SEC to Regulate Advisors to Private Funds and Others

Among the many looming financial reforms is a requirement that managers of large hedge funds and private equity funds register as investment advisors.

Many smaller funds, family offices and venture capital firms will get some relief.

Managers of hedge funds, private equity funds, venture capital funds and family offices who have fewer than 15 clients often rely on the so-called "private advisor exemption" from registering as an investment advisor. However, Title IV of the "Dodd-Frank Wall Street Reform and Consumer Protection Act," which was signed into law this month, removes this coveted exemption, requiring advisors to private investment funds and some other private investment advisors to register, unless alternative exemptions are available. Certain previously exempt advisors will have one year to register with the U.S. Securities and Exchange Commission (SEC), or in some cases a state regulator.

Who is Affected?

Hedge Fund and Private Equity Fund Managers — Managers who advise investment funds of $150 million or more and that would be registered investment companies but for the so-called 3c-1 or 3c-7 exemptions under the Investment Company Act of 1940 (collectively, "Private Funds") will have to register as investment advisors. Managers solely to private funds less than $150 million are exempt from registration as investment advisors, but will nonetheless be subject to upcoming SEC recordkeeping and reporting requirements.

Managers of private funds greater than $150 million will also be subject to systemic risk reporting not required by traditional registered investment advisors. For example, private fund advisors must report to the SEC their borrowings, off-balance sheet exposures, counterparty credit exposures, trading and investment positions, and other information to assess potential systemic risk and threats to U.S. financial stability. The SEC will share this information with other federal regulators to aid in assessing systemic risk.

Family Office Advisors — The legislation aims to exempt single family offices from registration. The SEC will define and exempt family offices consistently with previous exemptive policy and recognizing "the range of organizational, management, and employment structures and arrangements employed by family offices." A grandfather provision retains exemption for some family offices whose key employees invested alongside the family prior to January 1, 2010.

Based on prior exemptive orders for family offices, the SEC's family office exemption conditions might include that:

• All clients are family members, lineal or adopted descendants and their spouses, entities or charities funded and wholly-owned by family members, and trusts whose beneficiaries are family members
• Family members wholly own the advisor and hold a majority of seats on its board of directors
• The advisor was created solely to function as the family office and its fees are designed only to cover costs
• The advisor does not hold itself out to the public as providing investment advice, and does not solicit or accept non-family members as clients (possibly with isolated exceptions, such as a long-standing loyal employee)

Multi-family advisors and advisors to family assets held in a large private fund as described above may not be able to avail themselves of the family office exemption.

Venture Capital Fund Managers — Venture capital firms will be exempt from registration as investment advisors, but will nonetheless be subject to upcoming SEC recordkeeping and reporting requirements. Some anticipate that the SEC will create a narrow definition of "venture capital fund" so that other private funds cannot abuse the exemption. While purely speculative at this point, some possible limitations in the definition might include:

• Restrict to holding common shares in operating companies
• Prohibit or limit holding of debt or preferred shares
• Prohibit or limit acquiring publicly-traded securities
• Restrict the type of operating companies invested in

Depending on the definition adopted, venture capital firms might conclude that restrictions necessary to meet exemption criteria are too constrictive, and may consider registering to retain flexibility of investment approaches.

Operating as a Registered Investment Advisor

If you are required to register, your business will become more transparent to regulators, clients and the public. Most notably, your records become subject to confidential review by SEC examiners. Information about your business practices, ownership structure, client base, services offered and other disclosures become publicly available on an SEC-sponsored website. Certain advisors with investment discretion over $100 million or more of certain securities must also publicly disclose large individual securities positions. Required disclosures to clients (such as fees, types of clients serviced, types of investments and investment strategy employed, professional background, certain financial affiliates, and conflict-of-interest disclosures, as applicable) is not made public now, but the SEC did propose a rule which would make it available online.

A registered investment advisor has various ongoing requirements, restrictions, and prohibitions in its administrative and investing activities. The exact requirements can vary depending on size, activities, and complexity, but certain elements must always be present. One core requirement is a compliance program with customized written policies, designated chief compliance officer and an annual program review. The procedures should cover areas such as portfolio management, trading practices, proprietary and employee trading, accuracy of disclosures, safeguarding assets, recordkeeping, asset valuation, privacy of information, business continuity planning and marketing.

A host of other requirements or restrictions might apply, such as if you advertise performance, charge performance-based fees, have custody of client assets, use solicitors to obtain new clients, and other business activities.

Action Steps

Private advisors facing registration should prepare well in advance, and restructuring the business model or investment vehicles may provide some regulatory relief. If registration is unavoidable, advisors should begin to develop policies and procedures, recordkeeping systems, disclosure documents and resolve staffing issues prior to the registration compliance date. Advisors should also assess whether to develop particular systems and expertise internally or through outsourcing. Vendors and consultants can assist in easing the transition into a regulated environment and provide systems or outsourcing to streamline the new compliance-related workload.

Registration and life as a registered investment advisor will add a new layer of costs and operational complexity which will vary depending on the nature of your advisory practice. However, the requirements are not onerous. Managed properly, operating as a registered investment advisor can be achieved with minimal incremental risk. It may even provide a benefit by way of increased client comfort with your operations.