Category: Private Investment Funds

The One With a Private Fund End-Around

Bradway Financial provides traditional investment advice. More than 75% of its clients are individuals that are not classified as high net worth. It’s owner, Brian Kimball Case must have had big dreams and wanted to also invest in private equity and run a private fund. That would require some additional compliance costs that he wanted avoid. He schemed to make an end-around on the regulatory requirements.

According to the SEC order, which the parties agreed tom, Mr. Case formed a parallel adviser, Bradway Capital, to be the adviser to two private funds he formed.

Bradway Capital filed with the SEC as an exempt reporting adviser. It took this position because it was an adviser to private funds with assets under management of less than $150 million.

The SEC disagreed with this position and took the position that Bradway Financial and Bradway Capital should be treated together. The two advisers were under common control and operationally integrated. They shared the same employees, operated in the same office, and shared the same technology systems.

Investment Advisers Act Release No. 3222 at 125 (June 22, 2011) [76 FR 39645, 39680 (July 6, 2011)]. In adopting several exemptions form the registration provisions of the Advisers Act, the Commission noted that certain commenters supported, for purposes of determining an adviser’s eligibility for an exemption from registration, treating each advisory entity separately without regard to the activities of, or relationships with its affiliates. The Commission declined to adopt this view, referring to Section 208(d) of the Advisers Act, which prohibits any person from doing indirectly or through or by any other person any act or thing which would be unlawful for such person to do directly.

The SEC took the position that Bradway Capital was not acting solely as an adviser to private funds and was not exempt.

The reason Mr. Case took this approach was to avoid the expense of complying with the Custody Rule by having to pay for an annual audit or surprise examinations.

The registration problem was just the tip of the iceberg. Obviously, the private fund failed the custody rule. There were some egregious valuations issues. Bradway failed to confirm that investors in the funds were Qualified Clients in order to be eligible for incentive payments.

The final mistake was using fund assets to pay for legal costs associated with this enforcement action. The fund documents allowed payment for costs directly relating to the ongoing activities of the fund. The enforcement action was against the adviser, not the fund, so the fund should have paid the legal fees.

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Thank you,
Doug

ILPA Guidance on Subscription Lines of Credit

The Institutional Limited Partners Association (ILPA) released guidance regarding the use of subscription lines of credit facilities by private equity funds. ILPA outlines the risks and potential impact on limited partners.

As with most potential conflicts, ILPA recommends better disclosure and greater clarity for their use.

Subscription lines of credit are a great tool for a fund. It allows a quick draw on capital and gives the fund manager to give limited partners a better plan for when capital will be called.

But according to ILPA, some fund managers are starting to use the lines of credit to hold off calling capital for longer and longer periods of time.

ILPA is also concerned that disparate of use of lines of credit among different fund managers makes it hard to compare returns from one manager to another.

Some of the recommendations that caught my attention:

  1. Use the date the credit facility is drawn for calculating the waterfall instead of the capital call.
  2. Disclosure of the impact of the facility on IRR.
  3. Limit the outstanding balance to less than 25% of uncalled capital.
  4. Limit the borrowing to 180 days outstanding.

It would seem to me that if a fund agrees to the time limit for the outstanding balance, then the other 3 items are reduced. The facility is then much more about allowing the fund manager to have better speed of execution instead of a tool to manipulate returns.

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Financial Choice Act Passes the House

While the political lens was focused on the James Comey testimony, the House of Representatives passed the Financial Choice Act. The bill is big change to many of the Dodd-Frank. For private funds, the most interesting section is: TITLE IV—Unleashing Opportunities For Small Businesses, Innovators, And Job Creators By Facilitating Capital Formation.

The Financial Choice Act does some interesting things and overreaches in many other ways. I personally think Dodd-Frank missed the mark. But it was in response to the financial crisis. There was a lot of political will to pass something to hold Wall Street accountable for the financial crisis.

I don’t think there is the political will to de-regulate financial institutions, which means there is not a good political pitch for this bill. The main theme has been to provide relief to Main Street. Smaller banks are having a harder time dealing with the banking regulations. The bigger banks, with their bigger operations and bigger balance sheets, are better able to deal with the complexity and costs.

Most think the bill is dead in the Senate. Perhaps some part of it will get passed, but it will look little like the bill passed by the House.

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The Positives and Negatives of A Subscription Credit Line

I came across two competing narratives on the use of subcription credit facilities for private equity funds: (1) Howard Marks of Oaktree Capital published a memo on subscription lines of credit for closed-end funds and (2) Eileen Appelbaum’s Private Equity’s Latest Con.

