Will Your Family Office or Private Fund Be Exempt from SEC Registration?

As previously discussed in our July 2010 newsletter article, the Dodd-Frank Wall Street Reform and Consumer Protection Act requires managers of large hedge funds, private equity funds, and multi-family offices to register with the Security and Exchange Commission (SEC) as investment advisors.

The SEC recently proposed rules to implement registration exemptions for smaller funds, venture capital funds of any size, and single family offices. While those who qualify for these exemptions get relief from registration, they may not entirely escape increased regulation.

Registration for Large Private Funds

On July 21, 2011, managers who advise private investment funds of $150 million or more in aggregate will have to register with the SEC as investment advisors. A “private fund” would include a pooled investment vehicle exempt from registration as an investment company based on the so-called 3c-1 or 3c-7 exemptions under the Investment Company Act of 1940. In addition to typical hedge funds and private equity funds, the proposed rules would also treat many real estate funds, liquidity funds, and securitized asset funds as private funds.

When calculating assets under management for the $150 million threshold test, the proposed rules would require use of the fair value method. Among other items, uncalled committed capital and assets of non-U.S. investors must also be included.

Exemption for Smaller Private Fund Advisors

Managers of one or more private funds totaling less than $150 million are exempt from federal registration as investment advisors and the full slate of regulations that would ensue. Despite this registration exemption, these so-called “exempt reporting advisors” will nevertheless be subject to SEC examination and recordkeeping requirements. Periodically, exempt reporting advisors would also publicly disclose their basic background information, such as their related business activities, fund organization and characteristics, and disciplinary history beginning on August 20, 2011. Many of these exempt reporting advisors would be required to register at the state level. However, many states are likely to adopt regulations mirroring the federal exempt reporting advisor requirements. The private fund exemption would not be available to a manager who also advises clients other than private funds. Instead, the manager would register either at the federal or state level depending whether assets under management are over, or under, $100 million.

Exemption for Venture Capital Fund Advisors

Managers who solely advise venture capital companies are exempt from SEC registration regardless of the amount of assets under management. Like the smaller private fund advisors, venture capital company managers would be deemed exempt reporting advisors subject to SEC examination, reporting, and recordkeeping requirements and possibly state registration as described above.

The proposed rules define a “venture capital company” as a private fund that:

  • invests only in equity securities of private “qualifying portfolio companies” to provide operating and business expansion capital (i.e., not to recapitalize the portfolio company);
  • directly, or through its investment advisors, offers or provides significant managerial assistance to, or controls, the qualifying portfolio company (i.e., not a hedge fund);
  • does not borrow or otherwise incur leverage, other than limited short-term borrowing (i.e., not a leveraged buyout fund);
  • does not offer its investors redemption or other similar liquidity rights except in extraordinary circumstances (i.e., long term investments);
  • represents itself as a venture capital fund to investors (i.e., not a multi-strategy fund that incorporates venture capital strategies); and
  • is not registered under the Investment Company Act and has not elected to be treated as a business development company.

There is also a grandfathering provision for certain venture capital funds but this provision effectively has limited and temporary utility.

Exemption for Family Offices

A “family office” company would be exempt from the definition of investment advisor so long as:

  • all clients fall under the definition of “family clients,” as described below;
  • it is wholly owned and controlled by family members; and
  • does not hold itself out to the public as an investment advisor.

The proposed rule contemplates a founding couple, and permits a family office to provide investment advice to the founders and their parents, siblings, and lineal descendents. The definition of “family client” is relatively generous and addresses spouses and “spousal equivalents;” adopted and step-children; family trusts; family charitable foundations and trusts; other family investment vehicles; former family members such as ex-spouses, key employees and former key employees; and involuntary transfers to non-family members. We believe the SEC sought to draft a thoughtful and permissive definition to incorporate the realities of a typical single family office. However, the devil is in the details. For example, the definition effectively excludes the founders’ aunts, uncles, and cousins. This can be particularly problematic when the family office was founded by one or more children or grandchildren of the patriarch or matriarch and thus has the founder’s extended family as clients. We are also seeing that many family offices would not be able to avail themselves of the proposed exemption due to restrictions on non-family minority ownership, control, funding or investments in the family’s trusts, charities or investment vehicles.

The second condition for the exemption requires the family office be wholly owned and controlled, either directly or indirectly, by family members. Here again, we are finding that non-family minority interests or trustee appointments within the ownership structure are causing some family offices to fall short of the ownership and control requirements.

The third, and likely simplest, condition for the exemption would require that the family office does not hold itself out to the public as an investment advisor. This condition is not thoroughly discussed in the proposal; however, the premise is that a family office holding itself out to the public as an investment advisor is likely a commercial business seeking out non-family clients.

Congress required that the SEC exclude a typical single family office from the definition of an investment advisor. Furthermore, the SEC indicated that it does not want to regulate the traditional activities of single family offices in the management of their own wealth. Public comments on the proposed rule provide numerous examples indicating that many family offices cannot avail themselves of the exemption as written. Thus, the SEC’s final rule may be more permissive regarding permitted clients and minority non-family ownership.