Category: Private Investment Funds

Are You a CPO?

The first question is what is a CPO and why should I care? The Commodities and Futures Trading Commission decided to tighten the exemptions from registration potentially pulling some hedge funds and private equity funds that previously ignored the CFTC. Davis Polk held a webinar on this topic. Some private fund managers may get the CPO label and have to deal with the CFTC regulatory regime.

CPO is the CFTC acronym for “Commodity Pool Operator”, which refers to any person engaged in the business of soliciting investors for an investment trust operated for the purpose of trading in commodity interests.

  • Commodity interests include futures (including agricultural, metal and financial futures), commodity options and, upon the issuance of final rules under Dodd-Frank, swaps.
  • Swaps include a wide variety of transactions, including interest rate swaps, many types of currency swaps, energy and metal swaps, agricultural swaps, commodity swaps, swaps on broad-based indices, and swaps on government securities.

The CFTC has long expressed the view that transacting in any amount of futures contracts (either directly or indirectly) would cause a fund sponsor to be deemed a commodity pool operator. There is no de minimis exception in the definition. So the CFTC position results in the conclusion that fund sponsors who have interest rate swaps or foreign exchange swaps will likely be deemed to be commodity pool operators and will need to evaluate whether an exemption is available. Even a funds of funds may also be deemed to be commodity pools depending on the investment activities of underlying funds.

There used to be a broad exemption. CFTC Rule 4.13(a)(4) provides a blanket exemption from CPO registration for sophisticated investor funds (i.e., those offered to Qualified Purchasers). The CFTC has decided to rescind this exemption.

A private fund sponsor will be required to register unless each of its funds satisfies the de minimis trading limitations under the terms of Rule 4.13(a)(3). Under these requirements, either:

  • Initial margin and premiums for commodity interest transactions must be less than 5% of the liquidation value of the fund; or
  • Aggregate net notional value of commodity interest transactions must be less than 100% of the liquidation value of the fund.

In addition to those de minimis trading requirement, Rule 4.13(a)(3) is available so long as:

  • the fund is offered privately to certain types of investors; and
  • the fund is not marketed as a vehicle for trading in the commodity futures or commodity options markets.

Investors in a Rule 4.13(a)(3) vehicle may include, among others:

  • any accredited investors under Reg D; and
  • knowledgeable employees as defined under Rule 3c-5 under the 1940 Act and certain other employees.

Most private equity and real estate private equity fund should be able to meet these hurdles and can focus on the 5% margin test and the 100% net notional exposure test.

5% margin test: The aggregate initial margin and premiums for commodity interest transactions (and minimum security deposits for retail forex transactions) must be less than 5% of liquidation value of the fund (including unrealized profits and losses to date).

100% net notional exposure test: The aggregate net notional value of commodity interest positions must not exceed 100% of the liquidation value of the fund.

  • Notional value is defined by asset class.
  • Futures contracts are valued by multiplying the number of contracts by the size of the contract.
  • Futures options are based on the strike price per unit and adjusted by the option’s delta.
  • Futures contracts with the same underlying commodity may be netted across markets.
  • Notional value of swaps cleared by the same DCO may be netted, “where appropriate”.

The 5% margin test or 100% net notional exposure tests are required to be met at each time that a commodity position is established.

The CFTC has requested comments during the 60-day period beginning on Friday, February 11, 2011.  If the proposed rule is adopted, the CFTC will issue a final rule that will specify when hedge fund and other private fund managers relying on CFTC Rules 4.13(a)(3) and 4.13(a)(4) will need to revise or cease their commodity interest trading or register as CPOs (and, if applicable, CTAs) and become members of the NFA.

The text of the proposed rule can be found here: http://www.cftc.gov/ucm/groups/public/@lrfederalregister/documents/file/2011-2437a.pdf

Will Private Equity Fund Managers Get a Registration Exemption?

Early versions of Dodd-Frank had an exemption from registration for private equity fund managers, just as there is one for venture capital fund managers. Perhaps there is some hope that the private equity exemption will once again surface?

Don’t count on it.

Although I appreciate the efforts of Congressmen Hurt, Cooper, Garrett, Himes, and others. They wrote a January 30 letter to the Securities and Exchange Commission urging the SEC to “delay the March 30, 2012 registration deadline and to exempt advisers to private equity funds that are not highly leveraged at the fund level from the new registration requirements.” They point out that The Small Business Capital Access and Job Preservation Act has a new registration exemption for private equity. Unfortunately, it’s been sitting dead since it was passed by the House Financial Services Committee in June 2011.

