On January 25, 2011, the U.S. Securities and Exchange Commission proposed two new sets of rules relating to private equity and hedge funds called for by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. Also, a day earlier on January 24, the public comment period closed on several key regulations under Dodd-Frank that the SEC had proposed in November 2010.
Net Worth Standard for Accredited Investors
Currently, a natural person meets the net worth standard for an "accredited investor" by having a net worth of at least $1 million, either alone or together with his or her spouse. Meeting this standard is the key to being eligible to participate in non-public securities offerings that are exempt from Securities Act registration pursuant to Regulation D, which is the safe harbor exemption utilized by virtually all private equity and hedge funds.
Dodd-Frank required that the net-worth calculation for determining accredited investor status must exclude the value of the investor's primary residence. Exactly how this exclusion is to be calculated, however, was left for the SEC to decide.
Under the proposed rules, the definition of "accredited investor" would exclude the value of an individual's primary residence for purposes of the net-worth calculation. The "value of the primary residence" - which must be excluded from the individual net-worth calculation - would be determined by subtracting from the estimated fair market value of the property the amount of debt secured by the property, up to the estimated fair market value of the property. Thus, an investor's net worth would be reduced by the amount of value that the primary residence would have contributed to net worth if the residence were not required to be excluded.
The public comment period for this proposed rule closes on March 11, 2011.
Rules Regarding Disclosure Obligations of Private Funds
The SEC also issued proposed rules requiring registered investment advisers (RIAs) to report certain information to the SEC on a new form (Form PF), which the SEC will turn over to the Financial Stability Oversight Council (FSOC) for its use in monitoring risk to the U.S. financial system. The new disclosures would cover all private funds advised by the RIA.
In this set of proposed rules, the SEC appears to recognize that different types of private funds pose different degrees of risk to the financial system. The proposed rules recognize that private equity funds that invest in private companies present a lower degree of systemic risk than do hedge funds that trade frequently in public markets. To differentiate the level and timing of reporting, the proposed rules define a "hedge fund" as a private fund that has any one of the following characteristics: (1) a performance fee or allocation calculated by taking into account unrealized gains; (2) authorization to borrow an amount in excess of one-half of its net asset value (including any committed capital) or may have a gross notional exposure of twice its net asset value (including committed capital); or (3) short-selling of securities or other assets. The proposed rules define a "liquidity fund" as any private fund that seeks to generate income by investing in a portfolio of short term obligations in order to maintain a stable net asset value per unit or minimize principal volatility for investors. "Private equity" funds are defined as any private fund that is not a hedge fund, liquidity fund, real estate fund, securitized asset fund or venture capital fund.
The type and frequency of reporting on Form PF would depend on the amount of AUM managed by the RIA and the type of funds advised. For purposes of measuring AUM, the proposed rules reference the calculation of AUM proposed in the SEC's November release, which includes not only traditional measurable AUM, but also the uncalled portion of investors' capital commitments. In practice, this means that an RIA which has raised a new private fund would be required to add the entire amount of the new fund’s capital commitments to the RIA's existing AUM.
For those RIAs having cumulative private fund AUM of less than $1 billion, the disclosure on Form PF would only have to made on an annual basis, and the information to be disclosed would include the following: (i) RIA identifying information; (ii) information regarding related persons; (iii) regulatory and net AUM; (iv) disclosure regarding the types of private funds; (v) aggregate notional value of derivative positions, by fund; (vi) borrowings information, by fund; and (vii) monthly net and gross performance information, by fund.
An RIA having cumulative private fund AUM of $1 billion or more would have to complete a Form PF on a quarterly basis, providing the information indicated above, plus significantly more detail regarding the activities of its private funds, including (i) value of borrowing facilities; (ii) weighted average debt-to-equity ratio of portfolio companies; (iii) breakdown of indebtedness of portfolio companies; (iv) incidence of events of default; (v) identification of bridge loans; (vi) investments in financial industry portfolio companies; (vii) breakdown of investments by industry; and (vii) geographical breakdown of investments. Advisers to large hedge funds and liquidity funds would have to provide somewhat different information. Large hedge funds, in particular, would be subject to more detailed reporting information than large private equity funds. The identities of portfolio companies and their fair market values would generally not be required to be disclosed.
The SEC must maintain the confidentiality of the information reported on Form PF, other than when used by the SEC in an enforcement action or in other narrow circumstances.
The public comment period for this proposed rule closes 60 days after it is published in the Federal Register (which has not yet occurred).
Comment Period Regarding November Proposed Rules Closed
Calfee furnished a First Alert client bulletin summarizing proposed rules issued by the SEC in November and their impact on private equity funds at that time, which may be viewed here. As we indicated in our previous First Alert bulletin, the SEC sought comments from the public on the November proposed rules, and the period for submitting such comments expired on January 24, 2011.
As expected, the SEC received numerous comment letters, including one from us which may be viewed here. In general, the comments can be divided into three categories:
Comments Regarding the Applicability of the Investment Advisers Act of 1940 (the Advisers Act) to Private Equity Funds
Certain of the comments, including some from advisers to private equity funds which can be viewed here, here and here, made the point that there are particular provisions of the Advisers Act which do not appear to have any logical connection to the manner in which private equity funds actually operate or to the reasonable protection of private equity investors. One such provision that was cited by several commentators is the so-called "custody rule," which requires registered investment advisers holding certificated securities of private companies to hire qualified custodians to hold such certificates.
Several commentators requested the SEC to exempt advisers to private equity funds for one year in order to study how best to apply the Advisers Act to such funds.
Comments Regarding the Proposed Definition of Venture Capital Funds
Several comment letters, including one from the National Venture Capital Association (which may be viewed here), commented on the SEC's proposed definition of "venture capital funds." Dodd-Frank provided an exemption from registration under the Advisers Act for advisers to "venture capital funds" and instructed the SEC to craft a definition for such term. The November proposed rules provided such a definition (for a discussion of which, see our previous First Alert).
Comments Regarding Foreign Private Advisers
Finally, a series of comment letters (which can be viewed here and here) address the impact of the November proposed rules on non-U.S. advisers.
The January proposed rules and the November proposed rules continue the process of supplying details which are critical to understanding how Dodd-Frank will ultimately affect advisers to private funds. Calfee will continue to monitor (and where appropriate, comment on) the rulemaking process and to report on significant legislative and regulatory developments affecting private funds.