Editor: Please describe your background and practice area at Proskauer.
Beber: I am a partner and co-head of our Private Investment Funds Group as well as the head of our Investment Advisers Taskforce. Our Private Investment Funds Group practice is very broad and global in nature in that we represent over 300 private investment funds on a global basis -- venture capital funds, private equity funds, debt funds as well as fund of funds, secondary funds, real estate funds and hedge funds. We also represent a significant number of institutional investors as well as other players in the private investment fund space, such as secondary buyers and sellers, intermediaries, gatekeepers and other agents.
Editor: On June 22, 2011, the SEC adopted final rules pursuant to Dodd-Frank to implement expanded registration and disclosure requirements for advisers to hedge funds and other private funds. Please describe the new exemptions for private fund advisers.
Beber: Dodd-Frank effectively eliminated the private adviser exemption contained in Section 203(b)(3) under the Advisers Act, which was the provision that most private investment fund managers historically relied on to remain exempt from registering with the SEC under the Advisers Act. Under that exemption, if a fund manager advised fewer than 15 so-called clients (clients being funds not investors in funds) in the U.S. during the preceding 12-month period, the manager was not required to register under the Advisers Act. Dodd-Frank eliminated that exemption, replacing it with three other exemptions, the first being the venture capital adviser exemption, the second the private fund adviser exemption and the third the foreign private adviser exemption.
The exemptions that we have now, while there are three, as opposed to one, are generally much narrower in scope. The venture capital adviser exemption can be relied on only by advisers who advise solely venture capital funds. The private fund adviser exemption can be relied on only by private fund advisers with less than $150 million of assets under management in the U.S. The foreign private adviser exemption can be relied on only by an adviser that has no place of business in the U.S., has, in the aggregate, fewer than 15 clients and investors in the U.S. and has aggregate assets under management attributable to clients in the U.S. and investors in the U.S. of less than $25 million.
Editor: What new role will the states play in regulating small and mid-sized investment advisers?
Beber: The SEC has been pretty vocal about the fact that, going forward, they want the regulation of small and mid-sized advisers to fall within the states. By increasing the minimum AUM (assets under management) threshold for SEC registration from $25M to $100M generally (subject to certain narrow exceptions), the SEC has shifted a greater degree of responsibility towards the states with respect to the regulation of small and mid-sized advisers. As a result, unless a registration exemption is available at the state level, a private fund adviser with less than $100M in AUM may have to register with one or more state regulatory authorities as opposed to the SEC. Additionally, even private fund advisers who are fortunate enough to rely on an exemption from SEC registration need to worry about potential state registration requirements, even if they have more than $100M in AUM.
Editor: For the purposes of calculating a private fund manager’s AUM, how should the manager calculate the value of its private investment funds?
Beber: For a private investment fund, assets must be valued at fair value (not at cost). Additionally, the SEC now requires uncalled capital commitments of a private fund to be included, and an adviser cannot deduct outstanding fund indebtedness and other accrued but unpaid fund liabilities in the calculation of AUM.
Editor: The SEC has adopted expanded disclosure requirements with respect to private funds managed by investment advisers. What are these disclosure requirements?
Beber: Pursuant to the recently adopted amendments to Form ADV, both SEC-registered and Exempt Reporting Advisers are now required to report extensive information about each private fund they manage, including: gross asset value of the private fund, the name of the GP/managing member, detailed ownership breakdown (including percentage of the fund owned by affiliates of the adviser, number of beneficial owners and certain types of investors), detailed information on the annual audit process and identity and detailed information about the fund’s placement agents, custodians, prime brokers and administrators.
Additionally, SEC-registered advisers with at least $150 million in AUM attributable to private funds are subject to additional private fund reporting requirements on at least an annual basis pursuant to the newly created Form PF. Information that must be reported on Form PF includes, but is not limited to, a private fund’s gross and net AUM, gross and net performance and use of leverage. These reporting obligations do not apply to unregistered advisers (including Exempt Reporting Advisers). The frequency of the reporting obligation and the amount of information that must be reported on Form PF will vary depending on the size of the SEC-registered adviser and on the type of private funds managed by such adviser (e.g., the reporting requirements for hedge funds are generally more extensive than those applicable to other types of private funds). In addition, the reporting requirements for certain large advisers will be more frequent and/or more extensive. Information reported on Form PF (unlike information reported on Form ADV) will be kept confidential and not made publicly available.
Editor: Why have advisers to venture capital funds been treated differently from advisers to other types of private funds (such as private equity funds)?
Beber: If you remember when Dodd-Frank was implemented, there was talk about changing the rules in order to help the government identify and appropriately regulate and monitor advisers that possibly could create systemic risk within the financial markets. The NVCA, the trade association for the venture capital industry, spent a lot of time educating Congress and then the SEC about what a venture capital fund is and how it differs from a traditional private equity or hedge fund. They spent time talking about job creation, which venture funds have helped to foster. They successfully argued that venture capital funds, because of their structure and the nature of the assets that they invest in (start-up private companies), do not fall into a category of private funds that could create systemic risk. The exemption from registration for a manager who advises solely venture capital funds, the availability of which (unlike the other private fund manager exemptions) is not dependent on the size of a venture capital fund manager’s AUM, is attributable at least in part to the NVCA’s lobbying efforts.
