Articles Posted in Private Funds

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Written by Michael Wu

The Alternative Investment Fund Managers Directive (the “Directive”) establishes a regulatory regime for all alternative fund managers, such as private equity and hedge fund managers, that are based in the European Union (the “EU”), manage funds based in the EU and market non-EU fund interests in the EU.  A general summary of the Directive is available here.

Although the majority of the Directive’s rules are likely to become effective by January 2013, some of the rules affecting non-EU funds and non-EU fund managers will be deferred until 2015 or later.  Thus, non-EU managers may still actively raise funds in the EU, but will have to comply with a number of additional regulatory requirements beginning in January 2013.

Beginning in January 2013, non-EU managers may actively fund raise in the EU provided that:

  • A regulatory cooperation agreement is in place between all of the relevant regulators (i.e., the regulator in the non-EU manager’s home jurisdiction and the EU country where the fund raising occurs) under which the regulators agree to cooperate on monitoring and managing systemic risk.  In addition, the home jurisdiction must not be designated by the Financial Action Task Force as a non-cooperative country or territory.
  • Non-EU managers comply with the following provisions of the Directive:
    • Transparency and Disclosure: the non-EU manager must prepare an annual fund report for investors in a prescribed format and disclose certain other prescribed information to investors and will be subject to regulatory reporting requirements aimed at monitoring systemic risk.  The European Commission will publish measures specifying the format and content of the reports.
    • Portfolio Company Disclosures: if a private equity fund acquires or disposes of a substantial stake in an EU company, the manager must formally notify the target company, the shareholders and the regulators.  Additional disclosures are required if a controlling stake is acquired.
    • “Asset-Stripping” Restrictions: the Directive restricts certain shareholder distributions for a period of 24 months after acquisition of an EU company (to prevent dividend recapitalizations during the period).
  • Non-EU manager is aware of the securities laws of each EU country in which it intends to raise funds, which may impose more onerous rules.

Beginning in early-2015, non-EU managers may be able to participate in the “passport” regime (i.e., they can fund raise in every EU country without obtaining separate regulatory authorization in each country) if the European Securities and Markets (“ESMA”) Authority decides to make the passport regime available to non-EU managers.  If the passport regime becomes available to non-EU managers, they would become authorized and regulated on the same basis as EU managers with respect to the passporting rights.  However, because the passport regime’s compliance obligations are onerous, non-EU managers may want to forgo the passporting rights and fund raise subject to country-by-country private placement regimes and the minimum directive requirements described above.

Beginning in mid-2018, non-EU managers may be required to operate under the passport regime in order to fund raise in the EU.  The Directive contains provisions that would ultimately terminate the national private placement regimes, leaving full authorization as the only option for non-EU firms that wish to fund raise in the EU.

ESMA and the European Commission have been tasked with issuing extensive implementing measures and guidance.  However, the details of these rules will not become clear for some time.

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Written by Michael Wu

On November 11, 2010, the European Parliament adopted the EU Directive on Alternative Investment Fund Managers (the “Directive”).  The Directive will affect a significant number of alternative investment fund managers (“AIFMs”) that manage and/or market alternative investment funds (“Funds”), including hedge funds, commodity funds, private equity funds and real estate funds, within the European Union (“EU”).  The text of the Directive is expected to be published in the Official Journal sometime in the first or second quarter of 2011.  The Directive will be effective 20 days after publication and the EU Member States will have two years from such date to implement the Directive.

Scope: The Directive regulates AIFMs, rather than the Funds that they manage.  Specifically, the Directive regulates (a) EU AIFMs and (b) non-EU AIFMs that either (i) manage a Fund that is domiciled in the EU or (ii) market a Fund to investors in the EU.  A “small fund manager” that is regulated by its home EU Member State will be exempt from the majority of the Directive’s provisions if the AIFM manages less than €100 million in assets (or €500 million in assets, if its Funds do not use leverage and have at least a 5-year lock-up).

