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The SEC Increases the Net Worth Requirement of the Definition of “Qualified Client” Impacting Both Registered and Some Unregistered Private Fund Managers

February 23, 2012 By Leave a Comment

Private fund managers who are registered with the SEC are required to follow federal regulations on performance compensation.  Generally, if a registered fund manager desires to collect fees based on fund performance (such at the typical 20% carried interest), then each investor in the fund must be a “qualified client.”  Prior to the passage of the Dodd-Frank Act, a qualified client was defined as either (i) an individual or company that immediately after investing into the fund has at least $ 750,000 under the management of the fund manager or (ii) an individual or company that has a new worth of $1.5 Million or more or qualifies as a “qualified purchaser.”[1]  The Dodd-Frank Act required that the SEC update these two thresholds for inflation, which it did, effective September 19, 2011.  It updated the thresholds to $1 Million and $2 Million respectively.

Now, the SEC has issued an additional order further increasing the net worth threshold to $2 Million excluding the value of the investors primary residence, similar to the change that was made last year to the net worth threshold component of the definition of “accredited investor.”  Like the exclusion from net worth of a primary residence in the accredited investor definition, the exclusion from the net worth threshold of the qualified client definition has a number of wrinkles:

  • If the primary residence is encumbered by any mortgage indebtedness, then the investor can exclude that mortgage indebtedness as a liability up to the estimated fair market value of the home.  If the home is “underwater” and the indebtedness exceeds the value of the home, then the investor must count the excess as a liability.
  • If the mortgage indebtedness on an investor’s home increased within the 60 days prior to the investor’s execution of the subscription agreement, then the amount by which the indebtedness increased must be counted as debt.  Essentially, this prevents a potential investor from taking out a line of credit on their home right before investing and artificially increasing their net worth for the purposes of this regulation.

This change may have a significant effect on what investors a fund manager can accept if the fund manager is a registered investment adviser.  In addition, while on paper, this change does not affect fund managers that are not registered with the SEC, many states’ securities regulators are requiring, as a condition to being exempt with own their states’ registration requirements, that a fund manager only accept qualified clients.  So these regulations have the ability to affect unregistered fund managers as well.  They will come into effect 90 days after their publication in the Federal Register.

Footnote

[1] A “qualified purchaser” is defined roughly as a person with at least $5 Million in investment assets or a company with at least $25 Million in investment assets.

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© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Filed Under: Investment Management Tagged With: , , , , , , , ,

Virginia Division of Securities Proposes New Private Fund Exemption Based on Model NASAA Rule

February 18, 2012 By Leave a Comment

On February 14, 2012, the Virginia Division of Securities and Retail Franchising proposed revised regulations exempting certain private fund managers from investment adviser registration with the Commonwealth of Virginia.

Background

Prior to the repeal of the federal 15 client exemption, Virginia had an exemption for fund managers that met the federal 15 client exemption and who advised only “corporation[s], general partnership[s], limited partnership[s], limited liability compan[ies], trust[s] or other legal organization[s]” with assets of $5 million or more.  This of course means that this exemption, left untouched, would no longer be available because of the repeal of the federal 15 client exemption. Pursuant to a Statement of Policy Regarding Regulation of Certain Investment Advisors Managing Private Equity and Venture Capital Funds (“Private Advisors”) dated July 19, 2011, the Virginia Division of Securities & Retail Franchising extended this exemption to advisers who previously were exempt from registration under the federal 15 client exemption, until such time as a more permanent approach could be adopted.  Now, the Division has proposed new regulations for comment, which have a target effective date of May 1, 2012.

The New Proposed Regulations

The new proposed regulations are based upon the NASAA model rule exemption for investment advisers to private funds.    They provide for an exemption from registration for “private fund advisers.” A private fund adviser is any investment adviser who provides advice solely to one or more private funds (i.e. a 3(c)(1) fund or a 3(c)(7) fund).[1]   A private fund adviser must not be subject to disqualification from prior bad acts such as fraud or other securities law violations.  The private fund adviser must also make the same Form ADV filings as an exempt reporting adviser would.  In addition, the private fund adviser must pay a filing fee to the Virginia State Corporation Commission.

Any private fund adviser that advises one or more 3(c)(1) funds (other than venture capital funds, as defined under federal regulations) must also comply with additional restrictions.  All investors in these funds must be “qualified clients.” [2]  If the adviser is relying on the net worth requirement to qualify an individual investor as a qualified client, then the value of an investor’s primary residence must be subtracted from his or her net worth.  The fund manager must also disclose in writing all services that are provided to individual owners (if any), all duties owed to individual owners (if any), and any other material information affecting the rights or responsibilities of owners.  Finally, the fund manager must provide audited financial statements to each investor.

