Government Attention on Private Equity Could Mean Changes for the Industry

By: LISA HOLTER, TIMOTHY R. NELSON & LEIGH-ERIN IRONS

April 2, 2009

The hedge fund, private equity, and venture capital industries appear to be under constant scrutiny this year. Attention on the industry is coming from all directions, including the Executive branch, both houses of Congress, and the Treasury Department as well. Proposals for change cover all aspects of the industry, potentially affecting the privacy the industry has traditionally enjoyed, how fund managers charge for their time and talent, as well as the tax rate they are subject to. The number of proposals impacting the industry is significant enough to speculate that a permanent change could be on the horizon. Below is a summary of four separate proposals under consideration this year alone.

Treasury Secretary Geithner Proposals Regarding Regulation of Private Investment Funds

By: Timothy R. Nelson

In testimony before the House Financial Services Committee on March 26, 2009, Treasury Secretary Timothy Geithner outlined the Department of Treasury’s proposed framework for comprehensive regulatory reforms to the financial system. The framework addresses four broad areas: systemic risk, consumer and investor protection, elimination of gaps in current regulatory structure, and international coordination. Secretary Geithner’s plans to address systemic risk include a number of proposals that would increase oversight and regulation of private equity funds, hedge funds and other private pools of capital, as follows:

• SEC Registration. All advisers to hedge funds, private equity funds, venture capital funds, and other pools of capital with assets under management above a certain threshold (as yet not determined) will be required to register with the SEC.

• Disclosure Requirements. All funds advised by an SEC-registered adviser would be subject to investor and counterparty disclosure requirements and regulatory reporting requirements. Such regulatory reporting requirements would require the confidential reporting to the SEC of information necessary to assess whether the fund or fund family is so large or highly leveraged that it poses a threat to financial stability.

• Sharing of Fund Reports with Systemic Risk Regulator. The Geithner proposals would create a new position referred to as the “systemic risk regulator” who would be responsible for oversight of major financial institutions, payment systems and settlement systems in order to ensure systemic stability. Regulatory reports submitted by SEC-registered advisers would be shared with the systemic risk regulator. If the systemic risk regulator determined that a fund or funds advised by an SEC-registered adviser posed a systemic risk, then the adviser and its funds would be subject to additional regulation by the systemic risk regulator, including imposition of liquidity, counterparty, and credit risk management requirements.

Other than stating that there would be a threshold, the proposals did not provide any detail in regards to the amount of assets under management that would trigger SEC registration, or how such amount would be calculated. Therefore, it is unclear at this time as to whether the proposals would affect only a small number or a large majority of private funds. The proposals also did not state whether SEC-registered funds would be registered as investment advisers, and therefore subject to additional regulation under the Investment Advisers Act. See “Hedge Fund Adviser Registration Act of 2009” included herein for a summary of key provisions of the Advisers Act that investment advisers are subject to. Furthermore, the proposals did not provide any detail on how they may interface with reforms already introduced in Congress, including the Hedge Fund Adviser Registration Act of 2009 and the Hedge Fund Transparency Act.

Secretary Geithner stated that comprehensive proposals of the reforms outlined in his testimony will be released in the upcoming weeks. We will provide additional updates as the proposals are released or as events otherwise warrant.   

Tax Hike on Carried Interests Resurfaces in President Obama’s Proposed Budget

By: Leigh-Erin Irons

President Obama’s 2010 budget proposal, released on February 26, 2009, includes additional revenue in 2011 of approximately $2.742 billion received through the taxation of carried interest income at ordinary income tax rates. Although details are not known, it appears the budget proposal assumes the application of ordinary income tax rates would apply to all partnerships that use a carried interest structure, including private equity, hedge, venture capital, and other private investment funds.

Managers of most private equity funds, venture capital funds, hedge funds, and real estate funds make money from the two and twenty formula. Such managers are generally compensated by a management fee, typically two percent of the assets managed by the fund, and a performance fee, typically 20 percent of profits earned by the fund. The performance fee, referred to as a “carried interest,” is the right to receive profits earned by the fund without contributing a corresponding share of the fund’s financial capital.

Under the current partnership tax rules, managers holding a carried interest are taxed as though they were investors who supplied a corresponding amount of capital and therefore pay tax on any carried interest income at capital gains rates (currently 15%, increased to 20% in 2011 under Obama’s proposal). Under Obama’s proposal, it is likely that any carried interest income will be categorized as compensation for services, not as a return on an investment, and therefore subject to taxation at ordinary income rates (currently 35% and increased to 39.6% under Obama’s proposal). If legislation is passed to implement Obama’s proposal, the tax rate applied to carried interest income could approximately double.

This is not the first attempt to increase taxes on carried interests. In 2008, the House of Representatives passed legislation that treated carried interests as compensation for services and therefore subjected carried interest income to ordinary income tax rates. The bill was defeated in the Senate.

At this time, there is no legislation proposed to implement Obama’s proposal on taxation of carried interests and it is uncertain what form such legislation may take.

Hedge Fund Adviser Registration Act of 2009

By: Timothy R. Nelson

The Hedge Fund Adviser Registration Act, introduced in the House of Representatives on January 27, 2009 by Representatives Michael Castle (R-DE) and Michael Capuano (D-MA), would require SEC registration of nearly all advisers to private investment funds, including advisers to hedge funds, private equity funds, and venture capital funds.

Currently, most advisers to private investment funds rely on the “private adviser” exemption to the Investment Adviser Act of 1940 in order to avoid SEC registration as investment advisers. The private adviser exemption generally is available to any investment adviser that (1) had fewer than 15 clients during the preceding 12 months, and (2) does not hold itself out as an investment adviser to the general public. Under the private adviser exemption, an investment fund generally counts as one client; therefore, advisers to private clients that advise fewer than 15 funds typically can rely on the exemption, notwithstanding the number of investors in each fund.

