PE advisers prepare for US registration requirements

Compliance may not come into effect until March next year, but most US private equity players are already jittery about the implications of the Dodd-Frank Act amendment requiring the registration of an estimated 750 investment advisers, inclusive of private equity managers, .
The measure, a small but significant part of the most sweeping change in US financial services regulation since the 1930s, is likely to have a marked impact on how private equity firms do business. Yet few of the parties involved – including the US Securities and Exchange Commission (SEC), which voted to adopt the rules in late June – seem to have a definitive view of what that impact might be.

The mechanics

The registration system will not cover foreign advisers without US business licenses, venture capital fund advisers or advisers with less than $150 million in assets under management. But those that do come under its writ will be subject to stringent disclosure requirements and potential government investigation.

The aim is to get more transparency. Funds will have to explain how many investors they have and specify whether they are individuals, trusts, broker-dealers, government pension plans, and so on. Private equity fund managers who have been operating unregulated for 15-20 years will have to get used to government officials visiting their offices and questioning the way things are done; collecting information for reports that may result in deficiency letters.

“If problems are uncovered and deemed serious enough, the SEC can refer the examination to enforcement, which is a nightmare for any fund manager,” says Sean O’Malley, a partner with White & Case in New York. “That’s when everything goes public.”
The examination results themselves will not be published, but the routine disclosures will be publicly accessible.

It is difficult to say at this stage what kinds of problems the regulators might focus on. One potential trouble spot, although the SEC has yet to comment on it, is on the marketing side. Disclosures include stating whether a fund marketer is a registered broker. Should a fund use an individual to solicit investors who is not unregistered broker, it amounts to a red flag.

According to Mitchell Nichter, investment management practice partner with Paul Hastings in San Francisco, the operations aspect of the new compliance program is where the real effort will have to be made. First, a chief compliance officer and team must be appointed and systems  put in place to deliver the information to the SEC on a regular basis. This in itself distracts from business activityalso has to be tailored to fit into a particular adviser’s practices.

“If the policies don’t fit the business, they’re not going to be followed. And that can cause major problems down the road,” Nichter tells  AVCJ.

Cost pressures

Another obvious downside is the simple increase in costs this implies, though AVCJ’s sources don’t see this aspect as substantial overall. But they cite other, more extended impacts on profitability that bear mentioning.
For instance, one rule states that any investment adviser, whether registered or not, must receive a client’s consent before engaging in a principal or related-party transaction. And any transaction involving the adviser – or an account (potentially a fund) that is more than 25%-owned by the adviser and its affiliates – is deemed to be a principal transaction. This doesn’t prohibit principal transactions, but it makes them more difficult to do.

In this way, O’Malley believes that Dodd-Frank is changing the comfort zone. “When you’re subject to examination – and we’re talking about US managers here, because non-US managers don’t really get examined – it means you are subject to a potential questioning of the judgments you’ve made with respect to these principal transactions or conflicts of interest.”
The definition of conflicts of interest is wide-ranging. It includes, for instance, being deemed as having taken away an opportunity for your client to invest because of a decision taken to invest for one’s own interest.
More broadly it includes fund manager decisions about the choice, valuation, execution and exit of investments. “When you’re talking about valuations within a PE fund, most times they are illiquid securities or private securities; there’s no ready market for them,” O’Malley notes. “So how do you value them? And how do you calculate your fee based on the value of the assets you are managing. That’s really important.”
Another impact will be in the area of investment advisers’ relationships with placement agents and other gatekeepers regarding the SEC’s pay-to-play rules. These measures are intended to outlaw the practice of making political contributions or other payments to public officials with a view to influencing the investment adviser selection process for pension plans and certain other government entities.

The SEC’s original intention was to impose pay-to-play restrictions on all investment advisers, third-party placement agents and solicitors retained to solicit business from these entities. The final rules represent a softer stance: Advisers will be able to pay placement agents and approach government entities on their behalf provided these agents are either registered municipal advisers or investment advisers subject to pay-to-play rules adopted by the Municipal Securities Rulemaking Board or the Financial Industry Regulatory Authority, respectively.

“If they enter into an arrangement with a third-party placement agent, steps will need to be taken to ensure that the adviser doesn’t inadvertently violate the pay-to-play rules by virtue of that placement agent’s activities,” Nichter says. “That means advisers will have to diligence how third-party marketers go about their business.”

Advisers will also need to negotiate extra protection into their placement agent agreements, and that amounts to extra work, extra costs and extra risk; but it’s unavoidable because the consequences of violating the pay-to-play rules are that advisers forfeit their fees.

Impact on Asia

Further restrictions will be imposed on how fund managers can promote their business. The constraint at present, which under the private placement rules prevents managers from general solicitation or advertising, will stay put. But now some of the promotional techniques of the recent past will be disallowed as well, such as past-specific recommendations, or distributing case studies of prior successful investments as an indicator of future performance.
As for the effect these new rules will have in Asia, though there are some variations in legal opinions, the consensus seems to be that if an investment adviser is headquartered in Asia, and doesn’t have an office in the US from which they provide investment advice to any of their private funds, and has no clients in the US other than private funds, it will automatically qualify for exemption, and so avoid SEC examination.
Interestingly, many Asian investors actually like the idea of having an SEC-registered adviser manage their money as it is seen to add an extra layer of comfort or protection.

With seven months still to run before the rules take effect, some politicians are seeking to minimize the impact on private equity. In March, Congressman Robert Hurt, a Republican from Virginia introduced a bill seeking to extend to private equity the same exemption venture capital firms receive under Title IV of the Dodd-Frank Act. Hurt said the measure would eliminate the “burdensome and costly government mandates,” noting that funds continue to invest in small businesses and create jobs.
The lawyers AVCJ polled reckon this bill has little chance of success, given that the Democrats control the US Senate.

There is another twist to this tale. For all the implied weight of the US government behind the threat of examinations and enforcement, hard experience shows that hitherto the SEC has not examined advisers very frequently; some say something on the order of once every 6-7 years.
“They’re trying to change that,” O’Malley says. “But what I heard on the live web-cast on June 22, when the SEC adopted these rules, was the five commissioners saying repeatedly that they don’t have enough staff to examine all the advisers they’re charged with examining. They’ve been given some extra money to hire more. But they’re still understaffed.”
Clearly this adds up to a work-in-progress. 

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• Topics
• Regulation
• North America
• David Morgans