A modest proposal

A $30 million AUM threshold proposed by the Obama administration would likely force nearly all private equity firms to register as investment advisers.

President Obama’s regulatory proposals would require hedge funds, private equity funds and venture capital funds to register with the Securities and Exchange Commission if their assets under management exceed a “modest” threshold: $30 million according to a bill the Treasury Department recently sent Congress. The announcement confirms what many firms were expecting, that all but the smallest private equity houses will fall under this regulatory umbrella.

Under the plan, private funds managed by SEC-registered advisers will be subject to recordkeeping requirements, disclosure requirements with respect to investors, creditors and counterparties, as well as undefined reporting requirements to a “systematic risk” evaluator. They will also have to report the amount of assets under management, debt and off-balance sheet exposures, and SEC will have the authority to conduct regular examinations to monitor their compliance.

The purpose of this regulation is to help the government to determine if a fund is so large, highly leveraged or interconnected that its failure could pose a threat to the financial stability of the US.The government also believes that higher capital requirements and regulatory scrutiny will “compel these firms to internalise the costs they could impose on society in the event of failure”, according to a White Paper released by the Obama administration.

The registration requirements proposed by the White House are similar to proposals outlined by US Treasury Secretary Timothy Geithner before Congress earlier this year, although at the time he had left firms guessing as to what the registration threshold will be.
Senate Banking Subcommittee Chairman Jack Reed has also introduced legislation that would require funds that manage more than $30 million in assets to register, while those falling under that level would be subject to state oversight. “This bill provides the SEC with long-overdue authority to examine and collect data from this key industry,” Reed told reporters. “It also authorises the SEC to share this data with other federal agencies in order to create a systemic approach to identifying and mitigating risks.”

Lowering the bar
While the proposed $30 million threshold is the same as in the Investment Advisors Act of 1940, many private equity funds over that level have avoided having to register due to a waiver for those with less than 15 clients. However, several attorneys have said it is likely that the Obama administration will reduce or eliminate that exemption in order to bring in more firms under the regulations.
“The current proposal will remove the existing exemption for advisors with less than 15 clients,” says Heather Stone a partner at Edwards Angell Palmer & Dodge. “So that is how [those who have not had to file] are going to end up being captured. Thirty million is pretty small, that’s already going to cover just about every professional fund out there.”
If so, then many small middle-market firms may have to deal with increased time and monetary costs associated with the new regulatory requirements. Morrison Cohen partner David Lerner has said that firms with assets under $50 million may not survive if they are required to bring on more resources to handle the additional workload.

“Keeping the kind of detailed records the SEC requires under the Investment Advisors’ Act is more burdensome, and having the SEC potentially having unannounced audits can certainly be a problem,” he says. “There are costs involved, and it definitely adds a significant layer of expense that mid-sized and smaller shops will find annoying, and if you couple that with their declining after-tax take-home, there will be a shakeout.”

He adds that private equity managers will also find keeping such extensive books and monitoring the personal trading of all the professionals in a fund management company to be highly intrusive.

Marco Masotti, co-head of the private equity group at Paul, Weiss, Rifkind, Wharton & Garrison, says while more mature, established firms have the financial means to handle the new demands, registration will likely present a roadblock to newer firms. “First and foremost it acts as an impediment,” he says. “There will be additional costs – including hiring a compliance person – and for a small firm it could be in the $200,000 to $300,000 range, which is real money for those firms.”
However, he adds that larger firms will feel some pain as well. “Different investments require sometimes different investment vehicles,” Masotti says. “There are co-investment vehicles, there are alternative investment vehicles, there are parallel vehicles, and the idea of having in some way to make filings for each of these is going to be very administratively cumbersome.”

Too big to fail
Another concern for private equity firms is that the proposals indicate that the SEC will share a private fund’s confidential reports with the Federal Reserve, which will take on a new role as a systemic risk regulator. The Fed would then determine whether such firms meet the criteria for being classified as a Tier 1 Financial Holding Company, which in essence would make them “too big to fail”. These firms would then be subject to the “prudential standards” for Tier 1 companies, including capital, liquidity and risk management standards that are stricter than those for other firms.

Masotti says that figuring out the boundaries of who is considered a threat and what that will mean for fund managers is something that lawyers will likely be spending a lot of time on in the coming months. “Based on the activities of these funds they need highly flexible investment mandates, and it is hard to see them functioning as financial holding companies.”

However, Lerner says he believes that most firms will likely not have to worry about getting swept up into these stricter standards. “For private equity and venture capital is it meaningless,” he says. “It would be impossible to find a private equity fund of any size, let alone a venture capital fund, that could qualify as having a Tier 1 risk. Even if you are talking about a $10 billion hedge fund, $10 billion is a drop in the bucket in terms of systemic risk, compared to banks holding g hundreds of billions of dollars in deposits. The systemic risk arises when these institutions employ leverage, including complex derivatives at rates of 50 to 1, so that if they fail it is calamitous”.

Stone agrees that while the standards for who will be classified as Tier 1 are subjective and not cut and dried at this point, the number of firms captured will be small. “I suspect that they will not be true stand-alone private equity houses, but more hedge funds that are associated with much larger financial enterprises,” she says.

Putting clients first
A side issue in the White Paper involves broker-dealers: the paper calls for legislation to bolster investor protections and bring consistency to the regulation of broker-dealers and investment advisers. The new rules would require broker-dealers who provide investment advice about securities to be subject to the same fiduciary obligations as registered advisers, as well as provide simple and clear disclosure to investors regarding the scope of their relationships with investment professionals.

“A fiduciary is expected  to put the interests of his client ahead of his own, so perhaps for an adviser to be subject to a fiduciary duty and the broker-dealer not to be didn’t seem right to them,” says Prakash Mehta, co-head of Akin Gump’s investment funds and private equity practice.
As it moves through the legislative process, various firms are taking different tacks in addressing the proposals. Madison Dearbon managing partner Mark Tresnowski recently testified on behalf of the Private Equity Council in front of the US Senate, saying that the group supports registration generally, although he cautioned on the administrative and financial burden that it would have on smaller firms.

In contrast, the National Venture Capital Association has come out more strongly against the proposals and its impacts on venture capital, which is often important for funding newer, innovative companies. Following Obama’s proposal it released a statement saying, “We strongly assert that the venture capital industry does not pose such risks and should not be swept up into regulation intended for other investment vehicles.”

Lerner says he believes the private equity industry will be willing to give ground on things like disclosing prior employment records, allowing the SEC to audit books and records and implementing appropriate trading policies. However, he says, “what hedge funds and private equity managers care most about is maintaining as much opacity as possible about how they do what they do. That is mother’s milk to them, and they will fight to the last breath to keep that information from being disclosed.”