The US Private Equity Fund Compliance Guide

One of the struggles with implementing a compliance program for a private equity fund is that the Investment Advisers Act is targeted at retail operations dealing with relatively liquid investments. Neither fits well with the private equity model of institutional investors and large, illiquid transactions. Most of the guidance and discussion about how to implement a compliance program focuses on the retail side. Given the changes coming from Dodd-Frank, most private fund managers will need to register with the SEC as investment advisers.

Private equity firms are going to need some good guides to help them out. PEI Media just published The US Private Equity Fund Compliance Guide. It is a useful resource to private equity firms putting together a compliance program.

Since it was just put together this year, the guide includes most of the new laws and regulations coming out of Dodd-Frank as they relate to private equity fund compliance. Of course, given the huge slate of rule-making in the pipeline, the guide will start getting out-of-date. You need to start sometime and the regulatory framework will continue to evolve.

Charles Lerner of Fiduciary Compliance Associates took the helm as editor of the guide and farmed out the individual chapters to a talented group of contributors. Most chapters do a great job of trying to translate the regulatory regime of the Investment Advisers Act to the realities of a private equity fund manager. A few chapters come up short. They merely tack on a paragraph at the end of the chapter pointing out that much of the preceding is irrelevant for most private equity firms or fail to provide a meaningful discussion for private equity.

Some chapters do a great job of addressing the problems that are more closely associated with private equity. The “Side Letters” chapter does a great job putting those agreement in the context of potential conflicts and the requirements of the Investment Advisers Act. I would give the same praise to the “Identifying Potential Conflicts of Interest” chapter.

Overall, I found the guide to be a great resource in helping me to craft my compliance program. My copy is already getting filled with notes and annotations. The downside it that it’s expensive: $795.

You can take a look at the table of contents for the guide and see how it fits into what you are doing and whether it would be worth the price.

The SEC Defines Venture Capital

The SEC is moving much faster in releasing proposed rules after the SEC Open Meetings. After Friday morning’s open meeting discussing the exemption from registration for venture capital funds, the SEC has released the full text of the proposed rule merely several hours later.

I have been waiting to see how broad this exemption will be. I’m still holding on to the slim chance that I could squeeze into the exemption. Given that the SEC is still looking for some broad reporting and subjecting venture capital firms to examination, I’m not sure the exemption will offer much benefit.

Here is the SEC’s proposed definition of a venture capital fund for purposes of the exemption:

A venture capital fund is any private fund that:

(1) Represents to investors and potential investors that it is a venture capital fund;

(2) Owns solely:

(i) Equity securities issued by one or more qualifying portfolio companies, and at least 80 percent of the equity securities of each qualifying portfolio company owned by the fund was acquired directly from the qualifying portfolio company; and

(ii) Cash and cash equivalents, as defined in § 270.2a51-1(b)(7)(i), and U.S. Treasuries with a remaining maturity of 60 days or less;

(3) With respect to each qualifying portfolio company, either directly or indirectly through each investment adviser not registered under the Act in reliance on section 203(l) thereof:

(i) Has an arrangement whereby the fund or the investment adviser offers to provide, and if accepted, does so provide, significant guidance and counsel concerning the management, operations or business objectives and policies of the qualifying portfolio company; or

(ii) Controls the qualifying portfolio company;

(4) Does not borrow, issue debt obligations, provide guarantees or otherwise incur leverage, in excess of 15 percent of the private fund’s aggregate capital contributions and uncalled committed capital, and any such borrowing, indebtedness, guarantee or leverage is for a non-renewable term of no longer than 120 calendar days;

(5) Only issues securities the terms of which do not provide a holder with any right, except in extraordinary circumstances, to withdraw, redeem or require the repurchase of such securities but may entitle holders to receive distributions made to all holders pro rata; and

(6) Is not registered under section 8 of the Investment Company Act of 1940 (15 U.S.C. 80a-8), and has not elected to be treated as a business development company pursuant to section 54 of that Act (15 U.S.C. 80a-53).