Unlike hedge funds, private equity funds call capital from limited partners over time as investments are made, up to the amount of their commitment. Subscription credit facilities allow a funds to use the commitments as collateral for a line of credit.

Subscription credit facilities are substantially different than margin borrowing used by hedge funds. They do not leverage the limited partner’s capital.  It acts a temporary substitute for capital, to repaid with a later call for capital from a the limited partners. A $10 million fund can’t invest more $10 million in total, but it may delay calling that capital.

To summarize Mr. Mark’s view of the positives:

  • Less frequent capital calls
  • Quicker ability to deploy capital from a loan draw
  • The use of borrowed money can reduce or even eliminate the deleterious impact on early returns of the so-called “J-curve.”

To summarize Mr. Mark’s view of the negatives:

  • Higher expenses for the fund to pay for interest and borrowing expenses
  • Lowering the hurdle can increase the GP’s probability of collecting incentive fees and cause the payment of incentive fees to the GP to begin sooner
  • Some LPs may actually want to have their capital called and earn their preferred return.
  • Complicates the selling of LP interest in a secondary transfer
  • Disclosure of LP financial information to the lender
  • Possibility of LP default

Ms. Applebaum takes the reduction of the J Curve as a negative and calls it a “sleight of hand.” The J curve is a particular quirk of private equity as it generally requires putting more capital into an investment resulting in a negative return before that new capital starts generating an appreciation for the investment.

Ms. Applebaum and Mr. Marks both agree with the negative distortion of the IRR calculation caused by delaying the capital contributions. Mr. Marks points out that the expenses affect a fund’s overall return and the total amount of IRR. Therefore it also has a effect on the fund manager’s IRR.

Mr. Marks then takes it to the next level by pointing out that IRR is not the single metric that determines a fund’s performance. Investors should also judge a fund by the amount of the capital deployed and the total amount of cash returned to investors.

Some things that funds have done to address the negatives:

  • Limit the length a time an investment can be on the line of credit before calling capital
  • Eliminating deal-by-deal incentive payments, so that overall fund performance, including the costs of the line, are taken into account
  • Reporting overall fund performance along side deal-by-deal performance

Subscription credit facilities provide fund managers with funding flexibility and liquidity, allowing quicker execution. As with any tool, you need to manage the risks.

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Headline Risk

On Thursday, The Wall Street Journal published an article on conflicts between the top executives of some private equity firms and their personal investments: “Fund Kings Open Family Offices.”

The article focused on two aspects of the executives’ wealth management: (1) distractions from activities outside the funds and (2) conflicting investments with the funds.

On the distraction issue, the article provided conflicting views from investors. One view is that executives should have all of their own money in the firms’ funds. The other view is the more pragmatic approach that diversification makes sense as long as the outside investments are not a distraction. Primarily, the concern is that the fund is the primary beneficiary of investment ideas and the executives’ time.

The second issue comes from those “distractions.” Personal investments may intersect with the fund investments. The article identifies instances where there was an overlap and a potential conflict. The article mentions the use of “family offices” by some fund executives. Some of these family offices also invest in private equity and other opportunities that may be opportunities that also interest the fund.

I think the article is a compilation of “headline risk.” There are no wrongdoings outlined in the article. There is just the appearance of conflicts.

The private equity firms require the investments of executives to be run through compliance and a conflicts review process. I have little doubt that big private equity firms that Blackstone, Apollo and TPG would have thoughtful review processes to make sure that the potential conflicts are resolved in a way that protects the funds.

The conflict review process is internal and the transaction is private so there is little disclosure made available to the public or to reporters that may be interested. That leaves the firms open to this type of headline risk.

The more high profile the outside investments, the greater media scrutiny they attract and the greater the headline risk.

One of the Fortress Investment Group executives bought a professional sports team, one of the most high profile investments you can make.

Financial Choice Act 2.0 for Private Fund Managers

The Republican agenda is moving ahead to unwind much of the Obama Administration’s legislative and regulatory achievements. The first attempt to repeal the Affordable Care Act failed. Next up is raising the debt ceiling, tax reform and Dodd-Frank appeal. (I question how much Congress can take on at one time.)

Jeb Hensarling, Chairman of the House Financial Services Committee, had a law he was ready to move forward with and now has a second version in a discussion draft. There are good things in the Financial CHOICE Act of 2017.

General solicitation

It narrows the meaning of general solicitation. Section 452 provides that a presentation at the following is not an act of general solicitation:

  1. College or University
  2. Non-profit
  3. Angel investor group
  4. Venture forum, or
  5. trade association

provided the advertising for the event does not reference a securities offering, and the event sponsor does provide investment advice to attendees, does not charge a fee other than for administrative costs, and the issuer limits the information provided.

