Investment Adviser Regulation Update

Investment Adviser/ Fund Regulation Update

December 2009C. Craig Lilly

General Partner, LLC (Delaware LLC)

Limited Partners

Fund Limited Partnership(Delaware)

Portfolio Investment #2Portfolio Investment #1

99% Capital80% of Profits

1% Capital20% Carried Interest

Management Advisor (Delaware LLC)

~2% Management Fee (Management Services Agreement)

Fund Structure

Applicable Laws

• SECURITIES ACT OF 1933 – Securities of Funds are typically offered in private

placement transactions which rely on the private placement “safe harbor” provisions of Rule 506 of Regulation D (or the safe harbor for offerings outside the United States contained in Regulation S).

– Form D filings with SEC within 15 days of closing.– States are still permitted to require “blue sky” notice

filings and collect filing fees (generally file within 15 days of closing).

Applicable Laws

• THE INVESTMENT ADVISERS ACT OF 1940– Most Fund managers or general partners choose

not to register under as an advisor as a result of an exemption from registration because they have fewer than 15 clients.

– This is because the Fund is generally deemed, under certain circumstances, to be one client and the managers do not hold themselves out to the public as investment advisors.

The Investment Company Act - Two Applicable

Exemptions• 3(c)(1) Fund Exemption

– The reference to “3(c)(1)” is to an exclusion from registration as an investment company pursuant to Section 3(c)(1) of the Investment Company Act (the purpose of this Act is to generally regulates mutual fund).

– A Fund will not have to register under the Investment Company Act if its outstanding securities are not owned by more than 100 persons.

• Counting to 100 is not as straightforward as it might seem. • Sometimes the rules force a fund to “look through” an entity

investor and count each of the underlying beneficial owners of the entity based on certain percentage tests which may increase the number of investors which count against the 100 investor limit.

The Investment Company Act

• 3(c)(7) Fund Exemption: the reference to “3(c)(7)” is to an exclusion from registration as an investment company pursuant to Section 3(c)(7) of the Act.

• This exclusion is available for a Fund which limits its limited partners to individual investors (“Qualified Purchasers”) who own not less than $5,000,000 in investments, and to entities which own not less than $25,000,000 in “investments”, as defined by the SEC.

• An entity that has less than $25,000,000, but which is beneficially owned by persons who are Qualified Purchasers may also be considered a Qualified Purchaser.

• A 3(c)(7) Fund is limited to under 500 investors (see below).

Securities Exchange Act of 1934

• Funds with 500 investors and $10,000,000 in equity must register with the SEC(Section 12(g) and Rule 12g-1 of the Securities Exchange Act of 1934).

Investment Adviser Regulation Update

• There are at least four major bills or proposals to regulate investment advisors and private equity funds:– (1) Private Fund Transparency Act of 2009 introduced on July

15, 2009 by Sen. Reed (D-RI);– (2) Private Fund Investment Advisers Registration Act

proposed on July 15, 2009 by the Obama Administration;– (3) House Financial Services Committee approved the Private

Fund Investment Advisers Registration Act, H.R. 3818 on October 27, 2009 (the “Act”) introduced by Congressman Kanjorski (D-PA); and

– (4) Proposal on November 10, 2009 by Senator Dodd (D-CT) released as part of broader legislation impacting financial services


• Key highlights of the Act proposed by Kanjorski are:• Registration requirement for private fund advisers. The Act

would eliminate the “private investment adviser” exemption, contained in §203(b)(3) of the Investment Advisers Act of 1940 (the “Advisers Act”). §203(b)(3) allows investment advisers who, among other things, have had fewer than 15 clients over the preceding 12 months and who do not hold themselves out generally to the public as investment advisers, to avoid registering with the SEC.

• A “private fund” is any investment fund that would be an investment company pursuant to the Investment Company Act of 1940 but for the §3(c)(1) or §3(c)(7) exemptions thereunder.


• Registration exemption for private fund advisers with $150M AUM. The Act calls for the exemption from registration with the SEC of any investment adviser to “private funds” so long as each “private fund” advised by the adviser has AUM less than $150 million in U.S.