The congressmen’s argument:

In addition, [the Congressmen] believe that requiring registration by private equity fund advisers not only misdirects resources at private equity firms but also at the Commission. As a result of private equity fund adviser registration, the Commission will have hundreds of new firms to oversee and inspect. The Commission’s resources will thus be diverted away its core responsibilities of protecting retail investors and other new oversight priorities that can contribute in a meaningful way to financial stability.

It’s a nice argument, but too late. The registration deadline is March 30, but the filing deadline is February 14. Private equity firms already have their resources allocated or are very far along in gathering them up.

I’ve heard some whispers from limited partners indicating they are concerned that private equity is fighting against SEC registration under the Investment Advisers Act. Although it’s a good regulatory scheme for hedge funds, there are many items in the scheme that is a poor fit for private equity. The insider trading requirements and custody rule are at the top of my list.

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Private Fund Managers and SEC Registration

The SEC has provided a no action letter in response to an American Bar Association request on guidance for private fund managers. The ABA requested clarification that a group of funds could use a singe registration where the fund managers are in a control relationship and conduct a single advisory business subject to a unified compliance program. The theory is that permitting a single registration (and a single Form ADV filing) to cover the entire group of related advisers would more accurately reflect the full nature and scope of the single advisory business conducted by the group. Therefore it would be more informative for advisory clients and private fund investors as well as the SEC.

The SEC agreed, subject to the following limits:

  1. The filing adviser and each relying adviser advise only private funds and separate account clients that are qualified clients (as defined in Advisers Act rule 205-3) and 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. Each relying adviser, its employees and the persons acting on its behalf are subject to the filing adviser’s supervision and control and, therefore, each relying adviser, its employees and the persons acting on its behalf are “persons associated with” the filing adviser (as defined in section 202(a)(17) of the Advisers Act).
  3. The filing adviser has its principal office and place of business in the United States and, therefore, all of the substantive provisions of the Advisers Act and the rules thereunder apply to the filing adviser’s and each relying adviser’s dealings with each of its clients, regardless of whether any client or the filing adviser or relying adviser providing the advice is a United States person.9
  4. The advisory activities of each relying adviser are subject to the Advisers Act and the rules thereunder,and each relying adviser is subject to examination by the Commission.10
  5. The filing adviser and each relying adviser operate under a single code of ethics adopted in accordance with Advisers Act rule 204A-1 and a single set of written policies and procedures adopted and implemented in accordance with Advisers Act rule 206(4)-(7) and administered by a single chief compliance officer in accordance with that rule.11
  6. The filing adviser discloses in its Form ADV (Miscellaneous Section of Schedule D) that it and its relying advisers are together filing a single Form ADV in reliance on the position expressed in this letter and identifies each relying adviser by completing a separate Section 1.B., Schedule D, of Form ADV for each relying adviser and identifying it as such by including the notation “(relying adviser).”

If I’m reading this right, it looks like you may be able to wrap the registration requirement for the general partners of funds into a single Form ADV Registration. Prior to this no action letter, I assumed you needed to have each general partner enter into an investment management agreement with the management company.

Given this, it looks like you may be able to take that item off your list of things to do in the next few weeks and merely list the general partners on the Form ADV (assuming you meet the other requirements).

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Comment Period Extended for Volcker Rule

The Securities and Exchange Commission and federal banking regulators have extended the comment period on the Volcker Rule proposed regulations from January 13, 2012 to February 13, 2012. In Release No. 34-66057, the regulators noted that the extension of the comment period is appropriate “due to the complexity of the issues involved and to facilitate coordination of the rulemaking among the responsible agencies as provided in section 619 of the Dodd-Frank Act.” The proposed rule was released in October. The Volcker Rule is scheduled to go into effect July 21, 2012.

The extension’s Release cites comment letters from the Center for Capital Markets Competitiveness of the U.S. Chamber of Commerce (November 17, 2011); American Bankers Association et al. (November 30, 2011); and Representative Neugebauer (R-TX) (December 20, 2011). The ABA letter points out the 1400 questions asked in the proposed regulations.