The Registration Act would completely eliminate the private adviser exemption, thereby requiring any general partner or other managing entity of a private fund to register as an investment adviser with the SEC. As registered advisers, private fund advisers would be required to comply with the extensive regulatory requirements of the Advisers Act. The following provisions of the Advisers Act could substantially affect the operations of private fund advisers:

• Fees. The Advisers Act generally prohibits an investment adviser from accepting compensation based upon a share of client gains. This prohibition includes carried interest and similar compensation structures. Notably, the Advisers Act contains several exceptions to this prohibition, including an exception that allows an adviser to collect gain-based compensation from any client with a net worth of at least $1.5 million.

• Inspections. The SEC conducts regular inspections of registered investment advisers. SEC inspections typically include review of a firm’s trading and accounting records, compliance policies and business practices.

• Form ADV. Registered investment advisers are required to file a Form ADV with the SEC. Form ADV requires detailed disclosure concerning an adviser’s owners, affiliates, clients, assets under management and investment strategies, among other things. Part of the Form ADV (Form ADV Part II) or a disclosure document containing substantially similar information must also be distributed to each client of the adviser.

• Compliance. The Advisers Act requires all registered advisers to adopt and implement written compliance procedures and policies designed to prevent employees from violating the Advisers Act. The compliance procedures must include a requirement that all employee securities positions be reported to the chief compliance officer on a regular basis. Registered advisors are also required to maintain a written code of ethics that all employees must comply with.

• Recordkeeping. The Advisers Act imposes extensive recordkeeping requirements upon registered advisers. Records that advisers are required to maintain include detailed trading and financial records.

The Registration Act has been referred to the House Committee on Financial Services. As of the date of this alert, the House Committee has taken no action on the Registration Act.

The Hedge Fund Transparency Act

By: K. Lisa Holter-Ankel

In late January 2009, Senators Charles Grassley (R-IA) and Carl Levin (D-MI) introduced the “Hedge Fund Transparency Act of 2009” (the “Transparency Act”). The Transparency Act would amend the Investment Company Act of 1940 (the “Company Act”), affecting all private funds that currently are exempt from registration under Sections 3(c)(1) and 3(c)(7) of the Company Act.

Private investment funds avoid registration and regulation under the Company Act in primarily two ways: (1) having 100 or fewer investors pursuant to Section 3(c)(1) of the Company Act; or (2) having only qualified purchasers as investors pursuant to 3(c)(7) of the Company Act.  

Funds with $50 million or more of assets under management would be required to register and file with the SEC in order to avoid being subject to all of the Company Act’s other requirements that apply to registered investment companies (such as mutual funds). Pursuant to the Transparency Act, an investment company with at least $50 million in assets must:

1. register with the SEC,
2. maintain books and records required by the SEC,
3. cooperate with any request for information or examination by the SEC,
4. file an information form with the SEC electronically, each year, that includes the following:
   1. the name and address of (i) each individual who is a beneficial owner of the fund (which is intended to mean the fund managers who are owners, and not the investors, of the fund); (ii) any company with an ownership interest in the fund; (iii) the fund’s primary accountant and broker,
   2. an explanation of the structure of ownership interests in the fund,
   3. information on any affiliation the fund has with another financial institution,
   4. the minimum investment amount required to invest in the fund,
   5. the fund’s total number of investors, and
   6. the current value of the fund’s assets along with other assets under fund management.

Other consequences to note:

• The bill as introduced clearly states that this information would be made available to the public in an electronic searchable format.

• All funds that rely on the exemptions under 3(c)(1) and 3(c)(7), including funds with less than $50 million of assets, would be required to establish an anti-money laundering program and report suspicious activity.

• The Treasury Secretary and SEC shall establish rules to carry out the anti-money laundering obligations, which would require funds to use “risk-based due diligence policies, procedures, and controls that are reasonably designed to ascertain the identity of and evaluate any foreign person” that provides funds, or intends to provide funds, to be invested under the advice of the fund.

• The Transparency Act would change the “look through” rules relating to 3(c)(7) funds that are held by qualified purchasers, which would be required to look through any entity that (i) owns 10% or more of its outstanding voting securities and (ii) is itself an investment fund that relies on the 100-investor or qualified purchaser exemption. The primary impact of this change would be to limit the ability of a fund-of-funds that rely on the 3(c)(1) 100-investor limitation from owning 10% of a 3(c)(7) qualified purchaser fund.

• The impact of the Transparency Act on registration under the Investment Advisers Act of 1940 (the “Advisers Act”) is unclear. Many private investment funds rely on the exemption under Section 203(b)(3) of the Advisers Act to avoid registration under the Advisers Act. This exemption is for advisers: (i) who have fewer than 15 clients (where each fund counts as one client); (ii) who do not publicly advertise or hold themselves out to the public as an adviser; and (iii) who do not advise a registered investment company (such as a mutual fund). Since the Transparency Act will require registration of funds with $50 million or more in assets, it is unclear whether managers of such funds can rely on the exemption under 203(b)(3), since they would then be advising funds that are registered under the Company Act. Along with the proposed legislation on Adviser Registration (see above), this would change the registration landscape for most private investment fund managers.

The Transparency Act has been referred to the Senate Committee on Banking, Housing and Urban Affairs. As of March 31, the Senate Committee has taken no action on the Transparency Act.

While none of these initiatives has yet been enacted, it would be prudent to assume that some form of regulatory or tax change is underway, and to prepare accordingly. The Private Equity Group at Fredrikson & Byron is monitoring these proposals, and can provide any updates upon request, as well as assist with planning for change.