What advisers need to know

Author: | Published: 1 Apr 2007
Email a friend

Please enter a maximum of 5 recipients. Use ; to separate more than one email address.

Why should non-US advisers to private equity funds be concerned about the US Investment Advisers Act of 1940? After all, the recent effort by the US Securities and Exchange Commission to regulate the advisers of private investment pools by requiring their registration has been struck down in US court. Those proposed regulations targeted advisers to hedge funds and not those advising private equity and venture capital funds. Also, the SEC itself has long held the view that the reach of the Advisers Act should not generally extend to a non-US investment adviser in its dealings with its non-US clients, even in situations where the adviser is registered under the Advisers Act. Despite all of this, non-US advisers to private equity funds should be aware of the possible implications that the Advisers Act might have for them, especially in light of the SEC's renewed efforts to regulate the private investment funds industry.

The Advisers Act generally

The Advisers Act requires certain investment advisers to register with the SEC and prohibits all investment advisers from engaging in deceptive practices through its broad anti-fraud provisions. The Act imposes general fiduciary duties on investment advisers, which require advisers to act in the best interest of their clients at all times. The Act further requires registered advisers to meet certain recordkeeping, reporting, custody, compliance, proxy voting and disclosure requirements.

An investment adviser of a private equity fund can generally avoid having to register with the SEC under the Advisers Act by relying on the private adviser exemption. Under this exemption, an investment adviser need not register under the Advisers Act if it has had fewer than 15 clients in the last 12 months and does not hold itself out to the public as an investment adviser. For a non-US investment adviser with a principal office and place of business outside of the US (an offshore adviser), only US clients need to be counted. Under the current SEC rules, each pooled investment vehicle advised by an investment adviser in exchange for compensation is counted as one client for purposes of this exemption, as long as the advice is based on the vehicle's investment objectives and not the individual objectives of the vehicle's respective investors. In the context of a US-based private equity fund adviser, the adviser must count each pooled investment vehicle that it advises (whether organized in the US or offshore) as a client for purposes of this exemption. For an offshore adviser, only pooled investment vehicles that are organized in the US, such as Delaware limited partnerships, must be counted.

Why offshore advisers might register

A non-US adviser of private equity funds should be aware of certain circumstances in which it might have to register with the SEC under the Advisers Act and the degree of compliance that would be required once registered. For example, if the offshore adviser elects to qualify as a qualified professional asset manager (QPAM) under the US Employee Retirement Income Security Act (ERISA), it is required to register as an investment adviser under the Advisers Act. Under the rules of the US Department of Labor (DOL), if a private equity fund raises money from ERISA-regulated investors and cannot satisfy certain regulatory exceptions, the private equity fund may be deemed to hold ERISA plan assets, and the fund will become subject to ERISA. The fund's management will be deemed to be fiduciaries of the ERISA-regulated pension schemes that are investors and, as such, will be subject to complex conflict-of-interest rules and certain transactional prohibitions restricting with whom the fund can do business and the way in which the fund's management can be compensated. Having the fund's adviser qualify as a QPAM reduces the potential that fiduciaries might engage in certain types of prohibited transactions as a result of the fund's investments.

One regulatory exception to ERISA that is commonly relied upon by private equity funds is the so-called 25% test exception. Recent amendments to ERISA have made it easier for private equity funds to satisfy this exception. Generally, under the 25% test, a fund will not be subject to ERISA or to its transactional prohibitions if less than 25% of any class of their equity interests is held by benefit plan investors, which include only benefit plans subject to ERISA (generally, US private employer and union benefit plans and certain private retirement accounts). Qualifying as a QPAM, however, might be the only option for an offshore adviser to a private equity fund if the fund: (i) cannot meet the 25% test exception because it expects a large portion of its capital commitments to come from ERISA-regulated plans; and (ii) cannot qualify for any of the other statutory exceptions under ERISA, including the venture capital operating company (VCOC) or real estate operating company (REOC) exceptions. Both of these exceptions generally require a fund to obtain substantial management rights with respect to its investments and, in the case of the VCOC exception, requires investments to be made primarily in operating companies. This could be an issue for certain types of private equity funds with particular investment strategies (for example, passive, non-control, non-equity investments, investments in entities other than operating companies), such as those investing in debt instruments or interests in other private equity funds.