The Dodd-Frank Act put the Volcker Rule in place to restrict the ability of bank and non-bank financial companies to engage in proprietary trading and to limit their ability to have interests in, or relationships with, a hedge fund or private equity fund.  The concept is simple, but difficult in execution. All banks and financial institutions engage in some form of proprietary trading to hedge the risks in their loan portfolios. Add in the extensive use of securitizations. Sprinkle in the decision by the remaining Wall Street firms to become bank holding companies after the 2008 crisis to get part of the bailout. Whip it all up with the difficulties in defining a non-bank financial company.

Feel free to add handfuls of industry lobbying to the mix, depending on your level of cynicism.  For example, Representative Schweikert is asking the regulators to exclude venture capital investing under Section (d)(1)(J)

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Massachusetts Revises Proposed Private Fund Adviser Exemption

From my discussions, many real estate fund managers are still not sure if they are subject to registration under the Investment Advisers Act. The definition of “private fund” can exclude many real estate funds depending on the structure of their investments. I think the result is that you end up under the federal level of registration and in the state level of regulation. Many states are still trying to get their regulations to mesh better with the changes coming from Dodd-Frank.

One of those is my home state of Massachusetts. Back in April the Massachusetts Securities Division proposed changes to 950 CMR 12. 00 et. seq. that would alter the definition of institutional buyer found at 950 CMR 12.205(1)(a)(6) and proposed an exemption for certain “private fund” advisers. A public hearing was held on June 23, 2011. In light of the comments and the SEC’s changes in the regulatory framework since the original proposal, the Securities Division has amended the proposed regulations and is now seeking additional comment.

A public hearing is scheduled for December 6. That’s going to be a tight time frame for advisors that are trying navigate through the new regulatory framework and face a mid-February filing deadline.

Currently, Massachusetts has an exemption from registration for advisers who only clients are “institutional buyers.”

An investing entity whose only investors are accredited investors as defined in Rule 501(a) under the Securities Act of 1933 (17 CFR 230.501(a)) each of whom has invested a minimum of $50,000.

For a private fund manager, this was a great exemption since their investors would need to be accredited investors. As long they kept capital commitments at a minimum of $50, 000 they could usually take advantage of this exemption.

The proposed regulations would phase out the use of the institutional buyer exemption for new funds. The regulations would also create an exemption for private fund advisers that is better aligned with the federal exemptions.

The regulations probably will not help real estate fund advisers who are looking at state-level exemptions to avoid registration.

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Form ADV, Valuations, and Timing for New Registrations

With hundreds (thousands?) of private fund managers set to register with the Securities and Exchange Commission next quarter, the new form ADV is on the IARD system and ready for you to start uploading information.

I noticed the first problem.

Question 5 asks you to “determine your regulatory assets under management based on the current market value of the assets as determined within 90 days prior to the date of filing this Form ADV.” I expect most private fund managers to wait until the filing deadline in the middle of February. That means third quarter valuations, presumably accurate as of September 30, will be older than 90 days. For private equity firms with very illiquid assets like interests in real estate and private companies, they are unlikely to have valuations as of December 31 finalized by the middle of February. Even if they do have final valuations, they probably have not yet disclosed the final valuations to the investors in their funds.

With a normal end of March annual filing deadline for Form ADV, this is less likely to be a problem. But initial registrants need to file 45 days ahead of that deadline to meet the SEC’s 45 approval period.

Perhaps I’m missing something, but I’m wondering if anyone else has thought about this issue and how they are handling it. One option is to use the third quarter valuations and be worried about getting a negative SEC response. Another is to get valuations finalized and disclosed earlier than usual.

I’d appreciate any of your thoughts on this. You can leave a comment or send an email to [email protected]