Clearly, this is trying to get the regulatory regime in  line with industry practice for venture capital. Issuers don’t want to be engaged in general solicitation, but the definition is too narrow.

Venture exchange

The bill contemplates the creation of marketplace for buyers and sellers of venture securities. The issuer would not have gone through an IPO. It must have a market cap of at less than $1 billion. It seems strange to use the definition of a market cap, when there is no existing market for the securities.

Regulation D and Form D

The bill slams the door on the SEC’s proposed changes to Form D. Those changes have been sitting on the SEC’s agenda for over two years.

Accredited Investor

Section 860 of the bill changes the definition of “Accredited Investor.” It keeps the two current brightline tests of income and net worth. I think those are key tests given the illiquid nature of private placements. It fixes those standards and removes Dodd-Frank’s requirement that the SEC adjust the amounts every four years.

The bill adds in a third test, allowing anyone licensed as a broker or investment adviser to also be an “accredited investor.” It adds a fourth test, allowing the SEC to create a regulatory regime for individuals to prove that the knowledge, education or job experience to allow them to invest in private placements.

We have seen from SEC Acting Commissioner Piwowar that he on board with opening up the definition of accredited investor.

Private equity fund exemption

The bigger change for private equity funds and probably for real estate funds is that it exempts “private equity fund” managers from the registration and reporting obligations of the Investment Advisors Act.

As you might expect, the bill does not take the time to define “private equity fund.” It gives the SEC six months to issue a rule for the definition.

The arguments are that private equity should be treated like venture capital. Private equity does not pose systemic risk. Private equity investors are generally sophisticated. The SEC would be more effective focusing its exam efforts on retail investment advisers.

What next?

Obviously this bill is a long way from being enacted. Chairman Hensarling is working on the pitch and has come up with the Top 10 wins for American People with the Financial Choice Act.

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Financial Choice Act

Congress is currently occupied with health care. That is just one item on the agenda for the Republican leadership in Congress and President Trump. All have mentioned in one way or another to undo some of the evils of Dodd-Frank.

The big questions is how long will it take to move the American Health Care Act through Congress and deliver a bill that President Trump will be willing to sign. The second question is whether Congress will be able to move forward with any other legislation while dealing with health care.

Whenever Congress is ready to work on other legislation, Jeb Hensarling, Chairman of the House Financial Services Committee, has a law he is ready to move forward: The Financial Choice Act.

The Financial Choice Act is the bill that he sees as undoing many of the evils of Dodd-Frank.

“As the dust begins to settle on the post-crisis response, however, there has been a growing recognition that financial regulation has become far too complex and too intrusive and places too much faith in the discretion and wisdom of bank regulators.“

It has many of the things you might expect: repealing the Volker Rule, adjusting bank capital requirements, limiting the powers of the Consumer Financial Protection Bureau, limiting the powers of the Financial Stability Oversight Council, limiting regulatory limits on community banks.

Two items struck me as particularly relevant to private funds: SEC Registration and the definition of accredited investor.

Section 452 changes the definition of “Accredited Investor.” It keeps the two current brightline tests of income and net worth. I think those are key tests given the illiquid nature of private placements. It fixes those standards and removes Dodd-Frank’s requirement that the SEC adjust the amounts every four years.

The bill adds in a third test, allowing anyone licensed as a broker or investment adviser to also be an “accredited investor.” It adds a fourth test, allowing the SEC to create a regulatory regime for individuals to prove that the knowledge, education or job experience to allow them to invest in private placements.

We have seen from SEC Acting Commissioner Piwowar that he on board with opening up the definition of accredited investor.

The bigger change for private equity funds and probably for real estate funds is that it exempts “private equity fund” managers from the registration and reporting obligations of the Investment Advisors Act.

As you might expect, the bill does not take the time to define “private equity fund.” It gives the SEC six months to issue a rule for the definition.

The arguments are that private equity should be treated like venture capital. Private equity does not pose systemic risk. Private equity investors are generally sophisticated. The SEC would be more effective focusing its exam efforts on retail investment advisers.

Obviously this bill is a long way from being enacted. These two small provisions could easily be eliminated from the final law during the legislative process. I expect health care is going to bog down Congress for a long time.

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Co-Investments and the SEC

Last year, regulators from the Securities and Exchange Commission raised concern about co-investments. The statements were vague about what was bothering the regulators.

Co-investments allow a private equity to lower its exposure to an investment and give others an opportunity to invest along side the fund at a discounted rate. It can be an opportunity to lure investors into the fund by granting them preferential treatment to co-investments. This would lower the effective management fee costs the investor pays to the manager.