Another situation that would trigger registration for a non-US adviser is where the adviser has had more than 14 US clients in the past 12 months. The most obvious situation is where the non-US adviser provides advisory services to more than 14 private equity funds organized in the US during a given 12-month period. Special attention should also be paid to ancillary investment vehicles that may be formed in the US for tax, regulatory or other reasons, such as parallel funds and alternative investment vehicles. These vehicles might constitute separate clients for purposes of the private adviser exemption and could cause an offshore adviser to have to register under the Advisers Act. Generally speaking, if an offshore adviser, or an affiliated general partner entity, receives any compensation in exchange for advisory services provided to an ancillary vehicle (for example, management fees or carried interest), the vehicle should be counted toward the 14 US client limit. Also, if an offshore adviser enters into a separately managed account with a US investor, that investor would count toward the 14 US client limit.

Implications of registration

If an offshore adviser of a private equity fund has to register under the Advisers Act, the degree to which it must comply with the Advisers Act's requirements will vary depending on whether or not the adviser has any US-organized investment funds or other US residents as clients. For a registered offshore adviser with US-organized funds or other US advisory clients, the adviser must comply with all of the requirements of the Advisers Act with respect to these US clients. A registered adviser must develop a comprehensive compliance programme, which includes adopting a compliance manual and a code of ethics governing the proprietary and personal trading by certain personnel with access to non-public information (access persons), and must appoint a chief compliance officer to oversee the programme. The adviser must also comply with the SEC's rules on the voting of portfolio securities held on behalf of its US clients and the custody of client securities, and must maintain certain records and documents required under the Advisers Act, including securities holding and trading reports for its access persons.

Under the so-called brochure rule, a registered offshore adviser must deliver to each prospective US client a written disclosure statement containing certain information about the adviser's business practices and background. The disclosure statement must describe, among other things, its code of ethics (which contains the adviser's personal/proprietary trading policy), its co-investment policies and related conflicts of interest. For an offshore adviser to a US private equity fund, the brochure will need to describe its policies for co-investments with the fund by the adviser or its affiliates in the same portfolio companies. Annual updates to the disclosure statement must be delivered or offered to existing US clients. The offshore adviser may comply with the brochure rule by delivering to each US client a copy of Part II of its SEC Form ADV, which is the form filed with the SEC to register as an investment adviser. Offshore advisers should note that, while the US private equity fund is technically the client under the current rule, the generally accepted practice (and the SEC's interpretation of the rule) is for an adviser to deliver the disclosure statement to each investor in the fund.

If a registered offshore adviser is to receive a performance-based fee (for example, carried interest) for advising a US private equity fund, all US investors in the fund must be qualified clients (generally having a net worth greater than $1.5 million).

The registered offshore adviser must comply with the restriction on principal transactions contained in the anti-fraud provisions of the Advisers Act. In general, the offshore adviser must obtain client consent before completing any transaction in which the adviser, acting as principal for its own account or the account of an affiliate, buys any security from, or sells any security to, a US client. For an offshore adviser to a US private equity fund, principal transactions of these sorts can include warehousing arrangements, where the adviser seeks to transfer investments from an affiliated entity to the fund once the fund is operational, or where it advises a US fund of funds that wishes to invest in another fund established by an affiliate of the adviser. The Advisers Act requires the prior consent of the US fund client for these principal transactions, and the offshore adviser may obtain this consent through the fund's investor advisory committee.

For a registered offshore adviser with no US-organized fund clients and no other direct US advisory clients, large portions of the Advisers Act will not apply. This position reflects the SEC's long-standing view that relationships between an offshore adviser and its offshore clients generally are more appropriately regulated by applicable foreign laws than US laws and that there is usually no expectation of the protection of US securities laws in these relationships.

