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Creeping regulation of private equity fund managers27/07/2004. Source: Testa, Hurwitz & Thibeault. Michael Collins 
 A spate of recent regulatory initiatives in the US, have served to focus increasing attention on operations that were once considered to be private. Michael Collins of Testa, Hurwitz, Thibeault examines the implications of this legislation for the nation's private equity industry.
Private equity fund managers commonly are regarded as being "unregulated"
in the United States. The appearance of being unregulated is the by-product of
a careful balancing of specific exemptions from certain aspects of regulation
and a sustained effort to maintain high standards of investment conduct by private
equity fund managers (Private Fund Managers). As the private equity industry matures
and expands, this careful balancing act is being sorely tested, leading to confusion
and concern about the increasing scope of regulation affecting Private Fund Managers.
Recent regulatory initiatives have served to focus more attention on operations
that were once considered quite "private."
Investment Activities. The investment activities of Private
Fund Managers have expanded to a variety of transactions — such as PIPES,
securitised facilities and public market portfolio hedging — that overlap
with activities ordinarily associated with regulated investment managers, mutual
funds and investment banks. Similarly, many regulated investment managers conduct
private equity investment programs. Though most Private Fund Managers are not
registered with the SEC as investment advisers under the Investment Advisers
Act (Advisers Act), with the advent of fund-of-funds vehicles, some Private
Fund Managers have registered in order to qualify to manage ERISA assets, even
though the nature of their activities may not otherwise require registration.
Standards of Conduct. Notwithstanding the absence of registration,
the SEC still evaluates Private Fund Managers’ activities in light of
the standards applicable to registered investment advisers. The anti-fraud provisions
of the Advisers Act serve as the standard for assessing the accuracy and thoroughness
of disclosure of performance data and reporting in a private placement memorandum
or other offering materials for a private fund. By way of example, in December
2003 the SEC brought an enforcement action against an unregistered adviser for
violations of Advisers Act standards arising from a failure to supervise and
deceptive practices. The SEC asserted that unregistered advisers would be held
to the same overall standards that are applicable to registered advisers, especially
in cases of fraud or deceptive conduct.
Hedge Funds. The current wave of legislation, regulation and
enforcement actions by the SEC and other agencies tends to regard all private
investment activities generically so as to include private equity funds together
with hedge funds, mutual funds and other investment vehicles without any distinction.
The recent SEC report recommending the regulation of hedge fund managers raises
particular concerns for Private Fund Managers. Currently, many hedge fund managers
and most Private Fund Managers rely upon the same exemption from registration
under the Advisers Act. The SEC report proposed to amend this exemption to require
hedge fund managers to register under the Advisers Act. Yet the SEC did not
differentiate hedge funds from private equity funds. The SEC also raised concerns
about valuations of illiquid securities, inconsistent reporting standards and
potential conflicts arising from incentive fees to managers. All of these issues
are present not only in the case of hedge funds, but also in the case of private
equity funds.
Most recently, SEC staff members and Chairman Donaldson have stated publicly
that the SEC does not intend to regulate Private Fund Managers as such; but
the lack of a clear delineation by the SEC between hedge funds and private equity
funds raises the possibility that, at some point, hedge fund regulation may
affect all Private Fund Managers.
Patriot Act/AML. Other legislation and regulations, such as
the Patriot Act and related anti-money laundering (AML) rules, apply to a broad
range of financial institutions, including investment managers, hedge funds
and private equity funds, and require these financial institutions and managers
to establish and maintain AML compliance programs.
Regulators have shown some willingness to limit the application of AML rules
since, in their view, most private equity funds do not pose a high risk of money-laundering
due to their long-term and illiquid interests and lack of periodic redemption
or withdrawal rights. Accordingly, proposed AML rules would not apply to private
funds that do not provide for redemption of investors within two years of admission,
thus exempting most private equity funds. By contrast, most hedge funds would
be required to follow AML rules, as hedge funds typically provide significant
liquidity and redemption rights to investors.
A separate set of AML rules has been proposed for managers of investment funds.
These manager-level rules do not have any exemption for Private Fund Managers,
but regulators have indicated a willingness to consider an exception for managers
of funds that are not required to have AML programs at the fund level.
Conclusion. The private equity industry has achieved great
success over the last thirty years without the need for direct regulatory oversight.
However, in an environment where regulatory oversight of the financial industry
has intensified, and as the activities and structures of private equity funds
have expanded and become more sophisticated, Private Fund Managers must be aware
of the increasing possibility that they soon may be subject to additional regulatory
requirements.
This article is reproduced with permission of Testa, Hurwitz & Thibeault,
LLP. For more information about Testa, Hurwitz & Thibeault, LLP, please
contact www.tht.com
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