Fund managers registered with the SEC will be required to make applicable notice filings to the Virginia State Corporation Commission even if they would otherwise qualify for the private fund adviser exemption.

The new rule also provides grandfathering provisions for fund managers of 3(c)(1) funds that existed before the effective date of the new regulations (May 1, 2012) but cease accepting non-qualified clients after the date, as long as the fund manager does comply with the disclosure and audit requirements of the new exemption.

Interested parties may submit comments by April 12, 2012.

Footnotes

[1] A 3(c)(1) fund is a fund which has under 100 investors.  A 3(c)(7) fund is a fund which is limited to qualified purchasers, which are defined roughly as a person with at least $5 Million in investment assets or a company with at least $25 Million in investment assets.

[2] A “qualified client” is defined as an individual or company that has at least $1 Million under the management with the investment adviser or has a net worth (together with assets held jointly with a spouse) of more than $2 Million.

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© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Filed Under: Investment Management Tagged With: , , , , , , ,

California Department of Corporations Proposes New Private Fund Exemption

February 9, 2012 By 1 Comment

On December 15, 2011, the California Department of Corporations proposed revised regulations exempting certain private fund managers from investment adviser registration with the state of California.

Background

Previously, under Cal. Code Regs. tit. 10, § 260.204.9, private fund managers in California were exempt from investment adviser registration if they met the federal 15 client exemption, and they had assets under management of $25 million or more or they provided investment advice solely to “venture capital companies.”  On June 13, 2011, the California Department of Corporations amended this rule to remove the reference to the federal 15 client exemption.  Under this change, a private fund manager is exempt if it “(1) does not hold itself out generally to the public as an investment adviser, (2) during the course of the preceding twelve months has had fewer than 15 clients, (3) does not act as an investment adviser to any investment company registered under… the Investment Company Act of 1940…, and (4) either (i) has assets under management… of not less than $25,000,000 or (ii) provides investment advice to only venture capital companies…”[1]

However, the June 13, 2011 rule was temporary and the exemption automatically expired on January 21, 2012.  The California Department of Corporations stated that it intended to “study how best to regulate advisers to alternative investment vehicles, while balancing the regulatory burden on such advisers, with any corresponding investor protections issues.”   Now it appears that the California regulators have acted.

The New Rule

The new December 15, 2011 rule did two things.  First, it extended the temporary June 13, 2011 rule described above until June 28, 2012.  Second, it proposes for comment, a new private fund adviser exemption based on the NASAA model rule.

The new proposed regulations provide for an exemption from registration for “private fund advisers.” A private fund adviser is any investment adviser who provides advice solely to one or more private funds (i.e. a 3(c)(1) fund or a 3(c)(7) fund).[2]   A private fund adviser must not be subject to disqualification from prior bad acts such as fraud or other securities law violations.  The private fund adviser must also make the same Form ADV filings as an exempt reporting adviser would.  In addition, the private fund adviser must pay a filing fee to the California Department of Corporations.

Any private fund adviser that advises a 3(c)(1) fund (other than venture capital funds, using the California definition not the Federal one) must also comply with additional restrictions.  All investors in these funds must be accredited investors.  The fund manager must also disclose in writing all services that are provided to individual owners (if any), all duties owed to individual owners (if any), and any other material information affecting the rights or responsibilities of owners.  The fund manager must provide audited financial statements to each investor.  Finally, the fund manager must comply with California rules on incentive allocations, which essentially means that all investors will also need to be “qualified clients”[3] in addition to being accredited investors.

Fund managers registered with the SEC will be required to make applicable notice filings to the California Department of Corporations even if they would otherwise qualify for the private fund adviser exemption.

The new rule also provides grandfathering provisions for fund managers of 3(c)(1) funds that existed before the effective date of the new regulations but cease accepting non-accredited investors after the date, as long as the fund manager does comply with the disclosure and audit requirements of the new exemption.  There is a technical problem here: the grandfathering provision makes no mention to the “qualified client” requirement, so it is unclear how it would apply to funds that are owned exclusively by accredited investors but not by qualified clients (a very common situation).

