The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) was signed into law on July 21, 2010. Effective July 21, 2011, the Dodd-Frank Act repeals the private investment adviser exemption of Section 203(b)(3) of the Investment Advisers Act. That exemption has been relied upon widely by managers and general partners of private equity funds to avoid any need to register with the SEC as an investment adviser.

Beginning July 21, 2011, many such advisers will be forced to confront the burdens of registration. Others, who fall within new, narrower exemptions provided by the Dodd-Frank Act, will nonetheless be faced with such new reporting and recordkeeping requirements as the SEC “determines necessary or appropriate in the public interest or for the protection of investors.”

Many advisers to private equity funds should prepare to register with or report to the U.S. Securities and Exchange Commission.

The “Old” Private Investment Adviser Exemption
The still effective Section 203(b)(3) of the Investment Advisers Act – which will vanish on July 21 of this year – provides that an investment adviser need not register with the SEC if the adviser during the course of the preceding 12 months has had fewer than 15 clients and neither holds himself out generally to the public as an investment adviser nor acts as an investment adviser to an “investment company.”

Section 202(a)(11) of the Investment Advisers Act defines “investment adviser” 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 regulated business, issues or promulgates analyses or reports concerning securities.”

Generally, a manager or general partner that receives management fees and/or a carried interest from a pooled investment vehicle is viewed by the Commission as an investment adviser.

Rule 203(b)(3)-1 under the Investment Advisers Act generally treats a corporation, partnership or limited liability company as a single client of an investment adviser (as opposed to counting each shareholder, partner or member of such entity towards the 15 client limit).

The definition of “investment company” excludes issuers that do not publicly offer their securities and either have 100 or fewer beneficial owners or owners who are exclusively qualified purchasers. Hedge funds, venture capital funds and other types of private equity pools typically fall under this exclusion and are considered “private funds.”

Essentially, so long as it advised fewer than 15 private funds within any 12-month period, the “old” exemption allowed the manager or general partner of private funds to operate as such without the need to register with the Commission as an investment adviser.

When this “old” exemption is repealed in July, advisers will have to look elsewhere for a new exemption. The Dodd-Frank Act has supplied two new exemptions likely to be relied on by some advisers to private equity vehicles: a venture capital fund exemption and a private fund exemption.
 
New VC Fund Exemption
Section 407 of the Dodd-Frank Act provides a new exemption from registration for advisers to “venture capital funds”:

No investment adviser that acts as an investment adviser solely to 1 or more venture capital funds shall be subject to the registration requirements of this title with respect to the provision of investment advice related to a venture capital fund.

The Dodd-Frank Act further directs the SEC to issue final rules defining the term “venture capital fund” by the time the new exemption takes effect on July 21, 2011. The SEC has proposed rules defining a venture capital fund as a private fund that satisfies the following:

• The fund represents itself as a venture capital fund to investors.
• The fund does not offer redemption or similar liquidity rights except in extraordinary circumstances.
• The fund owns solely cash, cash equivalents, US Treasuries with a remaining maturity of 60 days or less, and “equity securities” of private companies (defined in section 3(a)(11) of the Securities Exchange Act of 1934 and Rule 3a11-1 to include common stock, preferred stock, convertible debt and warrants).
• Each of the fund’s portfolio companies (i) does not incur leverage in connection with the investment by the fund, (ii) uses the capital provided by the fund for operating or business expansion purposes rather than to buy out other investors and (iii) is not itself a pooled investment vehicle.
• The fund acquires at least 80% of the equity securities of each of its portfolio companies directly from the issuer.
• The fund offers or provides significant managerial assistance to, or controls, each of its portfolio companies.
• The fund does not borrow, issue debt obligations, provide guarantees or otherwise incur leverage in excess of 15% of its aggregate capital contributions and uncalled capital commitments (and any such leverage must have a non-renewable term of less than 120 days).
• The fund is not registered under the Investment Company Act and has not elected to be treated as a business development company.
  