Marketing of Funds: The Directive defines “marketing” to mean “any direct or indirect offering or placement at the initiative of the AIFM or on behalf of the AIFM of units or shares in a [Fund] it manages to or with investors domiciled in the [EU].”  Under this definition, passive marketing (i.e., responding to inquiries from investors) would not be considered “marketing” under the Directive.  However, an AIFM’s use of a marketing or placement agent to conduct marketing activity in the EU would be considered “marketing” under the Directive.  The Directive implements a dual regime for marketing Funds in the EU.  An AIFM may market its Funds either (a) into an EU Member State if the EU Member State’s securities regulator expressly allows it, or (b) into all EU Member States under the EU “passport” regime.  However, the availability, applicable starting date and possible ending date will depend on whether the AIFM and/or the Fund is based in the EU or based outside of the EU.

Capital Requirements: If an AIFM only manages its own Funds, it must have initial capital of at least €300,000.  If an AIFM manages third party Funds, it must have initial capital of the higher of (a) ¼ of its annual expenditures and (b) €125,000.  In addition, if the Fund(s) managed by the AIFM have over €250 million in assets, the AIFM must have additional capital equal to 0.02% of the Fund(s) assets over €250 million.  However, in no event is the AIFM required to hold initial capital of more than €10 million.

Conduct of Business: The Directive will require AIFMs to meet certain conduct of business requirements, including the following:

  • No investor may obtain preferential treatment unless such treatment is disclosed in the Fund’s documentation.  Thus, side letter provisions would need to be disclosed to all investors in the Fund.
  • Conflicts of interest between the AIFM and the Fund or its investors must be disclosed and managed by the AIFM.
  • Risk management and portfolio management must be kept separate.
  • AIFMs must conduct stress tests and monitor the liquidity risk of open-ended Funds regularly.  The investment strategy, liquidity profile and redemption policy of each Fund managed by the AIFM must be consistent with each other.
  • In order to invest the Fund’s assets in any securitization positions, the originator of the securitization must retain at least a 5% net economic interest in the securitization.

Remuneration: AIFMs must have remuneration policies and practices that are consistent with and promote sound and effective risk management and do not encourage excessive risk taking.  For example, AIFMs may not guarantee multi-year bonuses, 50% of bonuses must be paid in the form of interests/shares of the Fund and 40-60% of bonuses must be deferred at least 3 to 5 years.  The remuneration policies and practices must apply to senior managers, but also to “control staff.”

Valuation: If an AIFM performs valuations internally, it must ensure that the valuation process is independent of the portfolio management and remuneration policies of the Fund and that measures are in place to identify and resolve conflicts of interest.  However, EU Member States have the authority to require an AIFM to subject its valuations to verification by external valuation agents or auditors.

Depositary: An AIFM must appoint a single depositary, such as an EU regulated bank or an EU securities firm, for each of its Funds.  If an AIFM manages a private equity fund, the depositary may be an “entity” that carries out depositary functions as part of its business activities.  For a non-EU Fund, generally, the depositary must be established in the jurisdiction where the non-EU Fund was formed or the jurisdiction of the AIFM’s principal place of business.

Delegation of AIFM Responsibilities: An AIFM must notify its regulator prior to delegating any of its responsibilities.  AIFMs may only delegate portfolio and/or risk management functions to regulated entities or with prior authorization from the AIFM’s regulator.  However, regardless of any delegation of functions, the AIFM will remain liable to the Fund and its investors as though no delegation was made.

Disclosure: Among other things an AIFM must satisfy the following disclosure requirements:

  • If the AIFM’s publicly available annual financial report does not satisfy the disclosure requirements of the Directive, each of its Funds must be audited annually.  The annually audited report must be made available to investors and the relevant regulatory agencies.  The report must provide details of remuneration.
  • An AIFM must provide its investors with information about the Fund, including its strategy (which may not work for “black box” hedge funds), what assets it may invest in, its valuation procedures, any descriptions of preferential treatment, the percentage of assets that are illiquid and subject to side pockets, changes in managing liquidity and its risk profile.  The AIFM must also regulatory disclose the amount of leverage the Fund employs.
  • An AIFM must report to its home EU Member State regulator(s) matters relating to the Fund, including those disclosed to its investors.  In addition, if the Fund uses leverage on a “substantial basis,” the AIFM must report the specifics regarding the Fund’s use of leverage.
  • If a Fund acquires 50% or more of the voting rights of a private company, the AIFM would have to provide information of its holding (a) to the company, (b) to all other shareholders of the company and (c) to its home EU Member State regulator.  The AIFM would need to disclose, among other things, the future development of the private company either in the company’s annual report or in the AIFM’s annual report.