Editor: For purposes of the venture capital adviser exemption, how has the SEC defined a venture capital fund in an attempt to distinguish such a fund from a private equity fund?
Beber: The SEC has defined a venture capital fund as a private fund that (1) represents to investors and potential investors that it pursues a “venture capital strategy” (a term that the SEC has not defined and which is not always the easiest thing to determine), (2) does not borrow, issue debt obligations, provide guarantees or otherwise incur leverage in excess of 15 percent of capital commitments or for a period in excess of 120 days, (3) does not offer investors redemption or similar liquidity rights except in extraordinary circumstances and (4) holds no more than 20 percent of the fund’s capital commitments in “non-qualifying investments” (other than qualified short-term holdings) at the time of each non-qualifying investment.
A “non-qualifying investment” is an investment that does not fall into the SEC’s definition of a “qualifying investment.” A qualifying investment is generally an equity security issued by a “qualifying portfolio company” that has been acquired directly by the private fund from the qualifying portfolio company (i.e. not from existing shareholders), an equity security issued by a qualifying portfolio company in exchange for an equity security issued by the qualifying portfolio company (i.e., securities issued in connection with capital restructurings) or an equity security issued by a company of which a qualifying portfolio company is a majority-owned subsidiary, or a predecessor, and is acquired by the private fund in exchange for an equity security described above (i.e., securities acquired in an M&A transaction).
A “qualifying portfolio company” is a company: (i) that, at the time of investment, is not a reporting (or foreign-traded) company and not affiliated with another reporting (or foreign-traded) company and therefore must be a private company, (ii) that does not incur leverage in connection with the investment by the private fund and distribute the proceeds of such borrowing to the private fund in exchange for the private fund’s investment and (iii) that is not itself a private fund (i.e., managers of venture capital fund-of-funds will not be able to rely on the venture capital adviser exemption).
Editor: Are private funds also required to provide a prospectus to all their investors as a mutual fund does?
Beber: While there is no requirement that prospective investors in a private fund be provided a prospectus or offering memorandum, it is good (and common industry) practice to do so. A private fund adviser (whether SEC-registered or not) is subject to anti-fraud rules under the Advisers Act that are designed to prevent fraudulent and deceptive practices that may harm current and prospective private fund investors. These anti-fraud rules require a private fund adviser to fully disclose to prospective investors all material risks relating to an investment in a private fund being offered by the adviser as well as all potential material conflicts of interest arising from the activities of the adviser and/or its affiliates. It has become established industry practice for a private fund manager to satisfy these obligations via appropriate disclosure in a private fund’s offering memorandum.
Editor: What restrictions are placed on investment advisers as regards advertising, such as performance results?
Beber: Advisers Act Rule 206(4)-1 and SEC interpretations of this rule prohibit registered investment advisers from engaging in a variety of advertising practices, including the following: (i) referring to any testimonials regarding the registered investment adviser; (ii) disclosure of past specific securities recommendations (e.g., portfolio company investments) that were or would have been profitable without disclosing all past recommendations or investments made by the registered investment adviser over the course of the prior one-year period (i.e., no “cherry picking” allowed); and (iii) providing clients or investors with a track record of the registered investment adviser’s performance unless all returns are calculated net of investment advisory fees, performance fees (including carried interest) and expenses. While these rules “technically” apply only to registered investment advisers, unregistered advisers should be aware that the anti-fraud rules apply to all investment advisers, and non-compliance with the referenced rules can be potentially problematic.
Editor: Under what circumstances can an SEC-registered fund manager (“Successor Adviser) advertise the performance of investment accounts that the Successor Adviser’s investment personnel previously managed while employed with another adviser (“Prior Adviser”)?
Beber: The SEC staff has provided no-action guidance stating that performance of funds or accounts managed at a Prior Adviser can be used by a Successor Adviser if: (i) the investment personnel who manage the relevant Successor funds or accounts at the Successor Adviser were primarily responsible for achieving the prior performance results, and no other person played a significant role in achieving the prior performance at the Prior Adviser; (ii) the accounts managed at the Prior Adviser are sufficiently similar to the relevant fund or account such that the comparison is meaningful and relevant to investors; (iii) the performance of all accounts managed in a substantially similar manner at the Prior Adviser is included (unless the exclusion of a fund or account would not result in materially higher performance); (iv) the performance information is presented in conformity with the performance advertising rules described above; and (v) the advertisement includes all relevant disclosures (e.g., that the performance results were from funds or accounts managed at a Prior Adviser). In addition, the Successor Adviser must have access to all documents that are necessary to form the basis for or demonstrate the calculation of the performance of the relevant funds or accounts at Prior Adviser.
Editor: What effect do you expect the enactment of this measure to have on these funds in terms of affecting their business operations or profitability?
Beber: That depends on whether the funds are advised by a registered or unregistered adviser. For unregistered advisers, such as those relying on the venture capital adviser exemption or the private fund adviser exemption, the periodic reporting obligations (and other compliance obligations under the Advisers Act) are, for the time being, relatively light in comparison to the compliance obligations imposed on SEC-registered advisers. For advisors who are required to register for the first time, compliance costs could result in a significant financial burden, depending on the complexity and scope of the advisers’ operations. Many of the larger private fund advisers are already registered with the SEC and often have internal compliance teams (including chief compliance officers) who are familiar with the regulatory requirements applicable to SEC-registered advisers and tasked on a full-time basis to maintain compliance with such requirements.