Many fund investor are interested, but its hard to spread the opportunities equally out to all of those interested. Splitting the co-investment equally will result in opportunities being so small per investor that it’s not worth the time, effort and money.

The biggest concern for fund managers is execution. It takes a great deal of effort to put the capital stack together for an acquisition. The fund manager needs a potential co-investor to be able to act quickly and decisively.

From the SEC’s perspective, I assume examiners would not be happy to find fund managers dangling the possibility of co-investments as an incentive for an investor to commit to the fund and then not actually offering co-investments to that investor.

Fund managers need to be honest with investors and let them know where they stand in line for co-investments. If a fund manager has offered priority co-investment rights to certain investors, the manager disclose this.

The other concern of regulators and one which should be a concern is allocating deal costs. If the deal goes ahead, co-investors should pay their portion of the deal costs. Last year, the SEC raised concerns about broken deal costs when co-investments are used on a regular basis. The SEC felt that not all of the broken deal costs should be paid by the fund when co-investments were a routine part of the investing strategy.

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California’s Private Fund Disclosure Bill

California’s soon to be enacted new law, AB 2833, requires every California public investment fund to require its alternative investment vehicle fund managers to make disclosures regarding fees and expenses.

welcome-to-california

AB 2833 mandates that that every California public investment fund (that includes CalSTRS and CalPERS) must make the following disclosures at least annually:

  • The fees and expenses the fund pays directly to the alternative investment vehicle, the fund manager or related parties.
  • The fund’s pro rata share of fees and expenses that are paid from the alternative investment vehicle to the fund manager or related parties. In lieu of having the alternative investment vehicle provide this information, the fund may calculate it using information contractually required to be provided by the alternative investment vehicle.
  • The fund’s pro rata share of carried interest distributed to the fund manager or related parties.
  • The fund’s pro rata share of aggregate fees and expenses paid by all of the portfolio companies held within the alternative investment vehicle to the fund manager or related parties.
  • Any additional information already required to be disclosed under the Public Records Act in regards to alternative investments.

The law defines “alternative investment” as “an investment in a private equity fund, venture fund, hedge fund, or absolute return fund.” That leaves me wondering if the term is intended to include real estate funds.

 The bill applies to new contracts that the public investment fund enters into on or after January 1, 2017, and to all existing contracts pursuant to which the public investment fund makes a new capital commitment on or after January 1, 2017.

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State Line 2-welcome-to-california
CC BY
Phillip Capper from Wellington, New Zealand

Umbrella Registration

Continuing with my look at the changes to Form ADV, I spent some time looking at the new umbrella registration.

Umbrellas_at_Caudan_Waterfront_Mall

One investment adviser (“Filing Adviser”) will be able to file a single Form ADV on behalf of itself and other investment advisers (“Relying Advisers”). This tackles the problem fund managers had when the manager was a collection of separate fund advisers.

For a variety of tax, legal and regulatory reasons, private fund managers are often carved into separate legal entities even though they operate together. There may just be a collection of fund general partners, even it looks like a single adviser to the outside.

Form ADV is based on the legal entity and therefore skews the information since the separate legal entities would have to file separate Form ADVs (or is it Forms ADV?). The SEC had provided some guidance for umbrella registrations in 2012, but there were complications around ownership on Schedules A and B.

For a group of private fund advisers that operate as a single advisory business to qualify for Umbrella Registration, they must meet these five requirements:

  1. The Filing Adviser and each Relying Adviser advise only private funds and/or “qualified clients” in separately managed accounts that are otherwise eligible to invest in the private funds advised by the Filing Adviser or a Relying Adviser and whose accounts pursue investment objectives and strategies that are substantially similar or otherwise related to those private funds.
  2. The Filing Adviser’s principal office and place of business is in the United States, and all of the substantive provisions of the Advisers Act and rules apply to the Filing Adviser and each Relying Adviser.
  3. Each Relying Adviser, its employees, and persons acting on its behalf are subject to the Filing Adviser’s supervision and control.
  4. Each Relying Adviser’s advisory activities are subject to the Advisers Act and rules, and subject to SEC examination.
  5. The Filing Adviser and each Relying Adviser operate under a single code of ethics and written policies and procedures adopted and implemented in accordance with rule 206(4)-7 of the Advisers Act and administered by a single chief compliance officer in accordance with the rule.

There is a new Schedule R for information on the Relying Advisers.

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Umbrellas at Caudan Waterfront Mall by Martin Falbisoner CC BY SA