Category: Fundraising

How Do You Define AUM?

The Securities and Exchange Commission took a big step with private funds and setting a defined standard of Regulated Assets Under Management. There is still discretion in how different aspects are calculated. It works well for hedge funds and private equity funds. It starts breaking down as you have more alternative assets that fall outside the definition of “private fund” and “securities portfolio” that ties to the RAUM definition.

For real estate, INREV published a tool for defining Assets under Management: Assets Under Management (AUM) 2021.  

INREV interviewed a bunch of asset managers to figure out how they came up with their AUM numbers. The resulting paper summarizes the main components of AUM and options for each component. It’s not a prescriptive attempt to standardize AUM. It’s just a thought peice.

INREV came up with ten components. Each component has two to four different ways of treatment. For example, one component is the ownership of JV’s and co-investments, with these options:

  • 100% regardless of ownership
  • 100% if the asset is consolidated in the financials but ownership
  • 100% if asset mgmt services are provided for the asset, but ownership share only if not
  • % ownership share only

Of course you can argue that JVs may be treated differently than co-investments, so there could easily be more components and more options.

The INREV summary is a good way to think about it. With the ten components and each factor, that gets you to over 36,000 different ways to calculate AUM using the INREV breakdown.

Obviously, one driving factor is the “ask” accompanied by the AUM request. It means having to give a summary of what went into the AUM calculation.

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Marketing Rule FAQs

The Securities and Exchange Commission finally published the new Marketing Rule for investment advisers. Based on the publication date, it becomes effective on May 4. The compliance date is November 4, 2022. A frequently asked question is whether you can slowly wade into the standards of the new rule or do you have to do a full belly-flop.

Apparently, that question has become frequent enough that the SEC published a response. The answer is the full belly-flop.

“An adviser may choose to comply with the amended marketing rule in its entirety any time starting on the effective date, May 4th, 2021. Until an adviser transitions to the amended marketing rule, the adviser would continue to comply with the previous advertising and cash solicitation rules and look to the staff’s positions under those rules. The staff believes an adviser may not cease complying with the previous advertising rule and instead comply with the amended marketing rule but still rely on the previous cash solicitation rule. “

https://www.sec.gov/investment/marketing-faq

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How to do a Fundraising Incorrectly

Ettro Capital developed real estate. It’s principal, Peter Ettro must have thought that using a private fund to raise some of the capital to finance the investments would be a good idea. He raised over $4 million from 13 investors in ECM Opportunity Fund. The problem is that he made some big fundraising mistakes.

The first category of mistakes was lying to prospective investors.

From April through October 2017, Ettro claimed that the Fund’s net return since inception ranged from as low as 26.4% to as high as 56%, its blended net return since inception exceeded 20%, its realized yield was 18.67%, and its total return was 43.67%. In truth, the fund didn’t have any returns until November 2017 and it wasn’t that good.

Ettro send another investor a description of the projects the fund had in its portfolio. It listed two completed projects that had gained over $900,000 and six projects in progress. It left out a third completed project that had lost over $1.1 million.

Ettro also inflated the size of the portfolio, claiming to invested in over $50 million of real estate projects. The truth was closer to $1.5 million.

The second category of problems was engaging in general solicitation.

Ettro had filed a Form D for the fundraising and checked the “Rule 506(b)” box. That makes it a private offering and prohibits general solicitation and general advertising. Ettro made the fundraising material available on a website. THat included target returns and investor testimonials that all visitors could access.

Ettro tried to fix the problem by filing an amendment to Form D, switching to the “Rule 506(c)” box. That public-private offering allows general solicitation. The big requirement is that you have to take steps to verify the accredited investor status of your investors. Ettro had not done so. At least one investor was not accredited.

Ettro voluntarily returned the management fees back to the fund investors and has to pay a $60,000 fine to the SEC.

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Investment Adviser Marketing Rule Finally Published

After sitting in limbo for three months, the Securities and Exchange Commission finally published the Investment Adviser Marketing Rule in the Federal Register on March 5, 2021. That makes the effective date May 4, 2021 and the compliance date 18 months after that (October November 4, 2022).

So far I’ve not heard any information on why the extended delay. There were rumors of changes to the rule under the new Chair of the SEC. There were rumors of combing the publication with the rescission of some of the 50 years worth of no-action letters and other guidance. The rumors were apparently not true.

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The New Advertising Rule for Private Funds and Investment Advisers Is Still Sitting

As an early Christmas present, the Securities and Exchange Commission approved a new marketing rule on December 22, 2020. This was after a vote on the rule was suddenly canceled at an open meeting the week prior.

Now we are two months after approval of the rule, but it hasn’t yet been published in the Federal Register. So it’s not effective yet and the long runway for compliance has not been laid out.

What’s going on?

The Biden administration imposed a regulatory freeze. It’s not legally binding on Securities and Exchange Commission. Perhaps the SEC is embracing the freeze even though its not required.

