On June 22, 2011, the Securities and Exchange Commission (SEC) adopted final rules called for by the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), which Congress passed and President Obama signed into law in July 2010. As discussed in numerous Calfee First Alert bulletins throughout the past year, Dodd-Frank affects virtually every kind of financial institution in the United States. Title IV of Dodd-Frank is called the Private Fund Investment Advisers Registration Act of 2010 (Registration Act). The Registration Act affects all private funds that claim exemption from the Investment Company Act of 1940 under Section 3(c)(1) or 3(c)(7) of that statute (private funds). This includes practically all hedge, leveraged-buyout, venture capital, real estate, mezzanine-debt, and distressed-debt funds, as well as funds-of-funds. These final rules implement significant portions of the Registration Act.
As discussed in Calfee's First Alert bulletin on June 23, the final rules extend the deadline for previously exempt investment advisers to register under the Investment Advisers Act of 1940 (Advisers Act) until March 31, 2012.
In addition to this delay, effective July 21, 2011, the final rules implement the Registration Act by, among other things,
- Detailing the exemption for investment advisors that solely provide investment advice to private funds with less than $150 million in assets under management;
- Defining "venture capital funds" (which, as dictated by Dodd-Frank, are exempt from registration);
- Defining "family offices" (which are exempt from registration);
- Detailing the requirement that U.S. advisers with less than $100 million in assets under management not be permitted to register as an investment adviser with the SEC;
- Detailing reporting requirements for certain advisers exempt from registration; and
- Detailing expanded reporting obligations for registered advisers to private funds.
PrivateFund Adviser Exemption - Less than $150 Million in Assets Under Management, Including Uncalled Capital Commitments
The final rules amend the Advisers Act to exempt advisers from registration under the Investment Advisers Act if such adviser (1) acts solely as an adviser to private funds (including any vehicle exempt under Section 3 of the Investment Company Act, not just under Section 3(c)(1) and 3(c)(7)); and (2) has assets under management in the United States of less than $150 million (importantly, if the adviser is based in the United States, all of its private fund assets would be considered "in the United States" even if the adviser has offices outside the United States).
The final rules define "assets under management" as the fair value of assets over which the adviser exercises "continuous and regular supervisory or management services," including proprietary assets, assets managed without compensation and, significantly, the value of uncalled capital commitments. Advisers may use GAAP, other international accounting standards and other valuation standards used consistently in good faith to determine fair value. Assets under management must be determined on a gross basis (without deducting liabilities such as accrued fees and expenses or the amount of any borrowing).
The SEC may, depending on the facts and circumstances, view two or more separately formed advisory entities, each of which with less than $150 million in private fund assets under management, as a single adviser for purposes of assessing the availability of exemptions from registration.
An adviser that becomes ineligible to continue relying on the private fund adviser exemption because the value of its private fund assets under management exceeds $150 million will have a 90-day transition period from the filing of its annual amendment to Form ADV to register with the SEC. This transition period is only available to an adviser that has complied with applicable reporting requirements (see below).
Exemption for Venture Capital Funds
The Registration Act also provides that advisers that solely advise "venture capital funds" are exempt from registration under the Advisers Act.
The final rules define a "venture capital fund" as a fund that (1) holds no more than 20 percent of the amount of the fund's aggregate capital commitments in "non-qualifying investments" (other than short-term investments); (2) does not incur leverage apart from a limited amount of short-term borrowing; (3) does not offer investors non-extraordinary redemption rights; (4) represents itself as a venture capital fund to investors; and (5) is a private fund.
Significantly, the final rules remove a requirement in the proposed rules that required the venture capital fund to control or be involved in the management of qualifying portfolio companies.
"Qualifying investments" are defined as equity securities issued by a "qualifying portfolio company" directly acquired by the fund from the company (not existing shareholders). The definition also includes "equity securities issued by the qualifying portfolio company that are received in exchange for directly acquired equities issued by the same qualifying portfolio company" and "any equity security issued by a company of which a qualifying portfolio company is a majority-owned subsidiary, or a predecessor, and that is acquired by the fund in exchange for directly acquired entity." These provisions permit a venture capital fund to participate in a reorganization of the capital structure of a portfolio company and to acquire securities of another company in a merger involving the securities of a qualifying portfolio company.
Qualifying Portfolio Company
The final rules define a "qualifying portfolio company" to be any company that:
- Is not a reporting company or a foreign traded company at the time of investment by the venture capital fund.
