During October and November 2010, the U.S. Securities and Exchange Commission proposed several key regulations called for by the Dodd-Frank Wall Street Reform and Consumer Protection Act, which Congress passed and President Obama signed into law in July 2010. We published a First Alert client bulletin summarizing Dodd-Frank's impact on private equity funds at that time, which may be viewed here. As we indicated in our previous First Alert bulletin, Congress delegated certain critical elements of Dodd-Frank's implementation to the SEC. Now, through its rulemaking proposals in October and November 2010 (the Proposed Regulations) which are summarized below, the SEC has begun to fill in a number of important details left unspecified by Congress in the original legislation.
The Proposed Regulations affect all private funds which claim exemption from the Investment Company Act of 1940 under Section 3(c)(1) or 3(c)(7) of that statute. This includes practically all hedge, leveraged-buyout, venture-capital, real-estate, mezzanine-debt, and distressed-debt funds, as well as funds-of-funds. As they relate specifically to private funds, the Proposed Regulations do three major things:
- First, they propose definitions and details regarding certain exemptions from registration with the SEC under the Investment Advisers Act of 1940 (the Advisers Act). (Dodd-Frank eliminated, effective in July 2011, the exemption which most private funds had been relying on until now, replacing it with new exemption criteria.)
- Second, the Proposed Regulations would require every firm that serves as an investment adviser to any 3(c)(1) or 3(c)(7) fund to file with the SEC and update annually a Form ADV. This requirement would apply even to smaller advisory firms which will remain exempt from registration because their assets under management are below Dodd-Frank's registration threshold.
- Third, the Proposed Regulations would impose new recordkeeping and reporting requirements on registered investment advisers.
Key definitions and details included in the Proposed Regulations
Advisers whose only clients are private funds and whose assets under management (AUM) are less than $150 million will generally remain exempt from registration under the Advisers Act when Dodd-Frank becomes effective in July 2011. (For advisers who have at least some non-fund clients, the applicable AUM threshold is $100 million.) The Proposed Regulations give guidance on how AUM is to be measured for this purpose.
Advisers whose only clients are venture capital funds will remain exempt from registration, regardless of the amount of their AUM. The Proposed Regulations would define the term "venture capital fund" for this purpose.
Advisers who qualify as "family offices" will also remain exempt from registration under the Advisers Act, regardless of the amount of their AUM. The Proposed Regulations would define the term "family office" for this purpose.
Exemption for advisers to private funds with cumulative AUM less than $150 million
The Advisers Act defines the term "assets under management" by reference to the "securities portfolios" with respect to which an investment adviser provides "continuous and regular supervisory or management services." The Proposed Regulations provide guidance on the calculation of AUM for private funds, as follows:
- An adviser to a private fund must include the fund's unfunded capital commitments in its AUM.
- An adviser to a private fund must include the value of proprietary assets, assets which the adviser manages on an uncompensated basis, and assets of foreign clients in its AUM.
- Advisers must use a fair-value methodology when measuring AUM, and cannot simply rely on cost basis.
Exemption for advisers to venture capital funds
Dodd-Frank exempts advisers solely to venture capital funds from registration under the Advisers Act. The Proposed Regulations define the term "venture capital fund" to include only private funds which satisfy all of the following criteria:
- The private fund invests only in equity securities of qualifying portfolio companies to provide them with business expansion and operating capital. At least 80% of the private fund's interest in the issuing company must be acquired directly from the company and not from the issuer's existing equity holders. An issuer can be a qualifying portfolio company if no more than 20% of the private fund's interest was acquired from founders or other preexisting investors.
- The private fund controls, or provides significant managerial services to, the qualifying portfolio companies.
- The private fund does not incur leverage at the private fund level, other than certain permitted short-term borrowings.
- The private fund is a closed-end fund, i.e., it does not offer routine redemption rights to investors.
- The private fund holds itself out as a venture capital fund to investors.
