Private Equity Direct - Feb 2011 - Dodd-Frank's Reform Impact on Private Equity
While the rules remain to be written, private equity and hedge fund firms are rushing to ensure they are compliant. The long-awaited Dodd-Frank Wall Street Reform and Consumer Protection Act includes a provision that requires private-equity fund advisors to register for the first time with the Securities and Exchange Commission (SEC). The law also introduces new rules that treat private-equity managers and investors differently.
“There was a vilification of Wall Street and anyone associated with it—and I think hedge and private-equity fund managers got caught up in the vortex,” says Neil Morris, a member of operational risk at Kinetic Partners, a global professional services firm which advises large hedge funds and traditional asset managers. Morris adds that the new regulations have few exceptions or loopholes. “Their whole goal was to instill confidence in the markets,” Morris says. “The SEC intends to avoid massive frauds and irregularities in the future and this bill is a step in that direction.”
At a meeting with fund managers on Friday, December 10, the SEC proposed a list of criteria under the definition of the venture capital fund, including that they hold themselves out to investors as such and aren't leveraged. Under the proposal, hedge funds and other private funds would have to provide information about the assets they hold, their investors and the advisor's services to the fund, under the proposal. The SEC also proposed new reporting requirements for all fund managers, whether or not they are exempted from registration.
The law is intended to reassure investors left in some instances either bereft or certainly shaken by the rapidity of the market downturn. "Information will be provided to the SEC about the fund advisors' clients but there is no provision to disclose information on the investors in particular," says Winthrop N. Brown, a partner at Milbank Tweed’s Washington D.C., office. "The investor could be comforted by that.” Brown predicts that regulation and oversight of managers will increase—but not in the immediate future. “The SEC has its foot in the door now and the industry is worried that it can only get worse," Brown says. "But if you take a snapshot in time and you assume a large enough operation, this isn’t a huge financial burden relative to the manager; I think it’s fair to say it’s a fairly light touch."
Morris believes that future reforms could be years ahead. “I don’t think this [law] is in preparation for anything else—nor is it a slippery slope,” Morris says. “There was a sigh of relief when this rule came out because it wasn’t as substantial a change as it could have been,” adds Peter J. Cogan, an audit partner at EisnerAmper LLP. Cogan believes that "there will be much more change for the 'larger institutions' compared to the retail investment side.”
The law does not impose tight restrictions on general partner managers (GPs) of private-equity funds. However, the costs associated with meeting the new registration requirements may pose problems for smaller GPs. "Many in the larger range of general partners have a compliance officer or are registered with the SEC already," Henry Bregstein, Global Chair of Financial Services at Katten Muchin Rosenman LLP says. "It’s the smaller GP that would most likely have the greatest financial burden and would have to upgrade more.” Bregstein agrees that from an investor standpoint, the changes in regulation likely represent at least a marginal positive.
Smaller advisors would not have to register if they fall under the $100-million cap. "But most of them are above that level,” Cogan points out. “I think the effects of costs for smaller private-equity funds will be significant; not all funds have a person in place already who could readily take on the compliance duties."
Under the new law, examiners will be in charge of overseeing private-equity funds—and deciding whether those fund managers are in compliance. "It’s going to come down to the education of those examiners," Morris says. "Are they well-versed with how private-equity funds work as they examine fund managers?" Morris emphasizes the need for examiners to understand the differences between hedge funds and private-equity funds and hopes examiners "don’t waste resources—and the PE manager’s time—getting educated."
The SEC has been more proactive when researching potential gaps in new statutes. "With this most recent law, the SEC has the power to put in a lot more rules—they will most likely do a study to find any gaps as a subset of the law," Cogan says."They didn’t have the ability to do that before."
In 2006, the U.S. Court of Appeals for the District of Columbia invalidated rules requiring certain hedge fund advisors to register with the SEC. This latest provision allows the SEC to regain some of the oversight it lost in that decision. During that time David Huntington, a partner at Paul, Weiss, Rifkind, Wharton & Garrison LLP, recalled that in anticipation of the hedge fund registration rule becoming effective, the SEC staff considered carefully what types of information they would need from hedge funds to effectively monitor risk. “The SEC was not supposed to regulate hedge fund investment decisions,” Huntington says, "It was supposed to investigate fraud and ensure that investors are provided with materially accurate information about their funds."
Huntington also notes that the next step will be to see how the SEC utilizes its new authority. “Will the SEC develop an intelligent, risk-based program that is effective in rooting out fraud, or will it just create headaches for advisors?” Huntington asks. “The challenge will be to gather information and conduct examinations without compromising proprietary data or interfering with investment activities.”
The law in its entirety remains open to debate regarding whether the new regulation really does drastically cut the amount banks can invest in hedge funds and private equity. Still, the consensus is that for larger private equity fund managers it will be business as usual. Smaller funds will likely accrue additional costs, as many smaller funds do not have a chief compliance officer on staff.
"For the most part, business is not going to dramatically change," Brown says. “But they are going to have to put funding toward a compliance consultant and be much more careful with their paper trail." When the industry faced with the same provision a few years back, many funds registered with the SEC—and remained so even though the rule was later vacated by the court. Says Brown, “They stayed registered—they figured it was a good best practice."
Private Equity Direct - February 2011 Issue