One other issue I have with the rule is that it uses the old California definition of “venture capital company” to determine whether a fund is a venture capital fund, rather than the new Federal definition, as many states are using in their exemptions.  Funds that meet one definition may not meet another.  It seems counterproductive to make venture capital fund managers have to deal with two conflicting standards.

Interested parties may submit comments until 5:00pm, February 20, 2012.  I suspect that some of these technical issues may get resolved prior to the rule being finalized.

Footnotes

[1] California has its own definition of “venture capital company,” not to be confused with the federal definition of “venture capital fund.”  Under California law, an entity is a “venture capital company” if, on at least one occasion during the annual period commencing with the date of its initial capitalization, and on at least one occasion during each annual period thereafter, at least fifty percent (50%) of its assets (other than short-term investments pending long-term commitment of distribution to investors), valued at cost, are “venture capital investments” or investments derived therefrom.  A “venture capital investment” is an acquisition of securities in an “operating company” as to which the investment adviser, the entity advised by the investment adviser, or an affiliated person of either has or obtains management rights.  An “operating company” means an entity that is primarily engaged, directly or through a majority owned subsidiary or subsidiaries, in the production or sale (including any research or development) of a product or service.

[2]  A 3(c)(1) fund is a fund which has not more than 100 investors.  A 3(c)(7) fund is a fund which is limited to qualified purchasers, which are defined roughly as a person with at least $5 Million in investment assets or a company with at least $25 Million in investment assets.

[3] A “qualified client” is defined as an individual or company that has at least $1 Million under the management with the investment adviser or has a net worth (together with assets held jointly with a spouse, but not including the value of the individual’s primary residence) of more than $2 Million.

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© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Filed Under: Investment Management Tagged With: , , , , , , ,

Indiana Securities Division Updates Its Private Fund Exemption to Include Non-Venture Capital Funds

January 20, 2012 By Leave a Comment

In August 2011, the Indiana Securities Division issued an Administrative Order updating its venture capital exemption from investment adviser registration under the Indiana Uniform Securities Act to harmonize its provisions with the new venture capital exemption in the Dodd-Frank Act.  Under the August 2011 order, a venture capital fund manager was exempt from investment adviser registration with the Indiana Securities Division if: (1) it maintains a place of business in Indiana, (2) during the preceding twelve months, it had no more than 5 clients that are residents of Indiana, (3) it does not hold itself out generally to the public as an investment adviser, and (4) it met the federal venture capital exemption from registration with the SEC.  The order included a qualifier stating that the order would be in effect “[u]ntil the Division can promulgate rules to address venture capital funds and investment adviser registration…”  Therefore, it was clear that the Indiana Securities Division viewed the order as temporary.

On January 9, 2012, the Indiana Securities Division issued an update to the Administrative Order that modifies the previous order.[1]  Conditions (1)-(3) described above still apply (relating to having a place of business in Indiana, having 5 clients or less, and not holding itself out as an investment adviser), but the exemption now applies to a much broader class of private fund managers.  Now any adviser that manages one or more private funds (and meets the first 3 requirements) qualifies for the exemption, so long as neither the fund manager nor any of its affiliates are subject to disqualification under the federal “bad actor” provisions.  Also, the order imposes three additional conditions on so-called “3(c)(1) funds”[2] that are not venture capital funds: (1) all of its owners must have been accredited investors at the time of their investment; (2) at the time of investment, the fund manager must have provided additional written disclosure which describes all services, if any, provided to the individual owners of the fund, all duties, if any, owed by the fund manager to the individual owners, and any other material information affecting the rights and responsibilities of the individual owners; and (3) the private fund must provide annual audited financial statement to each owner of the fund.  None of these three additional requirements apply either to venture capital funds (as defined in the federal regulations) or so-called “3(c)(7) funds.”[3]

As with the previous August 2011 order, the Indiana Securities Division has included language to indicate that this order is temporary, until the Securities Division decides on a more permanent approach.  It remains to be seen what that approach will be.

Footnotes

[1] Actually, nowhere does it mention on the face of the order that the new order replaces the previous one.  However, the previous order is no longer posted on the Indiana Securities Division website.  There is only one instance where a fund manager would be exempt under the August 2011 order but not under the January 2012 order.  A venture capital fund manager that is subject to disqualification under the federal “bad actor” exclusions would be exempt under the previous order but not the new one.

[2] 3(c)(1) funds are funds that are exempt from Investment Company Act registration because they have 100 or less beneficial owners.

[3] 3(c)(7) funds are funds that are exempt from Investment Company Act registration because they are sold exclusively to “qualified purchasers” which generally are individuals with $5 million or more in investments or companies with $25 million or more in investments.