Leverage: An AIFM must set and comply with reasonable leverage limits for each Fund that it manages.  EU Member States will have the authority to impose restrictions on the use of leverage.

The Directive will become effective in January 2011.  The EU Member States will then have two years to transpose the Directive into their respective national laws.  Over the next four years, the European Commission will pass further legislation to ensure consistent interpretation and effective implementation of the rules by the EU Member States.  The European Commission will also review the application and scope of the Directive four years after the Directive’s effective date, including its impact on private equity and venture capital funds.

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Written by Jay Gould

On March 10, 2010, the Securities and Exchange Commission (“SEC”) adopted amendments to Rule 201 and Rule 200(g) of Regulation SHO (“Rules”).  In order to give certain exchanges additional time to modify current procedures for conducting single-priced transactions for covered securities that have triggered Rule 201’s circuit breaker and to give industry participants additional time for programming and testing for compliance with the requirements of the Rules, the SEC has extended the compliance date for both Rules from November 10, 2010 to February 28, 2011.  A full text of the adopting rule is available here.

 

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According to the Wall Street Journal, the Commodity Futures Trading Commission has sent subpoenas to hedge funds and other large natural gas traders seeking information regarding trading activity in natural gas derivatives. The subpoenas request information regarding trading activity in 2008 and 2009, a period during which natural gas prices fell by close to 80%. The full text of the article is available here.

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Tagged: CFTC and Derivatives
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The Securities and Exchange Commission’s Asset Management Unit has been investigating whether hedge fund managers have overvalued assets in “side pockets” and then charged investors higher fees based on those inflated values. A side pocket is a type of account that hedge funds use to separate certain illiquid investments from the rest of their portfolio. Investors are typically not permitted to redeem their interest in a fund with respect to assets allocated to a side pocket until such assets have been liquidated or reallocated to the general portfolio by the investment manager.

Recent charges brought by the SEC highlight the need for hedge fund managers to establish reasonable policies for the valuation of illiquid assets and carefully adhere to such policies when valuing assets allocated to a side pocket. On October 19, 2010, the SEC charged two hedge fund managers and their investment advisory businesses with defrauding investors by overvaluing illiquid fund assets they placed in a side pocket. According to the SEC complaint, Paul T. Mannion, Jr and Andrews S. Reckles, through their investment adviser entities PEF Advisors Ltd. and PEF Advisors LLC, caused certain investments made by Palisades Master Fund, L.P. to be overvalued by millions of dollars.

Beginning in August 2004, the fund, at the direction of Mannion and Reckles, invested millions of dollars in World Health Alternatives, Inc. By July 2005, World Health was the fund’s largest single position and constituted at least 20% of the fund’s assets. As World Health (now bankrupt) began to experience financial difficulties, Mannion and Reckles became concerned about the value of the fund’s World Health assets and the potential for any report of substantial losses in relation to such assets to cause investors to redeem their interests in the fund. Recognizing the risk of large scale redemptions, Mannion and Reckles decided to place the World Health assets in a side pocket.

Palisades had adopted specific policies on how it would value different categories of securities and communicated those policies to prospective investors in its offering memorandum and financial statements. Mannion and Reckles allegedly valued the World Health assets contrary to the disclosed valuation policies, which resulted in such assets being significantly overvalued. Mannion and Reckles then charged management fees that were improperly inflated by their overvaluation of fund assets.

Robert B. Kaplan, Co-Chief of the SEC’s Asset Management Unit, commented:

Side pockets are not supposed to be a dumping ground for hedge fund managers to conceal overvalued assets. Mannion and Reckles deceived investors about the fund’s performance and extracted excessive management fees based on the inflated asset values in a side pocket.