SEC Release IA-3111 Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers With Less Than $150 Million in Assets Under Management, and Foreign Private Advisers

Proposed Changes to Form ADV

The SEC has released its proposed changes to Form ADV to better deal with private fund registration and the exempt, but reporting required of venture capital funds: Release No. IA-3110

The Securities and Exchange Commission is proposing new rules and rule amendments under the Investment Advisers Act of 1940 to implement provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act. These rules and rule amendments are designed to give effect to provisions of Title IV of the Dodd-Frank Act that, among other things, increase the statutory threshold for registration by investment advisers with the Commission, require advisers to hedge funds and other private funds to register with the Commission, and require reporting by certain investment advisers that are exempt from registration. In addition, we are proposing rule amendments, including amendments to the Commission’s pay to play rule, that address a number of other changes to the Advisers Act made by the Dodd-Frank Act.

Can I Be a Venture Capital Fund Manager?

That was one of the topics for the Securities and Exchange Commission Open Meeting on November 19.

In Shapiro’s opening remarks, it was clear that the SEC wants all private funds to register. Even thought venture capital funds are exempt from registration, they will need to supply information to the SEC.

The key in defining “venture capital” will be the lack of leverage in the funds and the non-public status of their investments.

They will not have to disclose the full panoply of information that is required by Part 2 of Form ADV. So they will not have to disclose compensation and conflict information.

The SEC has only been able to examine 10% of registered investment advisers each year.

They made it clear that private fund advisers will not be excluded from the “systemically important” label under Dodd-Frank. Big advisers will need to keep an eye on this rulemaking, scheduled to be released in January.

Then on to the specifics.

There are proposed changes to Form ADV to reflect the new thresholds for registration and some other changes. private funds will need to disclose key gatekeepers such as auditors and third-party marketers.

They will also include information for the venture capital funds that have to report, but not register. These exempt-reporting advisers will still be using Form-ADV. They will need to disclose information about ownership, fund structures, and disciplinary activity.

As for venture capital funds, it seemed clear that they struggled trying to come up with a definition of a “venture capital fund.” The definition in the proposed rule will include these limitations:

  • must get 80% of the shares directly from the company
  • investments must be in a private company
  • provide significant management assistance to the company
  • only borrow a portion of their fund’s capital
  • limited redemption rights to limited partners
  • self-label as a venture capital fund

They will allow a grandfathering for venture capital funds, giving them some time to restructure to fall under the definition. That should be a relief for fund wondering how they can meet the July 21, 2011 deadline and not take a hit on their illiquid investments.

Commissioner Casey did not like the approach of the rule on venture capital funds and Form ADV. She noted that the statute is ambiguous on the reporting requirements and thinks the rule is putting too much of a burden on venture capital funds.

(I missed Commissioner Walter’s remarks.)

Commissioner Aguilar focused on the valuation and leverage discussions for funds. He seemed to really be interested in having such a big database of information about private fund advisers.

Commissioner Paredes focused on the insertion of the venture capital exemption outside of the Section 203 exemptions.  To him that means they are subject to much more oversight and subject to examination. He is concerned about the distraction of the fund mangers from growing small companies. He seemed skeptical that the regulatory oversight will help investors. He was concerned about the requirement of “providing managerial assistance” and how that may affect a VC investor that does not get a board seat. He realizes that the SEC is stuck with the statutory framework enacted by Congress. (I guess that’s the problem with getting an exemption tacked on to the bill instead of a thoughtful reworking of the regulatory framework.)

As usual with the SEC, the actual text of the rules was not released as part of the meeting and we will have to wait to see the details. Of course, these are just proposed rules so there will be an opportunity to comment and the SEC may make some changes to the rules based on the comments.

Compliance Bits and Pieces for November 19

Here are some recent compliance related stories I found interesting.

SEC Charges Two Longtime Madoff Employees with Fraud

The Securities and Exchange Commission today charged a pair of longtime employees at Bernard L. Madoff Investment Securities LLC (BMIS) with playing key roles in the Madoff Ponzi scheme. One employee produced phony account statements for investors and feathered her own accounts for personal gain, while the other conspired to cash out Madoff’s friends and family as the fraud collapsed in addition to creating phony account statements and tracking the Ponzi scheme bank account.

