Thomas Bell and Jason Glover of Simpson Thacher & Bartlett explore the impact of regulatory changes, notably the European Union’s Directive on Alternative Investment Fund Managers and the Dodd-Frank Act, on private fund managers.
"Going forward private fund managers will continue to seek solutions to streamline their compliance operations to meet regulatory obligations more efficiently and cost-effectively."
In the 2010 edition of The International Who’s Who of Private Funds Lawyers, we wrote that the key changes to the regulatory landscape made in response to the financial crisis would test the skills of even the very best private funds practitioners. Three years later, the implementation phases for many of these changes are under way and have provided an abundance of challenges not only for private funds practitioners but also for the private fund managers themselves, both in terms of the way that their own internal legal and compliance functions are organised, and the measures being taken and the consequential costs being incurred to ensure compliance with these changes. In this edition, we assess the impact that new regulations are having on private fund managers generally, how those managers are adapting to these new regulations and what impact these new regulations might have on the private funds industry more generally.
The Regulatory Tidal Wave
The European Union’s Directive on Alternative Investment Fund Managers (the AIFM Directive) came into force on 22 July 2013 and impacts every private fund manager who either markets a fund into the EU or manages an EU fund after that date. The AIFM Directive sought to introduce a harmonised set of pan-European rules regulating private fund managers doing business across the EU. A wide-ranging scope of requirements are imposed on private fund managers in such areas as marketing (disclosure and transparency requirements), conduct of business (remuneration guidelines, rules of conduct, conflicts of interest), functions to be performed by third-party service providers (eg, depositaries), capital requirements and reporting and disclosures to investors and regulators.
Many commentators (the authors included) believe that the AIFM Directive’s “one size fits all” approach, under which a single set of rules are applied to distinct industries with significantly different operating models (eg, buyouts, venture capital, real estate, credit/debt funds, hedge funds), has resulted in the imposition of significant compliance costs on private fund managers with, in many cases, no corresponding benefit to investors. Indeed, whilst the AIFM Directive offered the potential for a consistent set of rules applicable throughout the EU, the reality (at least to date) has been somewhat different. The vagueness of the legislation, its lack of full implementation in several EU jurisdictions (at the time of writing) and the differing interpretations of its provisions in member state implementing laws make it a complex, unwieldy regime that has created additional legal uncertainty.
The Dodd-Frank Act
On the other side of the Atlantic, the major legislative response of the US to the financial crisis has been the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). Dodd-Frank’s elimination of the “private adviser” exemption that many investment advisers to private funds relied on and its replacement with several narrower exemptions has meant that SEC registration requirements now extend to virtually all US-based private fund managers and many non-US fund managers with US operations. SEC registration requires compliance with numerous obligations under the Investment Advisers Act of 1940. For example, a registered adviser must have a chief compliance officer and must adopt, implement and annually audit the effectiveness of the firm’s compliance programmes and procedures to address for example, portfolio management processes, trading practices, recordkeeping, marketing, valuation processes and privacy protection of client records and information. In addition, a registered adviser must file with the SEC a Form ADV (and annual amendments thereto) reporting to the SEC a comprehensive array of information about the firm and the private funds it advises, including information relating to the firm’s ownership, the disciplinary background of the firm and its management and advisory affiliates, the fees and other compensation charged to its funds and the investment strategies, practices, risk factors and its conflicts of interest in managing its funds. A registered adviser is also required to comply with extensive record-keeping requirements, abide by custody rules and maintain a code of ethics and enforce stringent insider trading procedures. For those not actually charged with the responsibility for compliance with this panoply of requirements, it may seem that the burden of being a registered adviser is not much different from applying for a driver’s licence and maintaining an inspection on one’s car, but the reality on the ground is assuredly different.
In addition to the foregoing, Dodd-Frank also imposes burdensome reporting obligations on registered advisers under Form PF (to report systemic risk exposure statistics). Form PF includes a section that requires all advisers to provide certain information about any private funds they advise, including among other things, information about the private funds’ assets under management, performance, investors and use of leverage and derivatives. Advisers that have at least $1.5 billion in assets under management attributable to hedge funds (so-called “large hedge fund advisers”) or have at least $2 billion in assets under management attributable to private equity funds (so-called “large private equity fund advisers”) are subject to more extensive disclosure requirements. Large hedge fund advisers are required to complete a section that requires certain aggregate information about the hedge funds they manage, including information about the funds’ investments by type of security or instrument, investments by geographical region and portfolio turnover. In addition, large hedge fund advisers must provide detailed information about each hedge fund that they manage, including among other things, information about each fund’s assets, large positions, risk metrics, market factors, financing information and side pockets. On the other hand, large private equity fund advisers are required to complete a section which requires certain information about the private equity funds that they manage, including information about guarantees of portfolio company obligations, the size and leverage of portfolio companies, the identities of all persons who have provided any bridge loan to any controlled portfolio company, and the amounts financed with each person. The frequency of Form PF filings depends on the size and nature of the fund. Large hedge fund advisers are required to make quarterly filings while other hedge fund advisers and all private equity advisers are required to make annual filings. Non-US private fund managers that are not required to register with the SEC are not subject to Form PF reporting. However, assuming that they have at least a modest amount of US investors in their funds, non-US private fund managers are subject to SEC examination of their activities, and many London-based private fund advisers have recently been subject to SEC examinations to determine whether they are in compliance with American regulations.