The SEC is seeking injunctive relief, disgorgement of profits, prejudgment interest, and financial penalties.

 

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On September 22, 2010, the Managed Funds Association submitted initial comments to the Securities and Exchange Commission and the Commodity Futures Trading Commission on regulatory topics under the Dodd-Frank Wall Street Reform and Consumer Protection Act. The MFA’s comments reflected concerns that the broad wording of the Dodd-Frank Act would result in certain provisions being inappropriately applied to private investment funds. To address these concerns, the MFA proposed that:

  • the SEC not create a self-regulatory organization to oversee investment advisers;
  • the SEC and the CFTC adopt guidance clarifying the criteria relevant to determining whether an investment adviser or a CTA that is registered with one of the agencies can rely on the relevant exemption from registration with the other agency;
  • strong confidentiality safeguards be put in place to protect proprietary information of private fund advisers provided to the SEC or CFTC;
  • appropriate implementation periods be provided to allow market participants time to adjust to any change in the definitions of “accredited investor” or “qualified client;”
  • the SEC define “accredited investor” to include “knowledgeable employees” of a private investment fund and amend Rule 3c-5 under the Investment Company Act of 1940 to expand the types of employees who can qualify as “knowledgeable employees” under that Rule;
  • the SEC and CFTC define “Security-Based Swap Dealer” (“SSD”) to exclude those market participants who are not in the business of buying and selling securities as well as those who buy and sell for their own account;
  • the SEC and CFTC exclude swap customers from SSD registration and regulation with respect to their cleared security-based swaps;
  • in setting capital requirements for non-bank Major Security-Based Swap Participants (“MSSPs”), the SEC and CFTC count collateral posted by such non-bank MSSPs towards any capital requirements;
  • position limits not be imposed on swaps;
  • the SEC not apply rules prohibiting incentive-based compensation to advisers of private investment funds;
  • the SEC retain the existing reporting periods under Section 13(d) and Section 16(a) of the Securities Exchange Act of 1934; and
  • the SEC not impose a new standard of conduct for investment advisers with retail customers.
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Bloomberg reports that the SEC is engaged in a probe of investment advisers who invest client assets in hedge funds, funds of funds, private equity, venture capital and other alternative investments. The SEC’s Office of Compliance Inspections and Examinations has recently requested that advisers provide extensive information about their alternative investments, particularly in regards to the due diligence processes used when evaluating alternative investments. A copy of the letter sent by the OCIE to examined advisers and the accompanying information request list is available here.

“This is further evidence of the SEC’s more proactive approach to the hedge-fund industry,” said Jay Gould, a partner at Pillsbury Winthrop Shaw Pittman LLP in San Francisco. “Hedge-fund managers, including funds of funds, can expect the agency to take a greater interest in their policies, practices and their relationships with investors and other fund managers.”

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Earlier this year the SEC staff commenced a review to evaluate the use of derivatives by mutual funds, exchange-traded funds and other investment companies, including, among other things, whether existing prospectus disclosures adequately address the particular risks created by derivatives.  In a July 30, 2010 letter to the Investment Company Institute, the SEC staff indicated that the initial results of its review are not encouraging.

It found that funds are providing generic disclosure about derivatives that is not adequately tailored to the specific investment strategies of the fund and does not emphasize the specific types of derivatives used by the fund, the extent of their use and the purpose of using derivatives transactions.  As a result, investors may not be receiving the disclosure they need in order to understand the risks associated with their investment in a fund.  The staff urged all funds that use derivatives to assess the accuracy and completeness of their disclosure, tailor their disclosure to include a description of the fund’s expected uses of derivatives and their relative importance and ensure that such disclosure is presented in an understandable manner using plain English.

Although the staff’s letter only addresses the disclosure provided by registered investment companies, hedge funds and other private funds are subject to anti-fraud principles requiring them to disclose all material information to investors and, therefore, should also take into account this guidance when preparing derivatives-related disclosure.