The Dodd-Frank Act will require private equity fund managers (who were previously exempt from registration) to register as investment advisers with state or federal authorities. As a result, private equity firms are bracing for the expected "culture shock" as, for the first time, they gear up for registration, a new compliance infrastructure, and public disclosure and scrutiny.

In this handbook, we summarize the principal aspects of the Dodd-Frank Act as it applies to the registration of private equity fund managers under the Investment Advisers Act of 1940. We describe who must register, the registration process, the timetable for compliance, and how registration will impact fund managers.

We note that this handbook contains only general summaries of the Dodd-Frank Act and recently proposed or enacted SEC rules.

Who Must Register?

Background

The Dodd-Frank Act effectively eliminates the principal Advisers Act exemption (referred to as the "fewer than 15 clients" exemption) that fund managers have long relied on to avoid state and federal registration. Prior to Dodd-Frank, an adviser with fewer than 15 clients that did not hold itself out as an investment adviser, was generally exempt from registration. As a result, very few fund managers were required to register as investment advisers, and were therefore exempt from many of the compliance obligations under the Advisers Act.

As we will discuss below, Title IV of the Dodd- Frank Act changes the "fewer than 15 clients" exemption, adds a number of new exemptions, and generally increases the dollar threshold for advisers who are required to register with the SEC. This changing regulatory landscape is expected to result in a significant number of private advisers being required to register and becoming subject to the full compliance obligations under the Advisers Act.1

The New Thresholds for Advisers Act Registration

The SEC has generally increased the threshold for registration with the SEC to $100 million in assets under management (AUM) rather than $25 million under the prior rules, subject to numerous exceptions. This creates the following three new categories of advisers:

  • Small Advisers (<$25 million in AUM) – generally prohibited from registering with the SEC2
  • Mid-Sized Advisers ($25 – $100 million in AUM) - generally prohibited from registering with the SEC, unless the adviser is specifically permitted or required to register with the SEC (as described in the tables below)
  • Large Advisers ($100 million + in AUM) – generally required to register with the SEC, unless an exemption applies3

Calculating Assets Under Management

To determine which category applies to a particular fund manager, it must calculate its "regulatory assets under management." In the Implementing Release4 (which we note is not yet final), the SEC proposed a uniform calculation of regulatory assets under management that can be used for all purposes under the Advisers Act.

In determining an advisers assets under management, the SEC instructs advisers to include the securities portfolios (including private equity funds) for which the adviser provides "continuous and regular supervisory or management services" as of the date of filing the Form ADV.

In an effort to achieve more consistency in reporting (and so advisers cannot opt into or out of state or federal regulation by including or excluding a class of assets), advisers are no longer permitted to exclude from their AUM calculations family or proprietary assets, accounts managed without receiving compensation, or assets of clients who are not U.S. persons (all of which an adviser currently may, but is not required to, exclude).

The SEC has also proposed new instructions in Form ADV to provide guidance for fund managers in determining the amount of assets the adviser has under management. Specifically, the instructions provide that:

  • Advisers to private equity funds are required to include the value of any private fund over which it exercises continuous and regular supervisory or management services, regardless of the nature of the assets held by the fund;
  • Value should be based on the current market value (or fair value) of the private equity fund's assets and the contractual amount of any uncalled commitments as determined within 90 days prior to the date the Form ADV is filed; and
  • Market value should be determined using the same method the adviser uses to report account values to its clients.

New Exemptions Under the Dodd-Frank Act

Investment advisers who may otherwise be required to register under the Advisers Act may be able to rely upon new exemptions created by the Dodd-Frank Act.

Foreign Private Advisers

The "fewer then 15 clients" exemption has been modified to extend only to "foreign private advisers." Specifically, the new exemption is available only to advisers who:

  • Have no place of business in the U.S.;
  • Have less than $25 million in AUM attributable to U.S. clients and investors in "private funds" (described below) advised by the adviser, and
  • Have fewer than 15 U.S. clients and investors in private funds advised by the adviser; and
  • Neither holds itself out as an investment adviser in the U.S., nor acts as an adviser to an investment company or a business development company.5

Note that the term "private funds" under the Dodd- Frank Act includes private equity and other investment funds that would be an investment company as defined in Section 3 of the Investment Company Act but for the exemptions in Sections 3(c)(1) or 3(c)(7) thereof. Most private equity funds rely on these exemptions, and therefore would be considered "private funds" under the new rules.

Intra-State Advisers

The Dodd-Frank Act also restricts the intra-state advisers exemption. This exemption generally provides that advisers who only advise clients in one state are not required to register with the SEC. Under the Dodd-Frank Act, the intra-state advisers exemption is preserved, except that fund managers that advise private funds may not rely upon such exemption.6

Advisers Only to Venture Capital Funds

The Dodd-Frank Act exempts from registration fund managers that advise venture capital funds, regardless of the number or the size of the funds.7 To rely on this exemption, a manager may only advise venture capital funds (advisers to any separate account clients may not rely on this exemption).