SEC Charges Steven Rattner in Pay-to-Play Scheme Involving New York State Pension Fund

The SEC alleges that Rattner secured investments for Quadrangle from the New York State Common Retirement Fund after he arranged for a firm affiliate to distribute the DVD of a low-budget film produced by the Retirement Fund’s chief investment officer and his brothers. Rattner then caused Quadrangle to retain Henry Morris – the top political advisor and chief fundraiser for former New York State Comptroller Alan Hevesi – as a “placement agent” and pay him more than $1 million in sham fees even though Rattner was already dealing directly with then-New York State Deputy Comptroller David Loglisci and did not need an introduction to the Retirement Fund.

To Crack Down on Insider Trading, UK to Require Recording Calls in the WSJ.com’s Law Blog

On Thursday, the U.K.’s Financial Services Authority said that starting in November next year, firms will have to record the cell phone conversations of some employees as part of its push to detect insider dealings.

Webinar Replay: The New Pay-to-Play Rules from Compliance Avenue

Earlier this year, the SEC adopted anti-fraud rule 206(4)-5 (the “Pay to Play Rule”) which serves to limit political contributions and “pay to play” activities. Prior to the effective date of this rule, all investment advisers should ensure that they build out comprehensive political contribution reporting and pre-clearance policies.

Mortgage Lending Practice after the Dodd-Frank Act by Bradley K. Sabel in the Harvard Law School Forum on Corporate Governance and Financial Regulation

On July 21, 2010, the President signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), enacting numerous provisions intended to reform the mortgage lending industry with an eye towards consumer protection. Many of these provisions are contained within Title XIV of the Dodd-Frank Act, the Mortgage Reform and Anti-Predatory Lending Act (the “Mortgage Act” or the “Act”)

Implications of Dodd-Frank for UK and EU fund managers and advisers

Many UK and EU investment managers and advisers (including those in the private equity, hedge
fund and real estate sectors) may be required to register with the US Securities and Exchange Commission (the “SEC”) with effect from 21 July 2011, even if they are already authorised by the UK Financial Services Authority or another EU regulator. Firms that register must comply with a number of US federal legal and regulatory requirements, many of which overlap with UK FSA rules. Some firms exempt from registration will still need to comply with certain record-keeping and reporting requirements. Whilst many of the detailed provisions of implementing legislation are yet to be finalised by the SEC, and there is considerable uncertainty about the scope of certain exemptions, firms should begin to consider the impact of the changes and plan for compliance.
2011.

Another CCO in Trouble

With failure, comes learning. As a compliance officer, disciplinary actions against other compliance officers can be a road map showing me what not to do. Recently, the SEC charged affiliated firms and their former chief compliance officer with failing to have adequate policies and procedures to prevent misuse of nonpublic information.

Section 204A and Rule 204A-1 make it very clear that every investment adviser must have written policies and procedures reasonably designed to prevent the misuse of material, nonpublic information. Buckingham Capital Management Inc. and its broker-dealer parent company, The Buckingham Research Group Inc. apparently did not.

BRG and BCM’s policies and procedures were deficient in a number of ways. BRG had a written procedure to address the misuse of material, nonpublic information, but did not follow its written procedure in practice. Important compliance policies and procedures were not contained in BCM’s written policies and procedures. Further, in some instances, BCM’s written policies and procedures were so unclear that employees did not understand their responsibilities. In other instances, the practices BCM employed varied materially from its written policies and procedures. These failures led to inadequate implementation and enforcement of the firms’ written compliance policies and procedures.

That’s bad, but more likely to result in a deficiency letter than an enforcement action, assuming they were not misusing the information. The problem was that these deficiencies were discovered during a 2003 SEC examination. BCM said they would fix the problem.

Trouble

In preparation for a 2006 SEC exam,  BCM discovered it was missing more that 100 pre-approval forms for trades and that its compliance review logs for 2005 and 2006 were incomplete.