- Does not incur leverage in connection with the investment by the venture capital fund. The final rules prohibit qualifying portfolio companies from incurring leverage in connection with the investment by the fund and distributing the proceeds of such borrowing to the venture capital fund in exchange for the venture capital investment. (Therefore, subsequent distributions of financing proceeds to a fund would not be prohibited.)
- Is not a fund. A qualifying portfolio company may not be a private fund or investment company. However, a venture capital fund may utilize a wholly-owned intermediate company formed solely for tax, legal or regulatory reasons to hold the venture capital fund's investment in the qualifying portfolio company.
An important change from the proposed rules permit venture capital funds to invest up to 20% of their capital commitments in "non-qualifying" investments, such as publicly-traded companies, debt or other investments that do not meet the criteria for "qualifying investments."
Family Office Exemption
The final rules define "family offices." The Registration Act specifically exempts "family offices" from registration under the Advisers Act, but left it to the SEC to define "family office." The final rules define a "family office" as any adviser that (1) has no clients other than "family clients," (2) is wholly owned by family clients and is exclusively controlled by one or more family members or family entities and (3) does not hold itself out to the public as an investment adviser.
"Family clients" include (1) current and former "family members"; (2) key employees of the family office; (3) non-profit organizations, charitable foundations and other charitable organizations funded exclusively by family clients; (4) estates of current and former family members or key employees; (5) trusts existing for the sole current benefit of family clients or, if both family clients and charitable and non-profit organizations are the sole current beneficiaries, trusts funded solely by family clients; (6) revocable trusts funded solely by family clients; (7) certain key employee trusts and (8) companies wholly owned exclusively by, and operated for the sole benefit of, one or more family clients.
"Family members" include all lineal descendants of a common ancestor, including by adoption, stepchildren and foster children.
In a change from the proposed rules, the final rules treat "former family members" such as ex-spouses and ex-stepchildren no differently than any other family member. The proposed rules restricted the ability of former family members from making subsequent investments with the family office.
The final rules provide for a transition period if assets under management by a family office are involuntarily transferred to a person or entity that does not qualify as a family client and the adviser may continue to advise such a client for one year following such transfer of assets.
$100 Million Threshold for Adviser Registration
To free the SEC to focus on larger investors, the Registration Act required the SEC to implement rules to increase the assets under management threshold from $25 million to $100 million for registration under the Advisers Act. The purpose of this requirement was to free the SEC to spend more time focused on larger investors. Effective July 21, 2011, generally, the minimum assets under management for SEC registration is $100 million.
The final rules require registered advisers to file an amendment to its Form ADV by March 30, 2012 and to report the market value of its assets under management to determine whether the adviser meets the revised eligibility rules for registration with the SEC. An adviser that does not meet the $100 million threshold will be required to withdraw its SEC registration no later than June 28, 2012.
Reporting Requirements for Exempt Reporting Advisers
The final rules provide that exempt advisers file a limited Form ADV with the SEC within 60 days of relying on the exemption.
This limited Form ADV would require the following information:
- Item 1 - identifying information;
- Item 2.B - SEC reporting by exemption reporting advisers;
- Item 3 - form of organization;
- Item 6 - other business activities;
- Item 7 - financial industry affiliations and private fund reporting;
- Item 10 - control persons; and
- disclosure information.
This limited Form ADV will be publicly-available and advisers must update the filing on an annual basis within 90 days of the end of the adviser's fiscal year. When an adviser ceases to be an exempt reporting adviser, it is required to file an amendment to its Form ADV applying for registration. Exempt advisers are required to file their initial Form ADVs by March 30, 2012.
While exempt advisers are not subject to regular examination, the SEC will retain authority to review the records of such adviser and would likely do so upon any indication of wrongdoing.
Additional Reporting for Advisers to Private Funds
The final rules amend Form ADV for a registered adviser to a private fund to require reporting of additional information, including the following:
- 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 a 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 by the fund, and the percentage of the adviser's clients invested 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.
- Disclosure about participation in client transactions.
- Information about the adviser's non-advisory activities.
Also, advisers with $1 billion in AUM may be subject to future rules regarding certain incentive-based compensation arrangements. On March 31, 2011, the SEC issued proposed rules relating to this disclosure, but final rules have not yet been issued.
The final rules bring some clarity to when and how Dodd-Frank will ultimately impact advisers to private funds. We will continue to monitor the rulemaking process and report on significant legislative and regulatory developments affecting private funds.