The SEC has proposed to define a "venture capital fund" as a private fund that:

  • Invests solely in equity securities of "qualifying portfolio companies" in order to provide operating and business expansion capital;
  • Acquired directly from qualifying portfolio companies at least 80% of each company's securities owned by the fund;
  • Offers or provides significant managerial assistance to, or controls, the qualifying portfolio company;
  • Does not borrow or otherwise incur leverage (other than on a short-term limited basis);
  • Does not offer its investors redemption or other similar liquidity rights except in extraordinary circumstances;
  • Represents itself as a venture capital fund to investors; and
  • Is not registered under the Investment Company Act and has not elected to be treated as a business development company.

The SEC has proposed to define "qualifying portfolio companies" as any company that:8

  • At the time of any investment by the private fund, is not publicly traded and does not control, is not controlled by or under common control with another company, directly or indirectly, that is publicly traded;
  • Does not borrow or issue debt obligations, directly or indirectly, in connection with the private fund's investment in such company;
  • Uses the capital provided by the fund for operating or business expansion purposes rather than to buy out other investors; and
  • Is not itself an investment company, a private fund, an issuer that would be an investment company but for the exemption provided by Rule 3a-7 of the Investment Company Act or a commodity pool.

Managers relying on this exemption will not be required to register with the SEC, but will be considered "Exempt Reporting Advisers," subject to certain limited (public) reporting requirements, including certain parts of Form ADV. Exempt Reporting Advisers are also subject to examination by the SEC.

The SEC has proposed a grandfathering provision to assist fund managers who are raising a fund during the rulemaking process and who may not otherwise qualify for the venture capital fund exemption. Under this provision, the SEC will expand the definition of "venture capital fund" to include any fund that:

  • Represents to investors at the time the fund offers securities that it is a venture capital fund;
  • Has sold securities to investors prior to December 31, 2010; and
  • Does not sell any securities to, or accept increased commitments from, any person after July 21, 2011.

With this exception, managers of these funds may rely on the venture capital fund exemption (despite the fact that the funds they advise may not otherwise satisfy the definition of "venture capital fund" under the final rules).

Advisers Only to Private Funds

The SEC has proposed rules that would provide an exemption from registration to any investment adviser that only advises private funds if the adviser has AUM in the U.S. of less than $150 million.9 As noted above, the term "private fund" will include most private equity funds.

Like the venture capital fund exemption, managers relying on the private funds exemption will be Exempt Reporting Advisers, and subject to SEC examination and modified reporting requirements.

Advisers Excluded from the Definition of "Investment Advisers"

An "investment adviser" is generally defined as "any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities,"10 other than advisers who are:

  • Banks or bank holding companies;
  • Lawyers, accountants, engineers or teachers whose performance of advisory services is incidental to their profession;
  • Certain broker-dealers;
  • Newspaper or magazine publishers;
  • Advisors whose advise relates to U.S. government securities;
  • Nationally recognized statistical rating organizations; or
  • Family offices.

Thus, if an investment adviser solely advises about matters other than securities, it may not be an "investment adviser" within the meaning of the Advisers Act. Where an investment adviser is not an "investment adviser" within the meaning of the Advisers Act, it will generally not be subject to the Advisers Act (and likely will not be subject to state investment advisers laws).

State vs. Federal Registration

Registration under the Advisers Act will preempt state registration.11 If an adviser is eligible for federal registration (but federal registration is not required) it may choose between federal and state registration. It is anticipated that in this situation, many advisers will choose to register with the SEC, rather than register with the applicable state authorities, because state registration can be more onerous as it may involve registration and fees in multiple states, various testing requirements for investment adviser representatives and compliance with certain state rules regarding investment advisers and investment adviser representatives. Thus, just because an exemption from the Advisers Act is possible does not mean that an investment adviser will desire to rely upon it.

The tables below provide a short-hand look at the Dodd-Frank Act registration and exemption provisions. Please be advised that despite the summary nature of the table below, the rules in this area are complex, very fact specific, and of course subject to change. Please contact your Morrison & Foerster Private Equity Funds attorney for further guidance on determining whether your firm must register with the SEC or state authorities.

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Footnotes

1. In addition, investment advisers who are already registered with the SEC, but who no longer meet the new AUM thresholds, will be required to deregister.

2. Advisers Act, Section 203A(a)(1)

3. Dodd-Frank Act, Section 410; Advisers Act, Rule 203A-1

4. Release No. IA-3110, Rules Implementing Amendments to the Investment Advisers Act of 1940, available at http://sec.gov/rules/proposed/2010/ia-3110.pdf

5. Dodd-Frank Act, Section 403

6. Dodd-Frank Act, Section 403

7. Dodd-Frank Act, Section 407

8. Release No. IA-3111, Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers with Less than $150 Million in Assets Under Management and Foreign Private Advisers, available at http://www.sec.gov/rules/proposed/2010/ia-3111.pdf

9. Dodd-Frank Act, Section 408

10. Advisers Act, Section 202(a)(11)

11. Advisers Act, Section 203A(b)

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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