To be a "venture capital fund" a private fund may invest only in "qualifying portfolio companies." The Proposed Regulations define that term to include only an entity which satisfies all of the following criteria:
- is not publicly traded at the time of the venture capital fund's investment,
- does not incur leverage in connection with the investment by the venture capital fund,
- uses the capital provided by the venture capital fund for business expansion or operating purposes, and
- is not itself a fund.
Exemption for Family Offices
Dodd-Frank exempts family offices from registration under the Advisers Act. The Proposed Regulations define "family office" as an adviser whose clients include only persons who are family members. A "family member" includes a spouse, a spousal equivalent, a subsequent spouse, a parent, a sibling, a child (including children by adoption and stepchildren), and a spouse or spousal equivalent of the foregoing.
In the event of an involuntary transfer from a family member, the Proposed Regulations would afford the adviser a four-month transition period in which to register under the Advisers Act or transfer the management of the assets. In case of a divorce, a former spouse could continue to receive advice for the assets already being managed by the family office, but could not make additional investments with such adviser.
The clients of a family office may include any charitable organization that is funded solely by a family member, and any trust or estate existing for the sole benefit of a family client, or any investment vehicle wholly-controlled by a family client and operated for the sole benefit of family clients. Clients may also include non-family members who are executive officers, directors, trustees or general partners of the adviser, or other persons who have participated in the investment activities of the family office for at least 12 months.
New filing requirements for advisers exempt from registration
Under the Proposed Regulations, all investment advisers which are exempt from registration under the Advisers Act, but whose clients include any 3(c)(1) or 3(c)(7) private fund, would nevertheless be required to comply with certain limited reporting obligations. These exempt advisers would be required to file a limited Form ADV with the SEC and provide certain information about their activities to the SEC. The information required to be reported would include, among other things, the adviser's form of organization, a description of its other business activities, its financial industry affiliations, the identity of its control persons and owners, and any disciplinary history for the adviser and its employees.
The Proposed Regulations would require exempt advisers to file their first limited Form ADV by August 20, 2011, and to update their Form ADV filings annually.
Additional Reporting for Advisers to Private Funds
The Proposed Regulations amend Form ADV for a registered adviser to a private fund (exempt advisers will also be required to provide certain of this information in its limited Form ADV) in order to require reporting of the following information:
- The amount of AUM.
- Information regarding its private funds, including: (1) names and jurisdictions of such funds (though a code can be used to preserve anonymity); (2) general partners and directors; (3) names and jurisdictions of any foreign financial regulatory authorities are subject; (4) status as a master/feeder.
- Whether private fund is a fund of funds.
- The fund's investment strategy. The fund's gross and net asset value, minimum investment and number of beneficial owners.
- Whether clients of the adviser are solicited to in the fund, and the percentage of the adviser's clients invested in the fund.
- The number and types of investors in the fund.
- The name of the adviser's auditor, whether it is independent and registered with the PCAOB and whether audited financials are distributed to investors.
- The name of the adviser's prime broker and whether it is SEC-registered and acts as a fund's custodian.
- The name and role of the fund's administrator.
- The name of each marketer, whether it is a related person of the adviser, its SEC file number and URL for any website used to market the fund.
- Information regarding employees, including the number employees registered as representatives of a broker-dealer.
- Information regarding the adviser's clients, including disclosure as to whether any are business development companies, insurance companies or other investment advisers and whether any are subject to ERISA.
- Disclosure about participation in client transactions: The Proposed Regulations require advisers with discretionary authority to determine whether brokers or dealers used in client transactions would be required to report whether any such brokers or dealers are related persons.
- Information about the adviser's non-advisory activities.
- Advisers with $1 billion in AUM may be subject to future rules regarding certain incentive-based compensation arrangements.
The Proposed Regulations begin the process of providing details which are critical to understanding how Dodd-Frank will ultimately impact advisers to private funds. We will continue to monitor the rulemaking process, submitting our own comments to the SEC where appropriate, and to report on significant legislative and regulatory developments affecting private funds.