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© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Filed Under: Investment Management Tagged With: , , , , , ,

What are “regulatory assets under management” and why does a private fund manager need to determine them?

January 18, 2012 By Leave a Comment

With the new registration requirements under the Dodd-Frank Act and the enhanced reporting required of some private fund managers under Form PF, private fund managers must now make a yearly (or sometimes more frequent) calculation of their “regulatory assets under management.”  Essentially this is a total tally of the assets over which the fund manager provides investment advice, calculated using a method proscribed by the SEC.  There are a number of instances where a fund manager needs to make this determination:

  • ADV Reporting.  With the new registration requirements under the Dodd-Frank Act, more private fund managers must now register as investment advisers with the SEC or with state securities divisions.  In addition, even though some private fund managers may be exempt from such registration, they must still submit Form ADV as an “exempt reporting adviser.”  In either case, Form ADV requires that the fund manager disclose its regulatory assets under management.
  • Eligibility for an Exemption.  Even after the enactment of the Dodd-Frank Act, some fund managers are still exempt from registration.  Fund managers that have less than $25 million under management are exempt completely if the fund manager’s home state provides an exemption.  In addition, fund managers with less than $150 million under management may be exempt from registration with the SEC (though they must still submit Form ADV as an exempt reporting adviser).  To make a determination whether a fund manager qualifies for one of these exemptions, the fund manager must calculate its regulatory assets under management.
  • Division of Responsibility Between Federal or State Regulators.  If a fund manager must register, because it does not qualify for an exemption, there is a division of responsibility between the state securities divisions and the SEC.  If a fund manager has $100 million or less of regulatory assets under management, then in most cases, it must register with its state securities division instead of with the SEC.  Once again, the calculation of regulatory assets under management is used to make this determination.
  • Form PF.  Private fund managers with $150 million or more of assets under management within private funds are required to file Form PF annually, which requires the fund manager to disclose regulatory assets under management. In addition, certain large fund managers such as those with over $1.5 billion in hedge fund assets under management will be required to report quarterly.  A determination of regulatory assets under management is used to determining whether a fund manager qualifies for these requirements.

Therefore, being able to determine regulatory assets under management is important for a variety or reporting and compliance needs.  The procedure for determining regulatory assets under management is described in the instructions for Form ADV and in the final rule published by the SEC regarding “Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers With Less Than $150 Million in Assets Under Management, and Foreign Private Advisers.”  For private fund managers, there are a number of pitfalls.

First, when counting assets, the fund manager is required to include all gross assets without any deduction for debt or leverage.  Therefore, if a fund has $30 million of assets and $20 million in debt, it is considered to have $30 million in regulatory assets under management, not $10 million.

Second, the fund manager must also include uncalled capital commitments.  This especially affects venture capital funds and private equity funds, who will often require investors to commit a certain amount of capital but not actually contribute cash to the fund until a later date.  Therefore, if a fund manager obtains a commitment from an investor to invest $1 million, and the investor has only actually contributed $200,000, the fund manager must include the remaining $800,000 in its regulatory assets under management.

Finally, all assets must be valued at their market value or fair value.  For assets that are publicly traded securities, this is relatively simple.  The fund manager can use the most recent trade price.  But private funds often hold illiquid assets that are difficult to value.  How does the fund manager go about valuing those?

The SEC’s guidance offers a number of suggestions.  First, for funds that issue financial statements for their investors that utilize GAAP or some other internationally recognized accounting standard, the values used in those statements can be used for calculating regulatory assets under management.  However, there are funds that do not produce GAAP financial reporting (especially those which do not allow investors to enter or leave the fund over its lifespan).  For these funds, the process of valuing assets becomes more complex.  The SEC has explicitly said in its commentary to the final rule that the requirement for calculating fair value does not mandate a particular procedure nor require the use of a third-party pricing service or appraiser.  Rather the fund manager must act consistently and in good faith.  This ambiguity will likely cause fund managers a great number of headaches in the years to come.  It will be crucial for them to adopt standards that are reasonable and consistently applied year in and year out across all illiquid assets and to document all decisions and methodologies used in determining asset values.

Fund managers should consult an attorney familiar with securities laws in making any difficult determinations.  Failure to do so could lead to a fund manager failing to register when they should have, or reporting inaccurate information, both of which could lead to sanctions from securities regulators.

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© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Filed Under: Investment Management Tagged With: , , , , , , , , , , , ,
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