In connection with the new Marketing Rule the SEC stated that it was reviewing the 60 years of guidance and no-action letters that have governing marketing under the old advertising rule. Perhaps the erasure of that guidance will be part of the final publication.

Otherwise, the SEC is giving us time to re-read the new Marketing Rule and thinking about the roadmap.

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Performance Advertising and the Funds That Weren’t There

Eric Malley decided that buying buy hundreds of luxury Manhattan residences on the cheap and leasing them to corporate tenants would be a great way to make money. He would let others in on his plan as investors. He created MG Capital Management Residential Fund III and raised $23 million from about 60 investors. It seemed successful enough that he launched a follow up Fund IV that raised $35 million.

You may be asking yourself: What about Fund I and Fund II?

The marketing materials for Fund III and Fund IV described very successful predecessor funds. In the Fund III PPM the outcome was described as

Fund I:
(1) raised $350 million of investor capital;
(2) earned a gross return on investment (ROI) of 38.99% and a net ROI of 30.81% during its six-year investment term from 2007 through 2013;
(3) outperformed the S&P 500 Index by 4.5-to-1; and
(4) sold its 74-property portfolio to two buyers for $750 million

and

Fund II:
(1) raised $55 million of investor capital in only 30 days; and
(2) achieved an average gross ROI of 38.06%,
cumulative unrealized gains on equity of 154.55%, and
a gross investment multiple of 2.55x.

In the complaint filed by the Securities and Exchange Commission, there is no evidence that these funds existed. Nor is there any evidence that MG controlled the $1.8 billion portfolio of real estate supposedly owned by the funds.

As for the Fund III and Fund IV, well, they did not perform well. According to the SEC complaint, Fund IV “earned $1.6 million in rent and incurred operating expenses of $8.3 million, resulting in net operating losses of approximately $6.7 million” and “$4.7 million in unrealized losses on portfolio investments, bringing Fund IV’s total net loss to approximately $11.4 million.”

As you might expect, MG is accused of illegally siphoning money from the funds. The SEC claims that (1) MG retained cash rebates from the sellers of the properties purchased by the funds and (2) charged the fund for unearned brokerage fees.

MG Capital and its principal Eric C. Malley are subject to civil charges by the SEC, criminal charges by the Department of Justice, and civil suits by investors. We haven’t heard their side of the story. Take the information above as a clear statement of what you should not do.

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Changes to the Definition of Accredited Investor

The Securities and Exchange Commission made some small changes to the definition of “accredited investor” last week. The changes had been first proposed last December.

The definition of “accredited investor” is at the nexus of the Securities and Exchange Commission’s missions: (1) to protect investors, (2) to maintain fair, orderly, and efficient markets, and (3) to facilitate capital formation.  If you’re an accredited investor you have access to private offerings. That enables capital formation. Private offerings are not subject to review by the SEC so they have fewer protections in place for investors. The commissioners were split on their votes to approve the changes.

Lots of arguments around the accredited investor definition are about an investor’s ability to assess risk in making the investment. I’ve long argued that the risk with a private placement is not the risk of loss, but the risk of liquidity. Some private placements are very risky and some are not. All private placements are less liquid than publicly traded securities. Tesla is at a crazy price right now, but you can sell and exit out of your position in minutes. You may not be able to exit from a private placement position for years.

The big news in the changes in the definition are the items that are missing. There were no changes to the wealth or income levels for qualification. Those levels have been unchanged for decades, broadening the pool of accredited investors with inflation.

The changes to the definition really just make some small expansions.

The SEC added a new category to the definition that permits qualification based on certain professional certifications, designations or credentials.  In conjunction with the changes, the SEC designated holders in good standing of the Series 7, Series 65, and Series 82 licenses as accredited investors. These are deemed as individuals with an ability to assess risk.

For private funds, there is an application of the “knowledgeable employee” definition over to accredited investor status. The SEC established Rule 3C-5 to allow “knowledgeable employees” to invest in their company’s private fund without having to be a “qualified purchaser”. The rule also exempts these knowledgeable employees from the 100 investor limit under the Section 3(c)(1) exemption from the Investment Company Act. However, the knowledgeable employee had to separately qualify as an accredited investor. This rule change covers that gap.

In act of progressive politics, the SEC added the term “spousal equivalent” to the accredited investor definition, so that spousal equivalents may pool their finances for the purpose of qualifying as accredited investors.

“The term spousal equivalent shall mean a cohabitant occupying a relationship generally equivalent to that of a spouse.”

There were additional marginal expansions for some investment entities.

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Proposed Regulation of “Finders” in New York

The New York Attorney General has been keeping busy. Yesterday it was a lawsuit against the National Rifle Association. There are the previous lawsuits against the Trump Foundation and the Trump Organization. I missed the April announcement of proposed changes to some of the securities regulations in New York.

One caught my eye and caught the eye of Goodwin Procter lawyers Peter W. LaVigne, Nicholas J. Losurdo, and Jana Steenholdt. New York is stepping into the gray area of regulating finders.