• Advisers claiming the exemption are required to keep such records and make such reports to the SEC as the SEC determines necessary or appropriate in the public interest.


• Registration exemption for advisers to “venture capital funds.” The definition of “venture capital funds” would be left to the SEC.

• “Foreign private fund adviser” registration exemption. Exemption requirements are that the investment adviser (i) has no U.S. place of business, (ii) has for the preceding 12 months had fewer than 15 clients in the U.S. and assets under management attributable to clients in the U.S. of less than $25 million (or such amount as the SEC determines) and (iii) neither holds itself out generally to the public as an investment adviser.


• Registration exemption for advisers to small business investment companies. The Act also provides a registration exemption for investment advisers that solely advise licensed small business investment companies regulated by the Small Business Investment Company Act of 1958.

• The Act eliminates two current registration exemptions. First, the exemption currently available to an adviser whose clients are all residents of the state in which the investment adviser maintains its principal office and who does not offer advice regarding securities listed or traded on any national securities exchange is eliminated. Second, the Act eliminates the registration exemption currently available to commodity trading advisors.


• Books and records requirements. The Act would require the adviser to maintain and file with the SEC records and reports detailing each fund’s: – (i) assets under management; – (ii) use of leverage (including off-balance sheet leverage); – (iii) counterparty credit risk exposure; and– (iv) trading, investment positions, and trading practices.

• Mid-sized private fund advisers. With respect to advisers of an undefined class of “mid-sized private funds,” the Act does not provide an exemption, but instead instructs the SEC to ensure that “registration and examination procedures with respect to the investment advisers of such funds . . . reflect the level of systemic risk posed by such funds.”


• SEC rulemaking authority. The Act contain broad grants of authority to the SEC to craft appropriate rules to implement the intent of the legislation.

• Joint CFTC/SEC rulemaking. The Act requires the CFTC and the SEC to issue joint rules, after consultation with the Federal Reserve, regarding the collection of systemic risk data.

• Transition period. There would be a one-year transition period before its provisions would become effective.


• Adjustment for inflation to the “qualified client” determination. Section 205(e) allows the SEC to exempt persons or transactions from the prohibition on investment advisory contracts that provide the investment adviser with compensation on the basis of a share of capital gains upon, or capital appreciation of, the client’s funds. Accordingly, this provision would apply the inflation adjustment to the $750,000 assets under management and $1.5 million net worth tests for determining a client’s status as a “qualified client” under Rule 205-3 of the Advisers Act.


• Potential ramifications for investors:

– Flight of large fund complexes overseas

– Loss of talent to overseas complexes

– Proliferation of under $150M fund complexes in U.S. (some investment advisors may create multiple funds less than $150M each)

COMPARISON OF PROPOSED LEGISLATION

ProposedProvisions

ReedBill

(July 15, 2009)

ObamaAdministration(July 15, 2009)

KanjorskiBill

(October 27, 2009)

DoddProposal

(November 10, 2009)

Amendment to Private Adviser Exemption (provision that generally exempts from registration advisers with fewer than 15 clients and managing less than $25 million over the preceding 12 month period)

Bill would substitute the foreign adviser exemption for this exemption (see below for foreign advisor exemption)

Same Same, plus an exemption for advisers to private funds with less than $150M in AUM

Same, plus an exemption for advisers to private funds with less than $100M in AUM

Private Fund Definition (a 3(c)(1) or 3(c)(7) excepted fund which is (i) organized under U.S. law or (ii) has 10% or more of its securities owned by U.S. persons)

No definition Yes Yes Yes

Intrastate Exemption (generally exempts from registration advisers with clients resident in the same state, unless such adviser advises a “private fund” as defined above)

No Yes Yes Yes

Recordkeeping and Reporting by Private Funds (authorizes the SEC to require registered advisers to maintain records and file reports which may be made available to systemic risk regulators)

Yes, but does not specify the types of reporting information.

Yes, and specifies that the reports apply to private funds advised by the registered adviser.