Overall, the flow of new regulatory developments in the US remains unabated. For example, Rule 506 (the private placement safe harbour rule widely relied upon by private funds for their US fundraisings) has recently been amended to add a “bad actor” disqualification provision, which has imposed further due diligence costs and burdens on private equity firms since it requires a private equity firm to determine that each of its “affiliated issuers” (including all of its controlled portfolio companies) has not engaged in certain “disqualifying acts” in order for any fund that the private equity firm sponsors to be able to rely on Rule 506 for the fund’s private offering in the US. Another recent example has been the introduction since February 2013 of an obligation for any SEC-registered public reporting company (such as a private equity fund’s portfolio company that is publicly traded in the US) to disclose in its periodic reports certain activities of it or any of its affiliates (including all other portfolio companies controlled by the same sponsor) involving Iran pursuant to Section 219 of the Iran Threat Reduction and Syria Human Rights Act 2012. It appears from recent disclosures that private equity firms with US publicly traded portfolio companies have undertaken significant time and expense in collecting data about potentially reportable activities, including transactions with customers, vendors, and other business partners.
Furthermore, a recent report by the US Treasury Department’s Office of Financial Research (OFR) concluded that the existing systemic risk reporting by private fund managers allegedly leaves regulators with information gaps that impede the regulators’ effective macro-prudential analysis and oversight of fund managers and therefore need to be filled. The OFR proposes that enhanced reporting requirements should be introduced for private fund managers. The irony of all this is not lost on the authors – while no one can rationally point a finger at private funds as a cause of the “great recession”, the imposition of additional regulation on private fund managers to mitigate systemic risk to the financial system shows no sign of slowing.
Impact on private fund managers
The cost of doing business for private fund managers has gone up considerably over the past few years, as firms have navigated the new regulatory environment and adapted their operations accordingly. A recent survey of hedge fund managers found that one-off compliance costs for AIFM Directive-related projects have ranged from $300,000 to $1 million per firm while on-going compliance costs are not insubstantial. For example, the requirement under the AIFM Directive to appoint a depositary is expected to result in additional costs of, typically, five to 10 basis points of NAV per annum. In the US, although many large private equity firms were registered before the implementation of Dodd-Frank, the regulations have added significant burdens to their on-going compliance costs. Our understanding is that total ongoing annual compliance costs typically range from $350,000 for smaller firms (eg, less than $1 billion of AUM) to as high as $8 million for firms with AUM in excess of $100 billion. This is in addition to initial costs of compliance, which, for example, for mid-market firms with AUM of up to $15 billion can typically range from $600,000 to over $2.75 million.
The increase in costs is principally a function of an increase in back-office compliance staff and in services provided by outside legal counsel and consultants, as well as investment in additional technology to enable private fund managers to improve their data management capabilities and reporting processes.
The increase in regulation has also resulted in firms adopting a more systematic and controlled (some might say bureaucratic) approach to their operations. Internal systems and procedures have been put in place and a greater emphasis has been placed on process, checklists and prompts to ensure that all boxes are checked correctly and on time. Whereas it used to be the case that compliance matters were dealt with on more of an ad hoc basis, there has been a pronounced shift towards forward planning to proactively address areas of concern of regulators. In this regard, firms have sought to put in place data management systems to collect, store and manage information to demonstrate compliance, which can then be effectively retrieved, updated, packaged and distributed to regulators on an ongoing basis. The development of these systems has typically occurred without the involvement of outside counsel, although in-house counsel has typically been integral to the process.
Impact on the private funds industry generally
The consequences of the recent regulatory changes are that firms are increasingly having to “institutionalise” their operations to cope with increased bureaucracy and red tape. While many larger firms already have much of the requisite infrastructure in place to absorb incremental compliance work within existing administrative functions, smaller and medium-size firms are having to make (in many cases painful) choices to employ new dedicated resources to manage the increased compliance burden, instead of devoting those resources directly to investment management. As a consequence, we would suggest that the increased compliance burden is having a disproportionately adverse effect on smaller and medium-size firms who are likely to see a proportionally higher impact on profitability caused by such incremental compliance work. This in turn leads us to believe that larger firms will enjoy a competitive advantage in this regard over smaller rivals, which in turn will serve as a force to drive a consolidation of assets under management in an effort to exploit administrative/compliance economies of scale. Further, as the private funds industry becomes a more capital intensive business with greater upfront working capital requirements, barriers to entry will increase and act as a deterrent to new entrants. As such, we are likely to witness fewer first time fundraisings and team spin-outs going forward.
Higher costs will inevitably also impact fund returns as some costs will be allocated to the funds rather than to management overheads. Over the long run, economic theory indicates that, as with any increased cost of production, increased compliance costs will largely be passed onto investors. Accordingly, institutional investors should not regard themselves as passive observers without a stake in this regulatory drama. Rather, they should appreciate that they have a key role to play in ensuring that regulatory burdens placed upon private fund managers are appropriately matched by a corresponding public policy benefit.
Going forward private fund managers will continue to seek solutions to streamline their compliance operations to meet regulatory obligations more efficiently and cost-effectively. A key question however is how can a regulated business model be deployed to create strategic advantage in the market place? It seems clear that, at least on this metric, the larger fund managers have an opportunity to entrench their positions and increase their competitive advantages over smaller rivals. As such, there may be opportunities for consolidation within the industry and for increases in market share and returns among a handful of dominant firms. Conversely, the future outlook for small and medium-size private funds looks distinctly more challenging.