Much has been written in the short time since the adoption in December 2013 of final regulations implementing the Volcker Rule about the rule’s restrictions on the ability of banking entities to sponsor and invest in ownership interests in private equity or hedge funds or other “covered funds” as defined in the rule. Less attention has been paid to the impact of the Volcker Rule on asset managers who are not banking entities subject to the rule, who now face the loss of a significant source of capital and buy-side liquidity for the funds they manage. Many banking entities affected by the Volcker Rule are already refraining from investing in private equity and hedge funds or have already withdrawn their investments, while others are asking asset managers for investment solutions that permit their continued investment. Asset managers who understand the Volcker Rule and can design and operate new investment vehicles that are Volcker-compliant will be positioned to maintain some access to the significant source of capital that banking entities can provide. Set out below is a table that describes various types of investment vehicles, highlighting those that might be eligible for banking entities, followed by a more detailed discussion of the salient characteristics of each type, and market opportunities developing in the wake of the Volcker Rule.
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POTENTIAL FUND STRUCTURING OPPORTUNITIES FOR ASSET MANAGERS
U.S. banking entities and non-U.S. banking entities2 continue to be able to invest in private funds that either are not covered funds as defined in the Volcker Rule, or qualify for a specific exclusion from the definition of covered fund provided by the final Volcker Rule. We discuss below several of the most readily applicable alternatives under both approaches.
VEHICLES FOR NON-U.S. BANK INVESTORS
Non- U.S. domiciled private funds offered outside the United States
Non-U.S. banking entities, unlike U.S. banking entities, are free under the Volcker Rule to invest in non-U.S. investment vehicles that are not offered to U.S. persons (Foreign Funds), as these vehicles do not rely on Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940 (Investment Company Act) to be exempt from registration as investment companies, pursuant to Securities and Exchange Commission (SEC) staff interpretations of Section 7(d) under the Investment Company Act. Those vehicles should, therefore, not be treated as covered funds under the Volcker Rule. Managers should take precautions in offering and operating a Foreign Fund so as to avoid inadvertently entering into commerce in the United States, which could result in the Foreign Fund being recast as a covered fund. In this regard, particular attention should be given to marketing efforts, transferability of fund interests and the geographical location of advisory and marketing personnel. The SEC and its staff have provided guidance with respect to these issues, and the preamble to the final Volcker Rule regulations specifically recognize that this guidance is relevant to determining a non-U.S. vehicle’s status as a covered fund. Managers also must remember that a Foreign Fund that is a “4.7”3 commodity pool is a covered fund, and must therefore be mindful of the amount and type of commodity interests held by a Foreign Fund and commodity swap trading in which a Foreign Fund engages in order to avoid this designation.
A Foreign Fund that is structured as a feeder fund for a master fund could be considered a covered fund for Volcker Rule purposes if the underlying master fund relied on either Section 3(c)(1) or Section 3(c)(7). The preamble to the Volcker Rule suggests that such a structure could be integrated, with the result that a banking entity’s investment in the feeder Foreign Fund would be treated as if it were an investment directly in the underlying master fund. Consequently, the Foreign Fund option would present a clear-cut solution only in those instances involving a true stand-alone fund – including a parallel fund, which we discuss below – that does not offer any interests to U.S. persons.
While Foreign Funds (including, potentially, a feeder Foreign Fund) would be available for investment by non-U.S. banking entities, asset managers should consider including disclosures in their Foreign Fund offering documents to highlight potential Volcker Rule prohibitions for investors that are, or are ultimately controlled by, a U.S. banking entity, or at least should be willing to discuss the structure and operations of their Foreign Funds with banking entities that are potential investors as an element of their Volcker Rule due diligence. While such a Foreign Fund may not be relying specifically on Section 3(c)(1) or 3(c)(7) of the Investment Company Act and may have no apparent Investment Company Act issues, a Foreign Fund could nonetheless be a covered fund for a potential U.S. banking entity investor and a potential source of Volcker Rule compliance issues for that investor.