A registered offshore adviser with no direct US advisory clients will generally be required to:

  • keep certain books and records as required under by the Advisers Act;
  • remain subject to examinations by the SEC's staff; and
  • comply with the Advisers Act's general anti-fraud provisions with respect to its offshore clients.

On the last point, there has been some confusion since the hedge fund adviser rule was overturned as to whether, for purposes of the anti-fraud provisions, the client of the offshore adviser is the offshore fund itself or the investors in the fund. While the SEC has maintained that the offshore adviser's clients for these purposes are the investors in the fund and not the fund itself, and most practitioners have assumed that this was the case, the court that overturned the rule suggested in its decision that the fund is the client for these purposes. To clarify this uncertainty, the SEC has proposed a new rule discussed in more detail below that would expressly extend the Advisers Act's anti-fraud protections to the individual investors in an offshore fund.

A registered offshore adviser to non-US private equity funds with no other direct US advisory clients should also be aware of the following exceptions to the substantive requirements of the Advisers Act:

  • The offshore adviser will not be required to adopt a code of ethics containing its personal/proprietary trading policies, but it must retain personal securities reports for its access persons that would otherwise be required under the code of ethics.
  • The offshore adviser will not be required to deliver a written disclosure statement to its non-US private equity funds (or any of the investors in the funds) under the brochure rule, but the adviser will have a fiduciary duty to provide those clients (which, in this case, presumably means both the funds and their investors) with full and fair disclosure of conflicts of interest. If an offshore adviser does not intend to adopt a code of ethics or provide a written brochure to these investors, it is still required to find other means of disclosing to these investors its proprietary/personal trading policies, its co-investment policies and the associated conflicts of interest. Full disclosure of these items should be included in the offering documents provided to these investors, such as the confidential offering memorandum.
  • Because the Advisers Act's restrictions on charging a fee do not apply to a non-US fund, a registered offshore adviser may receive performance-based carried interest from an offshore fund without the investors in the fund having to be qualified clients.
  • The Advisers Act's restrictions on principal transactions will not apply to an offshore adviser in its dealings with its offshore fund clients, so no prior client consent is required for these transactions. Because of the conflicts of interest inherent in these types of transactions and the adviser's fiduciary duty to disclose conflicts, however, the adviser should disclose to investors in the offshore fund whether it intends to engage in principal transactions, such as warehousing arrangements.

If a registered offshore adviser is subject to partial compliance with the Advisers Act and intends to represent to investors that it is registered with the SEC, the adviser should fully disclose to investors that it is not subject to full compliance, to make this representation not misleading. The adviser might also wish to specify those requirements under the Advisers Act that do not apply to it. The adviser should include language to this effect in the confidential offering memorandum or other offering documents sent to investors looking to invest in its offshore fund.

For an offshore adviser that registers to qualify as a QPAM and has no US advisory clients, one issue to note is whether the adviser would still qualify as a QPAM if it were subject to the more relaxed set of Advisers Act requirements described above. Several ERISA-related provisions require that a person be an adviser registered under the Advisers Act (for example, the definition of investment manager in ERISA Section 3(38) and the definition of a qualified professional asset manager under prohibited transaction class exemption 84-14). Although the DOL has yet to provide formal guidance on this issue, practitioners in this area have generally taken the position that offshore advisers satisfy the registration requirement in each of these ERISA-related provisions solely by being registered with the SEC under the Advisers Act, even if they are subject only to partial compliance with the substantive provisions of the Advisers Act.

US offices and registered US affiliates

Another area where the Advisers Act might have implications for a non-US private equity fund adviser is when the adviser has offices both overseas and in the US. For an adviser to be considered an offshore adviser, it must have both a principal office and a principal place of business outside of the US. If, for example, an investment adviser has its principal office in London but most of its operations are in its New York office, it is possible that the adviser's principal place of business could be deemed to be in the US. The analysis will depend on specific facts and circumstances, especially because neither principal office nor principal place of business is defined in the Advisers Act. If the principal place of business is found to be in the US, the adviser will not be considered an offshore adviser and will need to count all clients to determine whether it can rely on the private adviser exemption.