The proposed rules also would grandfather in any private fund that (i) represented to investors and potential investors at the time the fund offered its securities that it was a venture capital fund; (ii) has sold securities to one or more investors prior to December 31, 2010; and (iii) does not sell any securities to, including accepting any additional capital commitments from, any person after July 21, 2011.
 
New Private Fund Exemption
Section 408 of the Dodd-Frank Act directs the SEC to provide an exemption from registration for certain private fund advisers:

The Commission shall provide an exemption from the registration requirements under this section to any investment adviser of private funds, if each such investment adviser acts solely as an adviser to private funds and has assets under management in the United States of less than $150,000,000.

Under the SEC’s proposed rules, an adviser would aggregate the fair value (not necessarily in accordance with GAAP) of all assets of private funds it manages in the United States to determine whether it is below the $150 million threshold. In addition to assets appearing on a fund’s balance sheet, an adviser would have to count any uncalled capital commitments.
 
All of the private fund assets of an adviser with a principal office and place of business in the United States would be included as “assets under management in the United States,” even if the adviser manages some of those assets through offices outside the United States.
 
Testing for this exemption would occur as of the end of each calendar quarter. An adviser that satisfied but subsequently failed the test (due to in increase in assets) would be required to register by the end of the calendar quarter following the failure.
 
Reporting and Recordkeeping Requirements Under New Exemptions
The Dodd-Frank Act directs the SEC to require advisers exempt under the new VC fund and private fund exemptions to “maintain such records and provide to the Commission such annual or other reports as the Commission determines necessary or appropriate in the public interest or for the protection of investors.”
 
Investment Adviser Act Release No. 3110, dated November 19, 2010 (the “Implementing Release”) discusses the SEC’s proposed reporting requirements under these two new exemptions. The Implementing Release and the “Exemptions Release” (Investment Advisers Act Release No. 3111 dated November 19, 2010) refer to advisers falling under either exemption as “exempt reporting advisers.”
 
Under the SEC’s proposed rules, exempt reporting advisers would be required to file reports electronically with the SEC on an amended Form ADV. Form ADV is currently titled “Uniform Application for Investment Adviser Registration” and is used by investment advisers to register with the SEC. The form would be re-titled to reflect its modified purpose (i.e., for use by registered advisers and by exempt reporting advisers). Exempt reporting advisers would be required to respond to the following subset of items in Part 1A of the amended form:

• Item 1 – Identifying Information;
• Item 2.C – SEC Reporting by Exempt Reporting Advisers (to be added to the new version of the form)
• Item 3 – Form of Organization
• Item 6 – Other Business Activities
• Item 7 – Financial Industry Affiliations and Private Fund Reporting
• Item 10 – Control Persons
• Item 11 – Disclosure Information
  

Exempt reporting advisers would also be required to complete corresponding sections of Schedules A, B, C and D. Once filed, the report would be publicly available on the SEC website.
 
The Implementing Release indicates that the SEC will propose recordkeeping requirements for advisers relying on the new VC fund and private fund exemptions in a future release.
 
Comment on the Proposed Rules
The Exemptions Release (http://www.sec.gov/rules/proposed/2010/ia-3111.pdf) and Implementing Release (http://www.sec.gov/rules/proposed/2010/ia-3110.pdf) request comments on the SEC’s proposed rules surrounding implementation of the new exemptions.  Comments may be submitted on the SEC’s comment form at http://www.sec.gov/rules/proposed.shtml, by sending an e-mail to rule-comments@sec.gov or by using the federal eRulemaking Portal at http://www.regulations.gov. All comments must be received no later than January 24, 2011, and should reference File Number S7-37-10 (for the Exemptions Release) or File Number S7-36-10 (for the Implementing Release).
 
All comments submitted will be posted on the SEC website without change – so only submit information you wish to make public.

Click here to see a related article by Tim Coxon.