Investment Banking and Private Equity

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August 19, 2010

Impact of the Dodd-Frank Wall Street Reform and Consumer
Protection Act on Private Equity Funds and Other Private Pools
of Capital
William E. Kelly

The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”), signed into law by
President Obama on July 21, 2010, is historic legislation to reform the nation’s financial regulatory
system. Although the legislation is designed primarily to implement changes in banking and financial
markets regulation, it includes several provisions that will have a direct and dramatic impact on
sponsors of, advisers to, and investors in private pools of capital such as buy-out and other private
equity funds, hedge funds, and unregistered funds of funds.

The portion of the legislation that most directly affects the private equity sector is Title IV (“The
Private Fund Investment Advisers Registration Act of 2010”). The legislation also enacts the so-
called “Volcker Rule,” which will limit the ability of banking entities to invest in private funds of all
kinds and restrict bank sponsorship of private funds.


Regulation of advisers to private funds
Although Title IV is styled as a law regulating advisers to hedge funds, its scope is much broader. It
amends Section 203(b) of the Investment Advisers Act of 1940 (the “Advisers Act”) to eliminate the
“fewer than 15 clients” exemption from the registration requirements of the Advisers Act, which has
been relied upon by managers of, and advisers to, private pools of capital (including not only hedge
funds but also venture capital funds, buy-out and other private equity funds, and funds-of-funds) as
well as by family offices and smaller “boutique” investment advisers. Title IV requires all advisers to
“private funds” (other than venture capital funds and other funds with less than $150 million in
assets under management) to register under the Advisers Act, and shifts jurisdiction over all
investment advisers with less than $100 million in assets under management from the SEC to state
securities administrators.




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“Private funds”
Title IV adds to the Advisers Act several new terms, including “private fund” and “foreign private
adviser.” A “private fund” is any entity that would be an investment company but for Sections 3(c)(1)
or 3(c)(7) of the Investment Company Act of 1940; a fund relying on Section 3(c)(1) may not have
more than 100 investors while a 3(c)(7) fund is not limited in the number of its investors but all of its
investors must be “qualified purchasers” (i.e., institutional investors and high net worth individuals).
The Act will require advisers to all private funds (except for advisers to “venture capital funds” and
private funds with less than $150 million in assets under management), who have heretofore relied
on the “fewer than 15 clients” exemption provided by Section 203(b) of the Advisers Act, to register
as investment advisers under the Advisers Act. The act does not define “venture capital fund” but
mandates that the SEC adopt a definition of the term within one year after the Act becomes law.
Because the registration requirements of the Act become effective on the first anniversary of the Act
becoming law, advisers to funds that may or may not be included in the SEC’s definition of a venture
capital fund (such as funds of funds that invest solely in venture capital funds or buy-out funds that
specialize in early stage companies) will likely find themselves having to register as investment
advisers before the SEC adopts regulations defining the term “venture capital fund.”

The Act also exempts from the registration requirements of the Advisers Act “foreign private
advisers”— investment advisers with no place of business in the United States, with fewer than 15
clients who are resident in the United States, and with no more than $25 million in U.S.-source assets
under management, which do not hold themselves out generally to the public in the United States as
investment advisers and which do not advise registered investment companies or business
development companies. Because of the relatively low limit on U.S.-source assets that may be
managed by foreign private advisers and the prohibition of maintaining a place of business in the
United States, the registration exemption for such advisers will not likely result in a shifting of private
equity fund management to off-shore jurisdictions.


Venture capital funds
The Act exempts from the registration and reporting requirements of the Advisers Act advisers that
solely advise one or more venture capital funds. Responsibility for determining what constitutes a
“venture capital fund” will reside with the SEC, but because the Senate version of the legislation had
exempted both venture capital fund advisers and “private equity fund” advisers, and the final
legislation removed the exemption for advisers to private equity funds, the SEC definition of a
venture capital fund (and, consequently, the scope of the exemption) is likely to be narrowly drawn
and to exclude advisers to buy-out and private equity funds.

Because this provision of the Act exempts only advisers that solely advise venture capital funds,
venture fund managers and general partners that, through side letter agreements or otherwise, also
advise or make investment recommendations to individual investors will not be eligible for the
exemption. Fund managers should review, and where appropriate revise, their co-investment
arrangements to make sure that in extending to individual investors opportunities to co-invest with
their funds, the managers are not engaging in any activities that could be deemed investment advisory
services.




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Although advisers to venture capital funds will be exempt from the registration and reporting
requirements of the Advisers Act, they will be required to maintain such records and to make such
periodic reports as the SEC may determine to be necessary or appropriate for the protection of
investors.


Smaller and “mid-sized” private funds; family offices
The Act also exempts from the registration and reporting requirements of the Advisers Act advisers
that solely advise one or more private funds that have, in the aggregate, less than $150 million in
assets under management. As with advisers to venture capital funds, advisers to private funds with
less than $150 million in assets under management will be required to maintain such records and
make such periodic reports as the SEC may determine to be necessary or appropriate for the
protection of investors.