Parallel foreign funds
As discussed above, the final Volcker Rule regulations suggest that a feeder Foreign Fund could be integrated into a master fund that is a covered fund. As a result, an asset manager in most cases likely will not be able to accommodate non-U.S. banking entities by simply forming a new non-U.S. feeder fund for an existing master fund. An asset manager could, however, establish a parallel or side-by-side Foreign Fund to invest alongside an existing covered fund. Neither the final Volcker Rule nor the preamble contains or discusses any explicit restrictions on a parallel fund structure in which an asset manager forms a Foreign Fund to invest in parallel with the manager’s existing fund structures, including covered funds. As a precautionary measure, asset managers may wish to review SEC and staff guidance applicable to the integration of parallel funds under the Investment Company Act.
VEHICLES FOR EITHER U.S. OR NON-U.S. BANK INVESTORS
Asset managers may establish separate accounts for their U.S. and non-U.S. banking entity investors and invest the account’s assets in accordance with existing banking regulatory investment restrictions. Any investments made through a separate account and not through an entity relying on Section 3(c)(1) or 3(c)(7) of the Investment Company Act would not be an investment in a covered fund, and thus a banking entity making such an investment would not be subject to the Volcker Rule restrictions and prohibitions, unless the banking entity used the separate account to engage in impermissible proprietary trading. An asset manager seeking to establish a separate account for a banking entity should consider the tax issues related to any performance-based compensation it might receive, which would be likely to be treated as ordinary income instead of receiving capital gains tax treatment as an allocation of profit from a fund.
Similarly, a private equity fund manager could offer both U.S. and non-U.S. banking entity investors case-by-case co-investment opportunities in operating companies in which the manager’s private funds invest, as certain bank holding companies may make investments in operating companies under the relevant federal banking laws. The preamble to the final Volcker Rule regulations specifically indicates that a banking entity may invest directly in an operating company in parallel with a covered fund so long as the investment is not made for the purpose of avoiding the restrictions of the Volcker Rule, such as investments made in coordination with investments made by covered funds owned or sponsored by the banking entity.
Registered investment companies
Asset managers may offer funds registered under the Investment Company Act (Registered Funds) to banking entity investors, or may establish new Registered Funds for such investors, because Registered Funds – including closed-end funds that elect to be treated as business development companies (BDCs) under the Investment Company Act – are specifically excluded from treatment as covered funds under the Volcker Rule. Over the past three years there has been a proliferation of Registered Funds that offer alternative investment strategies that were historically available only to private fund investors, as well as a number of new BDCs, including BDCs sponsored by banking entities as a means to address the sponsorship and investment restrictions under the Volcker Rule. While the Investment Company Act imposes a number of restrictions on Registered Fund and BDC operations, asset managers with a significant volume of banking entity assets may find it worthwhile to transition those investors to Registered Funds or BDCs that follow an investment strategy that is similar to that of the private funds they manage, and would enjoy the added benefit of being able to use their Registered Funds to access U.S. retail capital.
Foreign public funds
Non-U.S. investment managers in particular are in a position to benefit from offering non-U.S. vehicles that are authorized in their home jurisdiction to offer and sell ownership interests to retail investors and that sell ownership interests predominantly through public offerings outside the United States, as such “foreign public funds” (e.g., UCITS) are not covered funds. A foreign public fund may sell up to 15% of its ownership interests to U.S. persons and remain exempt from treatment as a covered fund.
Other alternative strategy vehicles
Any vehicle that may rely on an exception from Investment Company Act regulation other than Section 3(c)(1) or Section 3(c)(7) will not be a covered fund under the Volcker Rule, and asset managers should consider whether any new or existing investment strategies can fit within any other Investment Company Act exceptions and be a viable business alternative. Potential exceptions include:
- Section 3(c)(5)(A) and (B) for certain commercial financing and lending vehicles and factoring vehicles;
- Section 3(c)(5)(C) for real estate funds (including real estate securities funds); and
- Section 3(c)(9) for vehicles that hold oil and gas interests and securities of oil and gas funds.
Each of these exceptions requires the fund to conform to certain operational limitations, such as specific asset limitations, but accommodates a virtually unlimited investor base (in contrast to Section 3(c)(7), which requires investors to be qualified purchasers, and Section 3(c)(1), which indirectly requires investors to be qualified clients).
