SEC registration: Are Asian GPs taking it seriously?

Private equity managers were initially unnerved by the prospect of registration. Though only a small part of the Dodd-Frank Act - the most sweeping regulatory change seen in the American financial services sector since the 1930s - the Securities & Exchange Commission's (SEC) registration and disclosure rules for private investment advisors were a source of uncertainty.

Having enjoyed an existence largely free of direct regulation, how would private equity cope? What would be the impact on businesses in terms of additional costs? There was also no small amount of confusion regarding the compliance process itself - even the lawyers weren't sure what was going to happen.

Three months since the introduction of the new rules, barking about their disruptive potential has proved to be much worse than their actual bite.

"Certainly the principals of these firms really don't like having to turn in their personal securities transactions and reports of their personal holdings, which is now required by law with virtually no exceptions," says Sean O'Malley, a partner with White & Case in New York. "But that's just a part of being registered with the SEC. There are other irritants as well, but does that mean that it's gotten harder to raise capital? No. Does it mean that it's harder to manage money? No."

One of the reasons private equity isn't being held back, industry participants say, is because the SEC is dragging its feet on post-implementation follow-ups. "They are so busy with applications they haven't paid much attention paid to non-registrants" says Addison D Braendel, a Baker & McKenzie partner in Chicago. "Still, we expect that to occur once the existing glut of paperwork is processed."

His comments foreshadow difficulties for non-compliant advisers, including those based offshore. Anecdotal evidence suggests that the vast majority of larger Asia-based funds are stepping up to file. However, a fair number of their smaller counterparts, especially among the China-focused contingent, are treating the registration requirement as low priority.

"I'm pretty sure that there are plenty of people in Asia who have just said to themselves, ‘Forget it, I'm not doing this, it's too much. I'm going to take the chance that I'm not going to be flagged by the SEC because I reckon they don't have enough staff to come to Asia and catch me,'" Lorna Chen, a partner with Shearman & Sterling in Hong Kong, tells AVCJ.

Like her counterpart at Baker & McKenzie in Chicago, however, Chen believes the SEC will follow up, with vigor. And then the question for non-compliant managers will be whether they can bear the reputational risk.

"The market they are running in is very competitive," Chen notes. "And in the LP due diligence process, they'll always ask if the GP is registered with the relevant authorities. If they're really smart, they will ask them if they're required to register with same. A lot rides on how the manager answers that, unless they really don't care if they lie to their LPs as well."

In almost all transactional documents, including the fund subscription document, there is a representation saying that the GP and the manager have complied with applicable law. If this goes ignored, a manager would be in breach of SEC rules from the time he signs the contract.

Reading the fine print

So what are the rules pertaining to Asia-based PE fund managers and advisers? For perspective reasons, it's helpful to define how that market is comprised. Using the metric of total dollars invested, Asia is still dominated by mega-funds operated by the likes of KKR, TPG Capital, The Carlyle Group and Bain Capital.

"Most of them aren't really Asia-specific funds, or if they are, it's in the context of being part of a family of international funds," says Brian McDaniel, a partner with Goodwin Proctor in Hong Kong. "They're all headquartered in New York or London and subject to regulation as such. Of the remaining GPs that are based in Asia, however, by far the majority don't have an office in the US."

That is a critical distinction vis-à-vis the new SEC rules, because it means that by and large they aren't required to register, only report.

In essence, the Dodd-Frank Act created three new categories of investment fund managers for registration purposes. The first, including all of the major players cited above, and their confreres, are the full-blown registered investment advisers. They are subject to the most extensive obligations, but at the same time, compliance is simply a business necessity managed in stride by their existing teams, even if at some additional cost.

Next are the so-called exempt recording advisers. They are exempt from formal SEC registration, but they still have to file reports as of March. This category comprises firms managing funds of less than $150 million from offices in the US. "That dollar limit is irrelevant for the majority of Asian-based funds because they don't have a US office," McDaniel explains. "Or if they do, it's for minor functions - due diligence or fund-raising support, or for GP convenience when travelling to New York for conferences and in need of a secretary and a computer."