The Act further provides that, with respect to advisers to “mid-sized private funds” (a term the Act
does not define), the SEC shall take into account the size, governance, and investment strategy of
such funds to determine whether they pose systemic risk and directs that the SEC’s registration and
examination procedures with respect to the advisers to mid-sized funds shall reflect the level of
systemic risk posed by such funds.

The Act also requires the SEC to adopt regulations providing for an exemption from the registration
requirements of the Advisers Act, consistent with the SEC’s current exemptive policy, for family
offices.


Accredited investors
Title IV also requires the SEC to revise Regulation D, beginning four years after enactment of the
legislation, to make periodic adjustments to the net worth standard for an “accredited investor.” The
Act also immediately excludes from the determination of an accredited investor’s net worth the value
of his or her primary residence. The Act does not make, or require the SEC to make, any changes to
the other eligibility standards for accredited investor status (such as the minimum annual income
test). However, the Act directs the GAO to conduct a study of the appropriate criteria for
determining the financial thresholds and other criteria needed to qualify as an accredited investor and
for eligibility to invest in private funds, and to report its conclusions to Congress within three years.


The Volcker Rule
Section 619 of the Act (“Prohibitions on Proprietary Trading and Certain Relationships with Hedge
Funds and Private Equity Funds”) implements the so-called “Volcker Rule.” Originally proposed by
former Federal Reserve Chairman Paul Volcker, this provision severely limits investments by banking
entities in private funds of all types and will impose restrictions on sponsorship by banking entities
and their affiliates of hedge funds and other private funds.

Section 619 amends the Bank Holding Company Act of 1956 by adding a new Section 13 that,
among other things, prohibits “banking entities” from acquiring or retaining any equity, partnership,
or other ownership interest in, or sponsoring, a “hedge fund” or a “private equity fund.”




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Section 619 defines “banking entity” to include any insured depository institution (other than an
institution that functions solely in a trust or fiduciary capacity), any company that controls an insured
depository institution, any company that is treated as a bank holding company under the
International Banking Act, and any affiliate or subsidiary of any such entity. For purposes of the
Volcker Rule “hedge fund” and “private equity fund” mean entities that would be investment
companies but for Sections 3(c)(1) or 3(c)(7) of the Investment Company Act or such similar funds
that the banking agencies, the SEC, and the CFTC may determine by rule.

The prohibitions under the new Section 13 against investments in hedge funds and private equity
funds do not apply to a number of activities, including investments in small business investment
companies, in funds designed primarily to promote the public welfare, including the welfare of low-
and moderate-income communities or families (typically referred to as “CRA investments”), and in
vehicles that are qualifying rehabilitation expenses with respect to qualified rehabilitated buildings
and certified historic structures. Banking entities are also permitted to organize and offer private
equity funds and hedge funds if, among other things, the funds are organized and offered only in
connection with the provision of bona fide trust, fiduciary, or investment advisory services and only
to persons that are customers of the banking entity. The Act also provides that banking regulatory
agencies, the SEC, and the CFTC may adopt rules that would permit a banking entity to make other
investments in hedge funds and private equity funds, subject to the safety and soundness of the
banking entity and the financial stability of the market. These activities will not be permitted if they
(i) would result in a material conflict between the banking entity and its clients, customers, or
counterparties; (ii) would result in a material exposure by the banking entity to high-risk assets or
high-risk trading strategies; (iii) would pose a threat to the safety and soundness of the banking entity;
or (iv) would pose a threat to the financial stability of the market generally.

A banking entity may make investments in sponsored hedge funds and private equity funds that
would otherwise be prohibited under the new Section 13, provided (i) the banking entity’s position in
any individual fund is not more than 3% of the total ownership interests of the fund and (ii) the
aggregate of all interests of the banking entity in such funds does not exceed 3% of its Tier 1 capital.
A banking entity that sponsors a new private equity fund or hedge fund may make an initial
investment that represents more than 3% of the initial capital of such fund, so long as the banking
entity’s position is brought below the 3% limit within one year after the formation of the sponsored
fund.

The newly-established Financial System Oversight Council (the “FSOC”) is directed under Section
619 to conduct a study and make recommendations regarding implementation of the Act’s
investment restrictions, and the bank regulatory agencies, the SEC, and the CFTC are required to
develop regulations within nine months after completion of the FSOC study. The provisions of the
new Section 13 will take effect on the earlier of (i) 12 months after the date of the issuance of the
final rules by the bank regulatory agencies, the SEC, and the CFTC or (ii) two years after the date of
enactment of the Act. Thereafter, banking entities will have two years to divest the fund investments,
subject to up to three one-year extensions that may be granted by the Federal Reserve Board. The
Federal Reserve Board may grant an additional extension of the divestiture deadline for up to five
years with respect to banking entities’ investments in, and contractual obligations to make additional
capital contributions to, illiquid funds, so long as such interest was held and such contractual
obligation was in effect on May 1, 2010. Consequently, the full divestiture by banking entities of
prohibited investments in private equity funds will likely not be completed before 2022.




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Contact us
      William E. Kelly, Partner
       wkelly@nixonpeaby.com, 617-345-1195
      Kari K. Harris, Partner
       kharris@nixonpeabody.com, 617-345-1120




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