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Written by Michael Wu

Earlier this month, the Institutional Limited Partners Association (“ILPA”) published Version 2.0 of its Private Equity Principles (the “Principles”).  The Principles set forth the ILPA’s take on the best practices in establishing private equity partnerships between limited partners (“LPs”) and the general partner (“GP”).  The Principles focus on three guiding tenets for developing effective partnership agreements: Alignment of Interest Between LPs and GP, Fund Governance and Transparency to Investors.  The revised version of the Principles incorporate feedback from GPs, LPs and third parties in the industry to increase “focus, clarity and practicality.”

The following are the key changes from the prior version of the Principles under each of the three guiding tenets:

Alignment of Interest Between LPs and GP

  • GP cash contributions are preferred to fee waivers
  • European-style waterfalls (i.e., all contributions plus preferred returns are paid before the GP receives any carry) is preferred to American-style waterfalls (i.e., deal-by-deal), though with certain safeguards, such as carry escrows of 30% or more, 125% NAV tests and interim clawbacks, the American-style waterfall could be acceptable
  • GP clawbacks should be net of taxes, “fully and timely repaid” and should extend beyond the term of the fund
  • Joint and several liability of the GP’s members is preferred, but a joint and several guaranty from a substantial parent company or individual GP member may be acceptable, and LPs should be able to enforce the GP clawback guaranty
  • Lower management fees should be charged at the end of the investment period, the formation of a successor fund and if the term of the fund is extended
  • Deal sourcing fees should be a GP expense
  • LP clawbacks for indemnification should be capped at 25% of the capital commitments and should not apply after two years from the date of distribution
  • Term of the fund may only be increased in one-year increments and only with the consent of a majority of the Advisory Committee or the LPs, and if such consent is not obtained, the fund should be fully liquidated within one year of the end of the fund’s term
  • GP should not co-invest with the fund (i.e., GP’s entire interest should be through the fund)
  • Advisory Committee should review and approve any fees generated by an affiliate of the GP, whether charged to the fund or a portfolio company

Fund Governance

  • GP may be removed for “cause” and the fund terminated for “cause” upon a majority vote of the LPs
  • A 2/3 in interest of the LPs may terminate/suspend the commitment period without fault and a 3/4 in interest of the LPs may remove GP and dissolve the fund without fault
  • GP should accommodate LP investment policies and provide applicable excuse rights
  • A majority in interest of the LPs may make general amendments; a super-majority in interest of the LPs may make “certain amendments” (e.g., investor-specific provisions) and amendments affecting the fund’s investment strategy and the fund’s economics; and amendments negatively affecting any LP’s economics, require the consent of such LP
  • Where the interest of the LPs and the GP is not aligned, a reasonable minority of the members of the Advisory Committee may engage independent counsel at the expense of the fund

Transparency to Investors

  • Annual reports should be delivered within 90 days of the end of the year
  • Annual and quarterly reports should be provided to LPs regarding a portfolio company’s debt
  • Funds should use the ILPA’s standardized form of capital call and distribution notice template

Finally, the ILPA’s release also set forth best practices for Advisory Committees.  More information about the Principles can be found here.

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Written by Michael Wu

On January 26, 2011, the SEC proposed a rule that would require SEC-registered advisers to hedge funds, private equity funds and other private funds to report information to the Financial Stability Oversight Council (“FSOC”) that would enable it to monitor risk to the U.S. financial system.  The information would be reported to the FSOC on Form PF and the information reported on Form PF would be confidential.

The proposed rule would subject large advisers to hedge funds, “liquidity funds” (i.e., unregistered money market funds) and private equity funds to heightened reporting requirements.  Under the proposed rule, a large adviser is an adviser with $1 billion or more in hedge fund, liquidity fund or private equity fund assets under management.  All other advisers would be regarded as smaller advisers.  The SEC anticipates that most advisers will be smaller advisers, but that the large advisers represent a significant portion of private fund assets.

Smaller advisers would be required to file Form PF once a year and would report only basic information about their hedge funds, private equity funds and/or other private funds, such as information regarding leverage, credit providers, investor concentration, fund performance, fund strategy, counterparty credit risk and the use of trading and clearing mechanisms.

Large advisers would be required to file Form PF quarterly and would provide more detailed information than smaller advisers.  The information reported would depend on the type of private fund that the large adviser manages.

  • Large advisers to hedge funds would report, on an aggregated basis, information regarding exposures by asset class, geographical concentration and turnover.  If a hedge fund has a net asset value of at least $500 million, the adviser would report information regarding the fund’s investments, leverage, risk profile and liquidity.
  • Large advisers to liquidity funds would report the types of assets in their liquidity funds, information relevant to the risks of the funds, and the extent to which the liquidity funds comply with Rule 2a-7 of the Investment Company Act of 1940, as amended.
  • Large advisers to private equity funds would respond to questions regarding the extent of leverage incurred by their funds’ portfolio companies, the use of bridge financing and their funds’ investments in financial institutions.

The SEC’s public comment period on the proposed rule will last 60 days.

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Written by Michael Wu

On January 21, 2011, the SEC released its study on the effectiveness of the standard of care required of broker-dealers and investment advisers that provide personalized investment advice regarding securities to retail customers (“Covered Broker-Dealers and Investment Advisers”).  The study also considered the existence of regulatory gaps, shortcomings or overlaps that should be addressed by rulemaking.  The study was prepared pursuant to Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.

The study recommends that the SEC establish a uniform fiduciary standard for Covered Broker-Dealers and Investment Advisers that is at least as stringent as the fiduciary standard under Sections 206(1) and (2) of the Investment Advisers Act of 1940, as amended.  The SEC staff stated that under this standard, Covered Broker-Dealers and Investment Advisers must “act in the best interest of the customer without regard to the financial or other interest of the broker, dealer, or investment adviser providing the advice.”

To implement the uniform fiduciary standard, the study recommends that the SEC adopt rules to address the following:

  • Disclosure Requirements.  Rules should be adopted to address both the existing “umbrella” disclosures (e.g., ADV Part II) and specific disclosures provided by Covered Broker-Dealers and Investment Advisers when a transaction is executed.
  • Principal Trading.  Rules should be adopted to address how Covered Broker-Dealers can satisfy the uniform fiduciary standard when engaging in principal trading activities.
  • Customer Recommendations.  Rules should be adopted to address the duty of care obligations that Covered Broker-Dealers and Investment Advisers have in making recommendations to retail customers.

The study further recommends that the SEC harmonize other areas of broker-dealer and investment adviser regulation, such as regulations pertaining to advertising and communication, the use of finders and solicitors, supervision and regulatory reviews, licensing and registration of firms, licensing and registration of associated persons, and maintenance of books and records.

Based on the study, it appears likely that the SEC will adopt a uniform fiduciary standard in the near future.  However, at this time, it is not clear how the standard would affect the manner in which Covered Broker-Dealers and Investment Advisers conduct their businesses.

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Written by Michael Wu

On January 19, 2011, the Securities and Exchange Commission (“SEC”) released its study regarding the need for enhanced examination and enforcement resources for investment advisers.  Specifically, the SEC examined the following areas: (i) the number and frequency of examinations of investment advisers by the SEC during the past 5 years, (ii) whether the SEC’s designation of one or more self-regulatory organizations (“SROs”) to augment the SEC’s oversight of investment advisers would improve the frequency of examinations of investment advisers, and (iii) the current and potential approaches to examining the investment advisory activities of dually registered broker-dealers and investment advisers and investment advisers that are affiliated with broker-dealers.

According to the study, the number of registered investment advisers, including hedge fund and private equity fund managers, and the overall assets managed by such advisers has increased over the past 6 years, while the SEC staff dedicated to examining investment advisers has declined.  The study noted that the number of SEC examinations decreased since 2004 by nearly 30% and the frequency of such exams by 50% – this was before the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) created additional responsibilities for the SEC.  Under the Dodd-Frank Act, the SEC will be required to (i) examine larger, more complex entities, which take more resources to examine; (ii) examine municipal advisers, security-based swap dealers, major security-based swap participants and security-based swap data repositories, which are now required to register with the SEC; and (iii) conduct annual examinations of credit rating agencies and clearing agencies designated as systemically important.  In Commissioner Elisse B. Walter’s speech regarding the study, she stated that “the Commission is not, and, unless significant changes are made, cannot fulfill its examination mandate with respect to investment advisers.”

The SEC has recommended that Congress consider the following three approaches to strengthen the SEC’s investment adviser examination program: (i) authorize the SEC to charge SEC-registered investment advisers “user fees,” which would be used to fund the investment adviser examination program; (ii) authorize one or more SROs to examine, subject to SEC supervision, all SEC-registered investment advisers; or (iii) authorize the Financial Industry Regulatory Authority (FINRA) to examine dual registrants for compliance with the Investment Advisers Act of 1940, as amended.

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Posted by Michael Wu and Judy Deng

On January 11, 2011, the Shanghai Municipal Government released its Implementation Measures on Trial Projects of Foreign-Invested Equity Investment Enterprises in Shanghai (the “Shanghai RMB Fund Regulation”), which will become effective on January 23, 2011. Prior to the release of this regulation, it was widely expected that the Shanghai Municipal Government would launch a Qualified Foreign Limited Partners (“QFLP”) legal regime to help large international institutional investors invest in Shanghai-based private equity funds. Although the Shanghai RMB Fund Regulation was implemented in response to such expectations, we believe it is just the first of many regulations designed to confer national treatment to private equity funds formed by non-Chinese fund managers.  For more information regarding the Shanghai RMB Fund Regulation, please see A Red Envelope From Shanghai?  New RMB Fund Rules Create Opportunities for Non-Chinese Fund Managers.

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Editorial Comment by Jay Gould

A recent action against a hedge fund manager by the Securities and Exchange Commission (the “SEC”) serves as interesting prologue to the state of enforcement against suspected securities frauds once the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) has been fully implemented.  On January 7, 2011, the SEC charged SJK Investment Management LLC, a North Carolina-based hedge fund manager (“SJK”), and CEO Stanley Kowalewski, its owner, with defrauding its hedge fund investors by diverting millions of dollars to themselves through various self-dealing transactions.

Nothing in this case is particularly unique.  Investment advisers who steal from their clients have proven to be a fairly routine occurrence and rarely attract mainstream press coverage unless the theft is on a significant scale.  Briefly, the SEC alleged that Kowalewski diverted investor money from the SJK hedge funds to pay his personal expenses and placed $16.5 million of the hedge funds’ assets into an undisclosed, wholly-controlled, fund that he created, and then misused for, among other things, purchasing a vacation home valued at $3.9 million.  The SEC stated that the agency became suspicious of Kowalewski as a result of an examination.  The examination staff referred the matter over to the Enforcement Division of the Atlanta Regional Office which obtained an order to freeze the assets held by Kowalewski.  Presumably, a receiver will be appointed by the court that will sift through the rubble and one day return whatever is left over to the investors.  In the end, this is just another example of one of approximately 200 Ponzi/investment fraud cases that the SEC has uncovered since the Madoff embarrassment.

What is interesting about this case is that as of July 2011, the SEC will no longer examine the Stanley Kowalewskis of the world.  In most cases, that job will be left to state securities commissions.  As a result of the Dodd-Frank Act, private fund managers with less than $150 million under management and other investment advisers with less than $100 million under management will no longer register with or be routinely examined by the SEC.  The SEC estimates that 4,100 investment advisers that are now registered with it will be forced to de-register and register with their respective state securities regulator.  Although the SEC will retain anti-fraud jurisdiction over these state-registered advisers, the primary regulators will be the often ill-equipped, inexperienced and resource strapped state regulators.  As a result of the budgetary concerns facing most states, it is unlikely that sufficient resources will be directed to enforcing investment frauds perpetrated by small, “under the radar” investment advisers.

And where do the majority of investment frauds occur?  The most recent filing of Kowalewski’s Form ADV indicates that SJK had $71 million under management.  This is not exactly an investment adviser that represents a systemic risk to the stability of the financial world, but this is the type of investment adviser that can cause great pain to every day investors seeking to diversify their assets or plan for their retirement.  In fact, the vast majority of investment fraud schemes that the SEC has uncovered since Madoff have been perpetrated by investment advisers that will not be subject to SEC scrutiny under the new regulatory regime.

The Dodd-Frank Act addressed this concern in part by directing the SEC to conduct a number of studies regarding the regulation of investment advisers.  One such study directs the SEC to make a recommendation as to whether investment advisers should be subject to a self-regulatory organization (“SRO”), much the same way broker-dealers are essentially required to become members of the Financial Industry Regulatory Authority (“FINRA”).  In recent weeks, FINRA has shown great interest in taking on this responsibility, much to the dismay of most independent investment advisers.  This SRO membership requirement would add another layer of expense to, and oversight of, investment advisers.  And some might argue that FINRA, which opposes the idea of creating a uniform fiduciary standard for investment advisers and retail brokers, is exactly the wrong SRO to oversee advisers that have traditionally been subject to a much more rigorous code of conduct.

This shift in regulatory responsibility to the states does not necessarily bode well for small investment advisers and start-up hedge fund managers.  Just as we have seen large investors gravitate toward established investment managers since 2008, the lack of effective regulatory oversight may portend an unwillingness for high net worth and smaller institutions to take a chance on a less well-established investment adviser or fund manager. Such investment advisers or fund managers can expect the lack of SEC oversight to be another hurdle in a very challenging capital raising environment.

But there are steps that state-registered and regulated advisers and fund managers can take to minimize this aspect of the Dodd-Frank Act.  Taking seriously the responsibility for full and current disclosure in fund documents, providing transparency to investors and maintaining sufficient operating systems and infrastructure will help to address the concerns of circumspect investors.  Also, providing clear and current disclosure in the new Form ADV Part 2 that explains the operations and investment approach and adhering to the traditional fiduciary standard that has applied to investment advisers for decades will provide greater comfort to investors.  Finally, choosing the right partners and service providers that can provide the oversight, checks and balances and industry expertise will also be important to investors.

Small investment advisers and fund managers may initially welcome the idea of no longer being subject to direct SEC oversight, but if investment frauds continue at this end of the investment spectrum, that may prove to be a hollow victory.

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By: Michael Wu

As the new year is upon us, we wanted to take a moment to remind you of some of the annual compliance obligations that you may have as an investment adviser that is registered with the Securities and Exchange Commission (the “SEC”) or with a particular state (“Investment Adviser”).  In light of the current regulatory environment, now more than ever, it is critical for you to comply with all of the legal requirements and best practices applicable to Investment Advisers.  The beginning of the year is a good time to review, consider and, if applicable, satisfy these requirements and best practices.

The following is a summary of the primary annual or periodic compliance-related obligations that may apply to Investment Advisers.  The summary is not intended to be a comprehensive review of an Investment Adviser’s tax, partnership, corporate or other requirements, nor an exhaustive list of all of the obligations of an Investment Adviser under the Investment Advisers Act of 1940, as amended (the “Advisers Act”) or applicable state law.  Although many of the obligations set forth below apply only to SEC-registered Investment Advisers, state-registered Investment Advisers may be subject to similar and/or additional obligations depending on the state in which they are registered.  State-registered Investment Advisers should contact us for additional information regarding their specific obligations under state law.

  • Update Form ADV.  An Investment Adviser must file an annual amendment to Form ADV Part 1 and Form ADV Part 2 within 90 days of the end of its fiscal year.  Effective on January 1, 2011, Investment Advisers must file both Part 1 and Part 2A of the Form ADV with the SEC through the electronic IARD system.  Accordingly, if you are SEC-registered adviser whose fiscal year ends on or after December 31, 2010, you must file Part 1A and Part 2A as part of your annual updating amendment by March 31, 2011.  If you are a state-registered adviser whose fiscal year ends on or after December 31, 2010, you must also file Part 1A, Part 1B and Part 2A as part of your annual updating amendment by March 31, 2011.
  • New FINRA Entitlement Program.  FINRA is implementing changes to its Entitlement Program, which provides access to an Investment Adviser’s IARD account.  Every adviser firm (new and existing) is now required to designate an individual as its Super Account Administrator (SAA).  The SAA must be an authorized employee or officer of the adviser firm.
  • Fund IARD Account.  An Investment Adviser must ensure that its IARD account is adequately funded to cover payment of all applicable registration renewal fees and notice filing fees.  Beginning November 15, 2010, Preliminary Renewal Statements (“PRS”), which list advisers’ renewal fees, are available for printing through the IARD system.  By December 10, 2010, an investment adviser should have submitted to FINRA through the IARD system, its preliminary renewal fee.  Any additional fees that were not included in the PRS will show in the Final Renewal Statements which are available for printing beginning January 3, 2011.  All final renewal fees should be submitted to FINRA through the IARD system by February 3, 2011.
  • State Notice Filings/Investment Adviser Representatives.  An Investment Adviser should review its advisory activities in the various states in which it conducts business and confirm that all applicable notice filings are made on IARD.  In addition, an Investment Adviser should confirm whether any of its personnel need to be registered as “investment adviser representatives” in any state and, if so, register such persons or renew their registrations with the applicable states.
  • Brochure Rule.  On an annual basis, an Investment Adviser must provide its private fund investors and separate account client(s) with a copy of its updated Form ADV Part 2A, or provide a summary of material changes and offer to provide an updated Form ADV Part 2A. The 2011 deadline for providing investors with Form ADV Part 2B depends on whether an Investment Adviser is a new or existing SEC-registered adviser and whether the Investment Adviser is providing it to prospective, new or existing investors.
  • Annual Assessment.  At least annually, an Investment Adviser must review its compliance policies and procedures to assess their effectiveness.  The annual assessment process should be documented and such document(s) should be presented to the Investment Adviser’s chief executive officer or executive committee, as applicable, and maintained in the Investment Adviser’s files.  At a minimum, the annual assessment process should entail a detailed review of:

1)      the compliance issues and any violations of the policies and procedures that arose during the year, changes in the Investment Adviser’s business activities and the effect that changes in applicable law, if any, have had on the Investment Adviser’s policies and procedures;

2)      the Investment Adviser’s code of ethics, including an assessment of the effectiveness of its implementation and determination of whether they should be enhanced in light of the Investment Adviser’s current business practices; and

3)      the business continuity/disaster recovery plan, which should be “stress tested” and adjusted as necessary.

  • Annual/Surprise Audit.  Because Investment Advisers are generally deemed to have custody of client assets, they must provide audited financial statements of their fund(s), prepared in accordance with U.S. generally accepted accounting principles, to the fund(s)’ investors within 120 days of the end of the fund(s)’ fiscal year.  Investment Advisers that do not provide audited financial statements to fund investors should remind their auditors that an annual surprise audit is necessary.
  • Annual Privacy Notice.  Under SEC Regulation S-P, an Investment Adviser must provide its fund investors or client(s) who are natural persons with a copy of the Investment Adviser’s privacy policy on an annual basis, even if there are no changes to the privacy policy.
  • New Issues.  An Investment Adviser that acquires “new issue” IPOs for a fund or separately managed client account must obtain written representations every 12 months from the fund or account’s beneficial owners confirming their continued eligibility to participate in new issues.  This annual representation may be obtained through “negative consent” letters.
  • ERISA.  An Investment Adviser may wish to reconfirm whether its fund(s)’ investors are “benefit plan investors” for purposes of reconfirming its fund(s)’ compliance with the 25% “significant participation” exemption under ERISA.  This is particularly important if a significant amount of a fund’s assets have been withdrawn or redeemed.  The reconfirmation may be obtained through “negative consent” letters.
  • Anti-money Laundering.  Although FinCEN withdrew its proposed anti-money laundering regulations for unregistered investment companies, certain investment advisers and commodity trading advisors, an Investment Adviser is still subject to the economic sanctions programs administered by OFAC and should have an anti-money laundering program in place.  An Investment Adviser should review its anti-money laundering program on an annual basis to determine whether the program is reasonably designed to ensure compliance with applicable law given the business, customer base and geographic footprint of the Investment Adviser.
  • Amend Schedule 13G or 13D.  An Investment Adviser whose client or proprietary accounts, separately or in the aggregate are beneficial owners of 5% or more of a registered voting equity security, and who have reported these positions on Schedule 13G, must update these filings annually within 45 days of the end of the calendar year, unless there is no change to any of the information reported in the previous filing (other than the holder’s percentage ownership due solely to a change in the number of outstanding shares).  An Investment Adviser reporting on Schedule 13D is required to amend its filings “promptly” upon the occurrence of any “material changes.”  In addition, an Investment Adviser whose client or proprietary accounts are beneficial owners of 10% or more of a registered voting equity security must determine whether it is subject to any reporting obligations, or potential “short-swing” profit liability or other restrictions, under Section 16 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”).
  • Form 13F.  An “institutional investment manager,” whether or not an Investment Adviser, must file a Form 13F with the SEC if it exercises investment discretion with respect to $100 million or more in securities subject to Section 13(f) of the Exchange Act (e.g., exchange-traded securities, shares of closed-end investment companies and certain convertible debt securities), which discloses certain information about such its holdings.  The first filing must occur within 45 days after the end of the calendar year in which the Investment Adviser reaches the $100 million filing threshold and within 45 days of the end of each calendar quarter thereafter, as long as the Investment Adviser meets the $100 million filing threshold.
  • Offering Materials.  As a general securities law disclosure matter, and for purposes of U.S. federal and state anti-fraud laws, including Rule 206(4)-8 of the Advisers Act, an Investment Adviser must continually ensure that each of its fund offering documents is kept up to date, consistent with its other fund offering documents and contains all material disclosures that may be required in order for the fund investor to be able to make an informed investment decision.
    • Full and accurate disclosure is particularly important in light of Sergeants Benevolent Assn. Annuity Fund v. Renck, 2005 NY Slip op. 04460, a recent New York Appellate Court decision, where the court held that officers of an investment adviser could be personally liable for the losses suffered by a fund that they advised if they breached their implied fiduciary duties to the fund.  The fiduciary nature of an investment advisory relationship and the standard for fiduciaries under the Advisers Act includes an affirmative duty of utmost good faith, and full and fair disclosure of all material facts, and an affirmative obligation to use reasonable care to avoid misleading clients.
    • Accordingly, it may be an appropriate time for an Investment Adviser to review its offering materials and confirm whether or not any updates or amendments are necessary.  In particular, an Investment Adviser should take into account the impact of the recent turbulent market conditions on its fund(s) and review its fund(s)’ current investment objectives and strategies, valuation practices, performance statistics, redemption or withdrawal policies and risk factors (including disclosures regarding market volatility and counterparty risk), its current personnel, service providers and any relevant legal or regulatory developments.
  • Blue Sky Filings/Form D.  Many state securities “blue sky” filings expire on a periodic basis and must be renewed.  Accordingly, now may be a good time for an Investment Adviser to review the blue-sky filings for its fund(s) to determine whether any updated filings or additional filings are necessary.  We note that as of 2009, all Form D filings for continuous offerings will need to be amended on an annual basis.
  • Liability Insurance.  Due to an environment of increasing investor lawsuits and regulatory scrutiny of fund managers, an Investment Adviser may want to consider obtaining management liability insurance or review the adequacy of any existing coverage, as applicable.

If you have any questions regarding the summary above, please feel free to contact us.