What is a Prohibited Ownership Interest?
The Volcker Rule broadly prohibits banking entities from acquiring “ownership interests” in covered funds; it does not prohibit other kinds of investments, such as loans. The term “ownership interest” is broadly defined to include the right to receive a share of the profits or assets of a private fund (other than in exchange for services). Acquiring a debt security, in which the right to repayment is not affected by the performance or condition of the issuer or of any of its underlying assets, is permitted. The critical question of what constitutes a debt security that is not an ownership interest under the Volcker Rule is the subject of a considerable amount of industry concern, and there is potential for additional guidance from the regulators on this point.
SECURITIZATION VEHICLES FOR EITHER U.S. OR NON-U.S. BANK INVESTORS
SECURITIZATION VEHICLES UNDER RULE 3A-7 OR SECTION 3(C)(5)
In addition to the alternative investment vehicles described above, banking entities may invest in vehicles organized to qualify under Rule 3a-7 under the Investment Company Act or Section 3(c)(5) of the Investment Company Act. Static pool securitizations and certain asset repackaging platforms may be structured to meet, or may be brought into conformance with, Rule 3a-7. Section 3(c)(5) may be used by a wider variety of structures, including commercial finance vehicles, noted above in section 1.2(d), more traditional receivables and loan securitization pools, and covered bond programs.
Asset managers may have relied in the past on Section 3(c)(1) or 3(c)(7) for exemptions from registration because it was readily accepted by the market, and may not be familiar with the aforementioned exceptions. A number of existing 3(c)(1) or 3(c)(7) investment vehicles may be good candidates for restructuring to fit within other exceptions without falling within the definition of covered fund for Volcker Rule purposes. At the same time, managers should be mindful to not inadvertently cause an investment vehicle to be treated as a 4.7 commodity pool as a result of its investments in commodity interests and commodity swap trading activity, which may make it a covered fund, as discussed above.
SECURITIZATION VEHICLES UNDER SPECIFIC VOLCKER RULE EXCLUSIONS
Managers of loan securitizations and asset-backed commercial paper conduits may be able to structure these investment vehicles pursuant to qualified exclusions from the definition of covered fund in the Volcker Rule specific to those asset classes. The terms of the exclusions are relatively narrow, but within those strictures a U.S. and non-U.S. banking entity could freely invest. We discussed the specific loan securitization and ABCP exclusions, in the context of European structured finance transactions, in an earlier eAlert.
POTENTIAL NEGOTIATING AND INVESTMENT OPPORTUNITIES FOR ASSET MANAGERS
The restrictions in the final Volcker Rule regulations on the ability of banking entities to invest in ownership interests in private funds also provide asset managers with an opportunity to take advantage of banking entities withdrawing their investments in private equity funds that are no longer permissible. Large-scale withdrawals by banking entities could harm certain fund categories and asset categories, which may create an opportunity for managers to negotiate discounted withdrawal payments or distributions and to acquire assets at discounted prices. Managers should assess their investment portfolios to determine the extent of potential harm to fund investments due to their banking entity investors’ potential redemptions, and consider buying opportunities.
With respect to funds that offer interests that are more freely transferable – including securitization vehicles that issue equity and mezzanine tranches (or any other interest that would be deemed an “ownership interest” under the final Volcker Rule regulations) – asset managers may see an opportunity to purchase such interests from banking entities affected by the Volcker Rule, possibly at heavy discounts. Asset managers may also see opportunities to fill the void left by banking entities that are no longer able to sponsor the securitization and lending vehicles that have been used to fund many middle market companies, by offering financing directly to such companies that may become credit-starved.
The discussion above is an overview of certain opportunities available for asset managers that seek to accommodate U.S. and non-U.S. banking entities affected by the Volcker Rule. Members of Allen & Overy’s U.S. Asset Management Practice have significant experience in structuring and documenting the types of solutions mentioned above, and we invite you to contact one of our attorneys listed below or any other attorney in the Asset Management Practice to discuss these opportunities in more detail.