Yes, and also specifies that the reports apply to private funds advised by the registered adviser. Bill allows the SEC to require additional information reporting from private fund advisers.

Yes, but indicates that the records (and side letters) required to be maintained may be used for assessment of systemic risk by the Agency of Financial Stability.


ProposedProvisions

ReedBill

(July 15, 2009)


KanjorskiBill

(October 27, 2009)

DoddProposal

(November 10, 2009)

Venture Capital Fund Exemption (generally exempts from registration advisers to “venture capital funds” as may be defined by the SEC)

No No Yes Yes

Private Equity Fund Exemption (generally exempts from registration advisers to “private equity funds” as may be defined by the SEC, who shall remain subject to annual or other SEC reporting requirements)

No No No Yes

Small Private Fund Exemption (exempting from registration an investment adviser to a private fund based on AUM of less than $150 million)

No No Yes No

Foreign Adviser Exemption (generally exempts from registration advisers: (i) without a U.S. place of business, (ii) that, during the preceding 12 months, advised fewer than 15 U.S. clients and managed less than $25 million attributable to U.S. clients, and (iii) that do not hold themselves out to the public in the U.S. as investment advisers and do not advise funds registered under the Investment Company Act)

Yes Yes Yes Yes


ProposedProvisions

ReedBill

(July 15, 2009)


KanjorskiBill

(October 27, 2009)

DoddProposal

(November 10, 2009)

Family Office Exemption (excludes from the definition of “investment adviser” an adviser to a “family office” as may be defined by the SEC)

No No No Yes

SEC Rulemaking Authority (clarifies that the SEC has authority to classify persons and matters within its jurisdiction (and to prescribe different requirements and to define the term “client”)

Yes Yes Yes. Persons classified as subject to SEC jurisdiction may be differentiated based on size, scope, business model, compensation, etc.

Yes

Examination of Records (records of private funds advised by a registered adviser are subject to periodic, special, and other examination by the SEC)

No Yes Yes Yes

Independent Custodian (registered investment advisers would be required to use independent custodians to hold client assets)

No No No Yes

2010 Fund Themes

• Private equity firms will be more specialized.• Future investments will be smaller, healthier

and less leveraged. • Increased dialogue with LPs will continue. • Increased scrutiny of fees, carried interest,

clawbacks, key man provisions, placement fees, etc.

• The private equity secondary market will see more opportunities

$0

$100

$200

$300

$400

'95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09Venture Capital Buyout/Corporate Finance MezzanineOther Private Equity Fund of Funds

Will Fundraising Hit $100B In ’09?Fu

nd

s R

ais

ed

($

B)

Source: Dow Jones Private Equity Analyst

$33.3

$38.7

$59.5

$101.2

$111.0

$177.9

$110.1

$68.3

$92.0

$151.8

$255.9

$325.7$265.

6

$79.9$49.4

$180.9

$49.4

$244.6

$178.2

$106.4

$57.4

$28.4

$43.1$51.5

$79.6

$43.4

$61.9

$41.5

$19.7$22.5

$0

$50

$100

$150

'95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09

U.S. Buyouts Fundraising Down….Commitments to Buyout & Corporate Finance Funds ($B)

Fu

nd

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ais

ed

($

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$24.7

$8.0

$32.0

$26.2$22.6

$16.9

$9.2$10.8

$39.4

$72.1

$48.6

$21.0

$14.3

$7.9$6.1

$0

$25

$50

$75

'95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09

VC Industry Struggling To Raise New Capital Commitments to U.S. Venture Capital Funds ($B)

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Disclaimer

This information has been prepared for general informational purposes only. It does not constitute legal advice, and is presented without any representation or warranty whatsoever as to the accuracy or completeness of the information.

No one should, or is entitled to, rely in any manner on any of this information. Parties seeking advice should consult with legal counsel familiar with their particular circumstances.

C. Craig Lilly650.843.3232 [email protected]

Investment Adviser Regulation Update

Documents

Transcript of Investment Adviser Regulation Update