumer Protection Act governing the security-based swap data repository registration process, the duties of such repositories, and the core principles applicable to such repositories.
The Commission will consider whether to propose Regulation SBSR under Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act to provide for the reporting of security-based swap information to registered security-based swap data repositories or the Commission and the public dissemination of security-based swap transaction, volume, and pricing information.
At times, changes in Commission priorities require alterations in the scheduling of meeting items. For further information and to ascertain what, if any, matters have been added, deleted or postponed, please contact: The Office of the Secretary at (202) 551-5400.
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.
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 Restoring American Financial Stability Act would exempt private equity firms from having to comply with the custody rule since they would not have to register. The House’s Wall Street Reform and Consumer Protection Act 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.)