Rather than deliver incomplete records, BCM staff altered the records. This apparently angered the SEC and they moved the case from examination into enforcement.

The former CCO, Karp was censured and agreed to pay a $35,000 penalty.

Lessons

If the SEC tells you there is deficiency, fix it and make it a priority. The first thing they will look at on their next visit is the area of the deficiency. I’m still surprised that the SEC reported only 90% of deficiencies get cured.

Don’t falsify records. That will get the problem moved from the inspection side to the enforcement side of the SEC. That would be a CCO Failure. (The complaint indicates that Mr. Karp did not participate in the falsification.)

Sources:

Securities and Exchange Commission’s FY 2010 Performance and Accountability Report

In June 2010, the SEC approved a new strategic plan for its fiscal years 2010 – FY 2015. The plan set out the agency’s mission, vision, values, and strategic goals. It also had a detailed list the outcomes the SEC wanted to achieve and the performance measures that will be used to gauge the agency’s progress.

The SEC has released its 2010 Performance and Accountability Report, the first to measure the SEC performance against its strategic plan.

I thought it would be useful to look at some portions of the report to see if it could offer some insight into what to expect from the SEC as real estate private equity moves into the SEC registration regime.

The first that caught my eye was GoalL 1 Measure 3: Percentage of firms receiving deficiency letters that take corrective action in response to all exam findings.

The Office of Compliance Inspections and Examinations missed its target of 95%, achieving only 90%. This was a drop from 94% in FY2009. I’m not sure what factors I would attribute to the decrease. Were the examinees less afraid of SEC action?

This is one that compliance professionals need to focus on. If the SEC identifies deficiencies, you need to fix them. Failure to fix them is a big red flag that could move the problem from OCIE to enforcement.

On the education side, the SEC’s CCOutreach program failed to meet its goal of having attendees rate the program as “useful” or “extremely useful.”

I attended a 2009 edition of CCOutreach in Boston and it was excellent. Looking back at my notes, it was a spot-on roadmap for the upcoming SEC initiatives. I still hate the name.

I think it’s worth spending some time to look through the report. I would guess that the SEC is going to step up its efforts in areas where it failed to meed the goals in its strategic plan.

That would mean more inspections, more enforcement actions. It will also mean more educational efforts and quicker resolution. One measure is the percentage of non-sweep and non-cause exams concluded in 120 days. The goal was 75%, but they only achieved 48%.

Sources:

SEC to Consider New Rules for Fund Managers

On Friday, The Securities and Exchange Commission will be considering rules that should be of interest to private investment fund managers.

It looks like we may have the first look at how the SEC will define a venture capital fund and who will fit into that new exemption to registration under the Investment Advisers Act. Section 407 of Dodd-Frank puts the onus on the SEC to define ‘venture capital fund.’

My guess is that the definition will be very narrow and many venture capital fund managers will not be happy with the definition.

Open Meeting – Friday, November 19, 2010 – 10:00 a.m.

The subject matter of the Open Meeting will be:

  • The Commission will consider whether to propose new rules and rule amendments under the Investment Advisers Act of 1940 to implement provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act. These rules and rule amendments are designed to give effect to provisions of Title IV of the Dodd-Frank Act that, among other things, increase the statutory threshold for registration by investment advisers with the Commission, require advisers to hedge funds and other private funds to register with the Commission, and address reporting by certain investment advisers that are exempt from registration.
  • The Commission will consider whether to propose rules that would implement new exemptions from the registration requirements of the Investment Advisers Act of 1940 for advisers to venture capital funds and advisers with less than $150 million in private fund assets under management in the United States. These exemptions were enacted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The proposed rules also would clarify the meaning of certain terms included in a new exemption for foreign private advisers.
  • The Commission will consider whether to propose new rules under Section 763(i) of the Dodd-Frank Wall Street Reform and Consumer Protection Act governing the security-based swap data repository registration process, the duties of such repositories, and the core principles applicable to such repositories.
  • The Commission will consider whether to propose Regulation SBSR under Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act to provide for the reporting of security-based swap information to registered security-based swap data repositories or the Commission and the public dissemination of security-based swap transaction, volume, and pricing information.