The third category is marginal from a PE perspective, being defined as those funds with less than $25 million of assets under management. These are completely exempt and aren't required to do anything.

There are other peripheral ways that some funds can keep their status as an exempt reporting adviser. Most notably, if a fund's investing activities fall within what is traditionally deemed VC territory, it can keep this standing regardless of how much capital raised. However, investors must put 80% of their capital to work in start-ups, usually in high-tech or life sciences, on an unleveraged basis.

Despite the early-stage jitters and valiant attempts to qualify for exemption, blanket registration is taking place. Complaints tend to focus on the unnecessary cost and hassle of filling out all the paperwork in the name of protecting the integrity of the financial system, but few anticipate a campaign to pressure Congress into rescinding the new rules.

In Asia, though, attitudes can be markedly different. This begins with regionally-based funds being irked at the basic reporting mechanics, even where they have been substantially diluted for offshore exempt reporting advisers.

The requirements are not onerous. Managers must complete only the first of two sections of Form ADV, which involves the disclosures of very basic information: who you are, where you are based, the nature of your business, and so on. The second section is more difficult, requiring a narrative description of the business in question, its policies and execution processes.

The resentment comes from perceived gray areas around exactly how much detail managers need to provide, because that information will be made available on the SEC website, and consequently accessible to the public.

Like many US advisers, Asian managers don't see why this level of disclosure is necessary. Unlike their US counterparts, however, some of these managers have concluded that, operating far from the US and its courts, they will likely slip under the radar because a resource-constrained SEC won't have the wherewithal to bring them to book. But the regulator is already taking a proactive stance, sending out letters asking offshore managers to send in documents.

"The worry is that this can also be the start of more in-depth examination," one source says. "Instances over the past months indicate that the SEC is increasingly focused on enforcement - and not just independently. They are turning to the investment managers themselves to buttress this enforcement, including among non-US funds. But as to how far they'll go, and when they'll really make their presence felt in Asian jurisdictions, we just don't know."

Again, the most prudent course for Asian-based advisers and funds seems to be to report the minimum information required to the SEC, rather than ignoring the new regime.

Truth or consequences

The penalties for non-compliance are severe, and few industry participants expect there to be any "wiggle room."

"I have been told by the head of the SEC's Asset Management Unit [a newly-formed SEC task force that focuses on the asset management industry] that private fund compliance is a priority," says Mitchell Nichter, a partner in Paul Hastings' corporate department in San Francisco. "This includes not only hedge fund managers, but PE fund managers and others in the private investment segment. Managers must take care to be compliant. There is no grace period."

The consequences depend on the rule that is violated. They can range from a simple deficiency letter to significant fines and even industry suspensions and bans in severe cases. Furthermore, regulatory enforcement actions will likely need to be disclosed to investors and prospects, and this can result in serious brand damage. There are situations in which investors would be within their rights to withdraw capital or force the liquidation of a fund.

Goodwin-Proctor's Brian McDaniel takes a softer line, arguing that there will inevitably be managers who try to apply in good faith but make mistakes. The SEC is unlikely to be too draconian. Poor wording of the rules doesn't help these situations. The registration legislation was originally written for registered investment advisers en masse, who usually have a markedly different structure compared to those of the more informal, unregistered private funds. It was also drafted under intense time pressure.

"There is a fair amount of interpretation uncertainties because they are now being applied in a context for which they weren't originally drafted," McDaniel reasons. "As such, it's difficult to imaging the SEC bringing a lot of enforcement actions based on misunderstandings of the rules, or poorly completed filings that are wrong in some technical aspect."

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• Topics
• Regulation
• Advisory
• North America
• Greater China
• regulation
• Us securities and exchange commission (sec)
• professional services
• GPs