ACG preps for another run at Dodd-Frank with new definition of middle-market funds

Under the definition developed by ACG’s public policy committee and approved by its executive committee this summer, funds would have to meet the following requirements to be considered middle-market (unless they are already small business investment companies, in which case they would automatically qualify):

  • Invest at least 80 percent of their capital in the debt or equity securities of private companies (at time of investment) that have either total enterprise values of $400 million or less or that generated annual revenue of $400 million or less in their most recent fiscal year;
  • Have accredited investors account for at least 90 percent of their investor base;
  • Offer no liquidity rights to investors outside of “extraordinary situations”;
  • Limit their long-term, fund-level leverage to less than 15 percent of fund contributions and uncalled commitments; and
  • Qualify as private funds under sections 3(c)1 or 3(c)7 of the Investment Company Act of 1940.

Defining middle-market funds should strengthen ACG’s hand when talking to legislators about making changes to the Dodd-Frank financial reform act signed into law in 2010, said Richard Jaffe, co-head of the private equity practice group at Duane Morris LLP, ACG vice chairman and until about a month ago co-chair of ACG’s public policy committee. Jaffe noted that the definition is similar in several respects to the definition that the SEC applied to venture capital funds for the purposes of enacting Dodd-Frank.

Designed to reduce economic risk and prevent another financial crisis, Dodd-Frank has elements widely regarded by buyout firms as overly burdensome. These include the requirement that most sponsors register as investment advisers under the 1940 Act. Twice the House of Representatives has passed a bill that would eliminate the registration requirement, once in December and more recently in September. But few see the bill as having enough support from Democrats in the near term to become law.

Jaffe believes that legislators would be more receptive to reversing the prohibition on insured depository institutions, bank holding companies and related entities from committing capital to most buyout funds—part of the so-called Volcker Rule scheduled to go into effect on July 21, 2015. The key, he said, is taking a more tailored approach that emphasizes the importance of channeling capital to middle-market companies.

Many of the major banks, including Bank of America, Citigroup and JPMorgan Chase, have already started the process of divesting private equity interests to comply with the Volcker Rule. According to a 2009 survey by Buyouts, banks accounted for more than 3 percent of the total capital raised by sponsors using placement agents.

ACG has to separate middle-market funds from mega-funds, said Jaffe, pointing to the example of venture capital firms, which successfully painted themselves as job creators on Capitol Hill, winning a carve-out from the registration requirement in the original Dodd-Frank legislation. Mega-firms are large asset managers that are already regulated, Jaffe said. But middle-market firms, he said, don’t pose a systemic risk to the economy, and Dodd-Frank regulations have imposed an unnecessary cost without benefit. He added: “We think mid-market funds are really contributing to (the) growth of the economy and don’t have the same kind of issues.”

ACG’s public policy committee, according to Jaffe, considered a definition of middle-market fund based on fund size, but it found that even very large funds, through consolidation strategies, might invest mostly in middle-market companies. In fact, at least 90 percent of recent U.S. sponsored deals, by number, fall under $400 million in enterprise value, according to data from PitchBook. “We’re trying to get capital into middle-market companies,” said Jaffe. “We don’t really care how large the fund is. If 80 percent of their capital is going into these middle-market companies, they should be exempt” from the prohibition on receiving capital from banks.

The strategy of approaching Congress or the SEC on behalf of a newly defined class of middle-market funds isn’t without risk. Legislators and regulators could push back and suggest an even more narrow definition of middle-market funds. The effort also threatens to alienate mega-firms whose deep pockets and lobbying savvy could help mid-market shops in other battles to come.

Pam Hendrickson, chief operating officer at lower-mid-market shop The Riverside Company and the immediate past chair of ACG’s global board, said ACG has no desire to create classes of “good” sponsors and “bad” sponsors. She pointed out that even ostensibly large firms such as TPG Capital could have funds that meet the definition of middle-market fund. But in the end, she said, ACG has an obligation to its membership of middle-market executives, private equity professionals, investment bankers and other service providers.

“We need to stay aligned (with big sponsors) on the issues that (we have) in common, but the middle-market firms can also get behind those issues that are really challenging for them,” Hendrickson said.