Form PF and Private Funds

IN addition to filing Form ADV with the SEC when they register with the Securities and Exchange Commission, private fund managers will also need to start filing Form PF next year. The amount of information required by Form PF is tiered. Advisers managing less than $150 million in private funds are not required to file, as these firms are not likely to generate systemic risk within the financial industry. Smaller private fund advisers must file Form PF only once a year within 120 days of the end of the fiscal year, and report only basic information regarding the private funds they advise. This includes limited information regarding size, leverage, investor types and concentration, liquidity, and fund performance. Smaller advisers managing hedge funds must also report information about fund strategy, counterparty credit risk, and use of trading and clearing mechanisms. Larger private fund advisers must provide more detailed information than private fund advisers. For example, large hedge fund advisers managing more than $1.5 billion (this threshold was raised from $1 billion in the proposed rule) need to file additional information on Form PF. Large private equity advisers with $2 billion in assets under management (this threshold was raised from $1 billion in the proposed rule) also must submit additional information on Form PF. Altogether, the seven types of private fund defined in Form PF are: (1) hedge fund; (2) liquidity fund; (3) private equity fund; (4) real estate fund; (5) securitized asset fund; (6) venture capital fund; and (7) other private fund. For real estate private equity funds, the FORM PF defines “private equity fund” as any private fund that is not a hedge fund, liquidity fund, real estate fund, securitized asset fund or venture capital fund and does not provide investors with redemption rights in the ordinary course. So real estate funds should only have to make the shorter annual report. Regarding timeframes, smaller private fund advisers and smaller private equity fund advisers only need to file Form PF once per year. Larger hedge fund advisers must file Form PF quarterly and have 60 days after each quarter ends to submit the form. (This is longer than the originally proposed 15 days.) Most private fund advisers will be required to begin filing Form PF following the end of their first fiscal year or fiscal quarter, as applicable, to end on or after December 15, 2012. However, three categories of advisers must begin filing Form PF following the end of their first fiscal year or fiscal quarter, as applicable, to end on or after June 15, 2012:

  • Advisers with at least $5 billion in assets under management attributable to hedge funds.
  • Liquidity fund advisers with at least $5 billion in combined assets under management attributable to liquidity funds and registered money market funds.
  • Advisers with at least $5 billion in assets under management attributable to private equity funds.

One other noteworthy change to Form PF requirements is that advisers will not be required, as originally proposed, to formally certify that information submitted on Form PF is “true and correct” under penalty of perjury. SEC has chosen FINRA to accept Form PF filings. That means more use of the IARD filing system. And perhaps, moving a step closer to FINRA becoming the SRO for investment advisers. Sources:

The EU Directive On Alternative Fund Managers Is in Effect

The chaos around the Swiss Franc may be a sign of a coming crisis in the European Union. For private fund managers, a different crisis may be the new European regulatory regimes for private funds. With all of the flux in the United States over the regulation of private funds, it’s been easy to forget that the EU has been trying to put a new regulatory regime in place.

Over the summer, the official text of the Alternative Investment Fund Managers Directive (2011/61/EU)(.pdf 73 pages) was published. The European Parliament adopted the Directive in November, 2010 and the Council of the European Union adopted it in May, 2011. The EU member states will have until July 22, 2013 to update their the national laws, regulations and administrative provisions to give effect to the AIFMD.

This new EU legislation will regulate managers of hedge, private equity
and real estate funds and other alternative investment funds. It covers almost any investment fund except funds regulated under EU legislation on Undertakings for Collective Investment in Transferable
Securities (UCITS).

There are still many moving parts. The EU regulatory regime will need to be in place and there will likely be variations from country to country in the EU.

If you have European investors or operations in Europe, you have more reading to do.

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Limiting Redemptions by Limited Partners

part of the money

Hedge funds usually give their limited partners an ability to redeem their interests at certain periods during the investment period. That ability is often subject to a “gates provision” that limits a quick outflow of capital. The provision is general there to avoid a liquidity crisis in the hedge fund which could hurt the remaining investors in the fund.

The ability to use a gates provision was recently fought over in the Delaware Chancery Court. The facts are bit strange. The fund had one investor. The apparent intent was for this first investor to be the seed investor and the the fund manager would go out and get addition investor for the fund. The seed investor would also get a share of the revenue from later the management fees and incentive fees paid by later investors. In exchange, the seed investor agreed not to redeem its capital for three years. With only one investor, the gates provision sticks out like a sore thumb.

The fund was set up in late 2007; a bad time to start investing. The manager deployed little of the funds capital and had no success raising funds from other investors. By early 2009, the seed investor let the fund manager know that they would be redeeming their capital at the end of the three year lock-up.  The relationship turned sour.

[You] should remember that our right to raise the [G]ates ensures that we will continue to manage your money throughout the litigation….

[W]e are fully prepared to litigate this matter to the bitter end because we will continue to manage your money, and collect management and incentive fees, until this matter is resolved many years hence.

Sure enough, on the three year anniversary the fund manager returned only the 20% required under the gates provision to the seed investor.

The perceived problem was that the seed money agreement did not address the gates provision in the partnership agreement of the fund.  The investor argued that the seed money agreement acted as a waiver of the manager’s ability to apply the gates restriction on the third anniversary. The manager argued that it merely supplemented the gates provision by adding additional limitations on withdrawal.

There is some arguing over how the contract provisions work together, but the court also piles on a fiduciary duty on the fund manager. After all, the fund is a partnership and the manager is the general partner.

The gates provision had an outlet that allowed the general partner to waive or modify the conditions relating to withdrawals for certain large or strategic investors.

The fund manager never identified a justification for using the Gates in view of the Hedge Fund’s investment portfolio. The only motivation for raising the Gates was to enable the Paiges to continue to receive the management fees payable under the Seeder Agreement for a longer period.

The court found that it was the self-interest of the general partner rather than the good of the limited partner in the fund that kept the gate up.  The Delaware’s Revised Uniform Limited Partnership Act permits the waiver of fiduciary duties, but the waiver must be set forth clearly. [6 Del. C. § 17-1101(f)] The court found no provision in the Partnership Agreement that says that general partner does not owe fiduciary duties to the Fund and its investors.

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Image: PART OF THE MONEY.jpg by Damien du Toit

Report on Self-Regulatory Org. for Private Fund Advisers

Section 416 of the Dodd-Frank Act require the Government Accountability Office to study the feasibility of forming a Self-Regulatory Organization to oversee private funds. With the removal of the 15 clients exemption, many private fund managers will have to register for the first time by March 30, 2011. The GAO beat Congress’s deadline by 10 days when it released the report on July 11.

In Private Fund Advisers: Although a Self-Regulatory Organization Could Supplement SEC Oversight, It Would Present Challenges and Trade-offs (.pdf), the GAO does not break any new ground. The big problem is obvious: the SEC lacks the resources to examine advisory firms on a regular basis. Congress seems to be willing to put a chokehold on funding as a way of limiting the effectiveness of the Securities and Exchange Commission.

Of the 11,505 investment advisers registered with the SEC on April 1, 2011, 2,761 advisers had private funds. But only 863 of those exclusively had private fund clients.  These numbers will change dramatically on April 1, 2012 when mid-sized advisers get kicked out of SEC registration and private fund advisers are dragged in.

Challenges

Legislation would be needed to create an SRO for advisers. I think most players are unsure whether it would be a good thing or a bad thing. Given that the SRO has no form, functions, membership or governance, it’s hard to have an opinion. Private fund advisers may not like registration with the SEC, but at least it’s a known regulatory regime.

“Some of the challenges of forming a private fund adviser SRO may be mitigated if the SRO were formed by an existing SRO, such as FINRA, but other challenges could remain,” the GAO states. As for FINRA, no private fund adviser I’ve spoken to wants to be under their oversight. They don’t like the overly rule-based approach.

Rules versus principles

The GAO report highlights one of the big differences between FINRA’s approach and the SEC’s approach. SROs, like FINRA, traditionally use a rules-based approach, in part, to address the inherent conflicts of interest that exist when an industry regulates itself by minimizing the degree of judgment an SRO needs to use when enforcing its rules. The SEC regime for investment advisers is primarily principles-based, focusing on the fiduciary duty that advisers owe to their clients. That fiduciary duty has been interpreted through case law and enforcement actions. Given the diverse business models among private funds, adopting detailed or prescriptive rules to capture every fact and circumstance possible under the fiduciary duty would be difficult.

Advantages of private fund adviser-only SRO

Through its membership fees, a private fund adviser SRO could have “scalable and stable resources for funding oversight” of its members. That would mean it could conduct earlier examinations of newly registered advisers and more frequent examinations of seasoned advisers than SEC could do with its current funding levels. With improved resources, an SRO could better technology to strengthen the examination program, provide the examination program with increased flexibility to address emerging risks associated with advisers, and direct staffing and strategic responses that may help address critical areas or issues.

Theoretically, the SRO could impose higher standards of conduct and ethical behavior on its members than are required by law.  It could also provide expertise and knowledge than SEC, given the industry’s participation in the SRO.

Disadvantages of private fund adviser-only SRO

The GAO listed these disadvantages:

  1. An increase the overall cost of regulation by adding another layer of oversight.
  2. Conflicts of interest because of the possibility for self-regulation to favor the interests of the industry over the interests of investors and the public.
  3. Limited transparency and accountability, as the SRO would be accountable primarily to its members rather than to Congress or the public.

Although the formation of an SRO could increase demand for CCOs, making it potentially good for me personally, I think it would be a terrible idea for the industry.

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