An unregistered non-US adviser should also be aware of the implications of the Advisers Act if it has a registered US affiliate that has been established to provide advisory services to US clients, particularly if the registered US affiliate intends to make use of the non-US adviser's personnel, offices or other resources in connection with the advice to be provided to US clients. The SEC will generally permit such arrangements without requiring the non-US adviser to register under the Advisers Act so long as certain conditions set forth in prior SEC guidance are met. These conditions are designed to ensure that the advisory activities of the unregistered non-US adviser that affect US clients or markets are subject to the Advisers Act and the SEC's regulatory oversight. Generally, the registered US affiliate must supervise all of the non-US adviser's personnel involved in the advisory services provided to US clients, keep certain records relating to the personnel and subject the personnel to the SEC's jurisdiction. The non-US adviser must also provide access to its trading and other records to the extent necessary for the SEC to monitor and police conduct that could harm US persons or markets.

Proposed anti-fraud rule

The final item that non-US advisers should note is the new anti-fraud rule under the Advisers Act proposed by the SEC. The proposed rule clarifies the uncertainty following the demise of the hedge fund adviser rule as to whether the anti-fraud protections of the Advisers Act extend to individual investors in an investment fund. The proposed rule prohibits investment advisers from: (i) making false or misleading statements of material facts to individuals investors in pooled investment vehicles; or (ii) otherwise defrauding these investors. The proposed rule is intended to protect both existing and prospective investors in a pooled investment vehicle. The SEC has indicated that the proposed rule will cover a broad range of communications, including account statements, private placement memoranda, offering circulars and responses to requests for proposals, and will apply regardless of the investment strategy or structure of the pooled investment vehicle.

Non-US advisers should note the broad scope of the proposed rule. While the hedge fund adviser rule was directed towards hedge funds, the proposed rule will apply to all pooled investment vehicles, as defined in the proposed rule, which would include hedge funds, private equity funds, venture capital funds and investment companies that are offered to the public. The proposed rule is also intended to apply to all investment advisers – whether registered or unregistered, US or offshore.

SEC prepares for battle

The Advisers Act could have implications on non-US advisers to private equity funds that they should be aware of and that will probably have a greater impact on them in the future. While its application to an offshore private equity fund adviser is generally limited, situations could arise where an adviser becomes subject to the some or all of the Act's regulations.

It is clear that the Advisers Act has become the SEC's weapon of choice in its attempt to regulate the private funds industry, and recent proposals by the SEC confirm that it looks to extend the scope and extraterritorial application of the Act to capture these types of advisers.

Albert Cho assisted in the preparation of this article. He is an associate in Dewey Ballantine's private equity group.

Author biographies

Joseph A Smith

Dewey Ballantine LLP

Joseph A Smith is the chairman of Dewey Ballantine's private equity and alternative investments group, where he represents fund sponsors, asset managers and institutional investors in connection with fund formation, the acquisition of portfolio investments and the implementation of exit strategies. In this capacity, Smith advises clients on securities, governance, ERISA, the Investment Advisers Act and structural issues. He has extensive experience with all alternative asset classes, including secondaries funds, venture capital and later-stage growth equity investments, leveraged buyouts, mezzanine investments, real estate funds and Reits, distressed debt and hedge funds. Smith was recognized in Chambers USA – America's Leading Lawyers for Business 2006 as a leader in the field of private equity: fund formation. He was also recognized in The US Legal 500 2007 as a leader in the fields of investment funds: alternative/hedge fund formation, private equity – buyouts: $10 billion and above, and private equity fund formation.

Edward D Nelson

Dewey Ballantine LLP

Edward D Nelson's is a partner at Dewey Ballantine, where his practice focuses on the organization and operation of private investment funds. He has represented a wide variety of private investment funds, including buyout funds, venture capital funds, real estate funds, secondary funds, distressed funds, international funds and hedge funds. Nelson also represents institutional investors in their private investment fund and other alternative investment activities. He has significant experience in issues relating to the Securities Act, the Investment Company Act and the Investment Advisers Act. Nelson's practice has also included many venture capital, private equity and merger and acquisition transactions.