Finders are not quite brokers and not quite investment advisers. They don’t give financial advice. They just have a big rolodex and want it to generate some revenue.

As pointed out by the Goodwin lawyers, the classic case is in the Paul Anka No-action letter. (Yes, the crooner.) He ended up connected with ownership syndicate trying to finance the newly formed Ottawa Senators hockey team. Anka was from Ottawa and was rooting for his home team, but didn’t want to do so for free. He would hand over his rolodex but wanted a cut of the money coming in. Anka also had good lawyers and they asked the Securities and Exchange Commission to bless the arrangement.

Mr. Anka did not:

  • participate in any negotiations between the Senators and any potential investors,
  • make any recommendations to them regarding an investment in the Senators,
  • participate in any advertisement, endorsement, or general solicitation for the investment,
  • participate, in the preparation of any materials relating to the sale or purchase of the investment
  • distribute the materials to any potential investor,
  • perform any independent analysis of the sale,
  • engage in any “due diligence” activities,
  • assist in or provide financing for the investment,
  • provide any advice relating to the valuation of or the financial advisability of such an investment.

He simply let the hockey club contact the people in his rolodex.

New York is interested in finders who did a bit more than Mr. Anka. The proposed definition of a “Solicitor”:

a person who as part of a regular business, engages in the business of providing investment advice to the limited extent that such person receives compensation for introducing a prospective investor or investors to an investment adviser or federally covered investment adviser…

Solicitors are subject to the same registration and examination requirements as investment advisers, and principals and representatives of solicitors are subject to the same registration and examination requirements as investment adviser representatives…

Mr. Anka probably falls outside that definition. He wasn’t in the regular business of making introductions. It may hit many organizations that are in that business.

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Private Fund Takes a Broadside Hit for Misleading Marketing

When using a track record in marketing materials, compliance officers will focus on the numbers and how they are used to portray prior results. The Securities and Exchange Commission will also scrutinize these results when they inevitably stop by to exam registered fund managers.

Keeping the track record straight is even more difficult for a new firm. Inevitably the principals will want to market their successful investment activity at the legacy firm.

Old Ironsides Energy ran into this problem when marketing its Old Ironsides Energy II fund.

The Securities and Exchange Commission charged the firm with using misleading marketing materials that mischaracterized a large, legacy investment with strong, positive returns. Old Ironsides identified it as an early stage “direct drilling investment” over which Old Ironsides had
direct management in partnership with project operators in its legacy portfolio. However the investment was better characterized as in interest in a private fund advised by a third party.

As you might expect, the private fund’s returns were really good. Also, Old Ironsides Fund II would not be investing in private funds.

It’s not that Old Ironsides couldn’t include that private fund in its returns. It needed to better describe that investment so that potential investors could understand it.

I found it strange that the SEC also include a charge that Old Ironsides failed to implement its policies and procedures. The P&Ps included a provision that:

“prohibited the use of performance results in Old Ironsides’ marketing materials that were false or misleading, including any misleading depictions of investment performance in both form and content leading to direct or indirect implications or inferences arising out of the context of the marketing materials.”

The SEC found that the marketing materials were misleading so the P&Ps were not followed. Is the SEC trying to say that a firm should not have language like that in its P&Ps? Or is just another charge the SEC can pile on when ti finds something it doesn’t like?

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Proposed Harmonization of Exempt Securities Offerings

In what proposes to be a big change in private placements, the Securities and Exchange Commission issued a set of proposed amendments that “provide a more rational framework, eliminate complexity and increase access to capital while preserving and enhancing important investor protections.”

Offering and Investment Limits. The Commission proposed revisions to the current offering and investment limits for certain exemptions.

For Regulation A:
– raise the maximum offering amount under Tier 2 of Regulation A from $50 million to $75 million; and
– raise the maximum offering amount for secondary sales under Tier 2 of Regulation A from $15 million to $22.5 million.

For Regulation Crowdfunding:
– raise the offering limit in Regulation Crowdfunding from $1.07 million to $5 million;
– amend the investment limits for investors in Regulation Crowdfunding offerings by: not applying any investment limits to accredited investors; and revising the calculation method for investment limits for non-accredited investors to allow them to rely on the greater of their annual income or net worth when calculating the limit on how much they can invest.

For Rule 504 of Regulation D:
– raise the maximum offering amount from $5 million to $10 million.

Integration:

The current Securities Act integration framework for determining whether multiple securities transactions should be considered part of the same offering is proposed to be revised with four new safe harbor. This would be particularly useful in private fund offerings. One is strict 30-day separation between the offerings.

General Solicitation:

Demo days and similar events would be exempt from “general solicitation” restrictions.

Accredited investor verification:

The amendments would change the financial information that must be provided to non-accredited investors in Rule 506(b) private placements to align with the financial information that issuers must provide to investors in Regulation A offerings.

There would be new items to the non-exclusive list of verification methods in Rule 506(c) public-private placements.

It’s just a proposed rule. You have two months to review and provide comments.

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