At times, changes in Commission priorities require alterations in the scheduling of meeting items. For further information and to ascertain what, if any, matters have been added, deleted or postponed, please contact: The Office of the Secretary at (202) 551-5400.

Have you been Dodd-Franked?

On Thursday, December 2nd, 2010, I will be part of panel discussing some of the effects of the Dodd-Frank Wall Street Reform and Consumer Protection Act on real estate investment management firms.

The session is open to the public, but not free.

Panelists

John Schneider, Principal, KPMG LLP
Paul D. Schwartz, Partner, Goodwin Procter LLP
Doug Cornelius, Chief Compliance Officer, Beacon Capital Partners

Have you been Dodd-Franked?
If you invest other people’s money in real estate you may have been. The Dodd Frank legislation’s impact on real estate investment managers is far reaching and evolving. Our panel of experts will discuss the legislation and answer these key questions:

  • Who will need to register or unregister with the SEC and State?
  • What is the timeline for compliance and rules making?
  • Will the SEC visit you and what is their focus?
  • What is a Compliance Program and CCO?
  • What reporting will be required regardless of registration requirements?
  • How is the definition of an “Accredited Investor” changing?
  • Other timely issues such as the “Pay to Play” rules.

Thursday, December 2nd, 2010
Wilmer Cutler Pickering Hale & Dorr LLP
60 State Street, 26th Floor, Boston
Registration 7:30 a.m.; Program 8:00 – 9:30 a.m.

Cost: $50 REFA Member | $80 Non-member
Members Register Online |  Faxable Registration Form | **72 HOUR CANCELLATION POLICY**

Questions? Please call Kayla Burmeister at 617-399-7863

Europe’s New Directive on Alternative Investment Fund Management

The European Parliament has approved the Directive on Alternative Investment Fund Managers. European countries will now be setting up a framework for regulating hedge funds and private equity funds. The AIRM Directive passed with 513 votes to 92 with 3 abstentions on November 10.

Under the Directive, an “alternative investment fund” is any collective investment undertaking which raises capital from a number of investors and is not registered under the EU’s Directive on Undertakings for Collective Investment in Transferable Securities (UCITS). So along with hedge funds, the directive sweeps up private equity funds, real estate funds and commodity funds.

One key and contentious provision is the inclusion of a single EU passport for fund managers. An alternative investment fund manager can register under the legislation in one Member State that complies with the rules of the Directive. Then the manager can manage or market funds to professional investors throughout the EU after notification. It will also eventually allows US and other non-EU fund managers to get a passport. There will be a dual system for three years during which US and other non-EU hedge funds and fund managers will be governed by national private placement regimes under each jurisdiction, until the passport rules take effect.

The directive has some limitations on the use of leverage by the funds and fund managers will be required to notify regulators about their use of leverage.

Here is a rough timeline for the directive and its effects:

January 2011 Entry into force of the directive
January 2013
(2 years after entry into force)		 Deadline for transposing the directive’s rules into national law, including those on granting
passports to duly-registered, EU-based, AIFs and AIFMs.
January 2015
(2 years after transposition)		 ESMA reports on functioning of passport system for EU AIFs and AIFMs, national private
placement regimes, and possible extension of passport system to non-EU AIFs and AIFMs.
April 2015
(at the latest 3 months after ESMA report)		 Commission adopts a delegated act, based on ESMA advice, specifying date when passports
for non-EU AIFs and AIFMs will be available.
April 2018
(3 years after entry into force of delegated act)		 Second ESMA report on the functioning of the passport and the possible ending of national
private placement regimes.
July 2018
(at the latest 3 months after ESMA report)		 Commission adopts a second delegated act, based on ESMA advice, specifying date
when national private placement regimes must be terminated.

I’m going to spend some time reading the Directive in more detail to figure how it will affect me. One thing is clear: It’s going to be more time-consuming and more expensive to market and manage private funds in the EU.

Sources: