The U.S. Securities and Exchange Commission has issued proposed rules to implement the systemic risk reporting requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act—and buyout shops with more than $150 million under management will almost certainly have to comply.
The proposed rules affect private fund advisers under the Investment Advisers Act as well as commodity pool operators and commodity trading advisors under the Commodity Exchange Act. Fund managers that are registered with the SEC will have to file proposed Form PF annually, and in the case of large funds, quarterly. The level of detail required to be reported is greater for large funds, but all registered fund managers will be required to disclose significantly more information about their funds and operations than was previously required.
Filed Forms PF will be shared with the Financial Stability Oversight Council to the extent the FSOC considers necessary for purposes of assessing the systemic risk posed by private funds, but FSOC and the SEC will hold the information subject to the confidentiality provisions of the Dodd-Frank Act. In addition, the information may also be shared with the Office of Financial Research (OFR). The FSOC may direct the OFR to collect additional information. The record-keeping requirements specific to private fund advisers for systemic risk assessment purposes have not yet been specifically addressed. The SEC will address this at some point in the future. These requirements will most likely overlap with the record-keeping requirements under the Investment Advisers Act, but each adviser’s compliance manual should address the new requirements when they are released.
All advisers to private funds that are registered with the SEC will be required to file Form PF. The proposed rules separate registered private fund advisers generally into two groups, large private fund advisers and smaller private fund advisers. Large private fund advisers are generally advisers to funds with more than $1 billion of the specified types of assets under management. Form PF has eleven pages of defined terms, which include, for example, “private equity fund assets under management,” “hedge fund assets under management,” “regulatory assets under management,” and “net assets under management.”
Because the test is measured by specified asset types, an adviser to a private equity and a hedge fund may be considered a smaller adviser for purposes of Form PF even if its total assets under management are over $1 billion so long as both the adviser’s private equity funds under management and hedge fund assets under management are each less than $1 billion.
Form PF is divided into five sections. Section 1 is applicable to all advisers registered with the SEC. Sections 2 through 4 apply only to large private fund advisers, and each of these sections applies to a different type of private fund. Section 2 applies to advisers to hedge funds, section 3 applies to liquidity fund managers and section 4 applies to private equity fund managers. Section 5 applies to advisers applying for hardship exemptions due to technical problems. For purposes of this article we will focus on sections 1 and 4.
Section 1 of Form PF is subdivided into three subsections. All private fund advisers that are required to file Form PF must complete subsections 1(a) and 1(b). Subsection 1(a) asks for general identifying information about the adviser and the types of private funds it advises. Subsection 1(b) asks for certain information regarding the private funds themselves. Section 1(c) applies to advisers to hedge funds and asks for fairly detailed information about these hedge funds. Section 1(c) must be completed with respect to all hedge funds and not just those that are required to complete section 2.
Section 1(a) includes information that, for the most part, is already disclosed in the advisers Form ADV. The adviser must provide a break-down of its assets under management by the types of private funds it advises (e.g., private equity funds, hedge funds, etc.) and also identify both its regulatory assets under management (this is the AUM reported in Part 1, Item 5F of the adviser’s Form ADV) and net assets under management (which nets out indebtedness and accrued but unpaid liabilities).
Section 1(b) includes information about the private funds themselves, and must be completed separately for each fund managed by the adviser. The adviser is required to aggregate certain funds and accounts, depending on the circumstances. For purposes of whether the adviser meets the $1 billion threshold, the assets of each parallel fund, parallel managed account and master-feeder fund advised by the adviser and its related persons must be aggregated.
For questions about individual private funds, the aggregate information includes information about the private fund, parallel managed accounts and master-feeder funds, but not parallel funds. Feeder funds are generally ignored. The assets of the feeder fund are aggregated with the master fund only if and to the extent that the feeder fund holds assets other than its interest in the master fund. Advisers to a “fund of funds” must complete Item 1(b) for each fund of funds, but for all other purposes a fund of funds should be disregarded. Note that for this purpose, the fund of funds must invest exclusively in other private funds.
In addition to assets under management, section 1(b) requires disclosure of borrowings by the fund, types of creditors (i.e., US financial institution, non-US financial institutions or other), identity of creditors and amounts borrowed from each, the aggregate value of derivative positions and investor concentration. Information regarding the performance of each fund must be reported, including a month-by-month table of changes in net asset value both before and after deducting performance fees.
Section 1(c) must be completed for all hedge funds advised by the manager, and section 2 is required to be completed for each hedge fund advised by the manager with more than $1 billion of AUM (subject to aggregation discussed above). Section 1(c) includes detailed questions about trading strategy, use of computer driven trading algorithms, and significant counterparty exposures (including the identity of counterparties). In addition the adviser is required to disclose, by percentage of the portfolio, holdings and clearing of securities, markets, holdings and clearing of derivatives, and clearing of repos.
Sections Two and Three
Section 2 requires very detailed information about the hedge fund’s holdings during the prior quarter, its investment strategy, counterparties, investors, geographic exposure, liquidity, turnover, risk metrics, and borrowing. Section 3 is significantly shorter than section 2 and requires information regarding liquidity funds (i.e., private money market funds).
Managers of private equity funds with more than $1 billion of assets under management must complete section 4 for each fund (subject to aggregation discussed above). Section 4 has two subsections. The first, Item A, is just information identifying the fund. Item B begins with questions regarding borrowings by the fund, guarantees of portfolio company debt, debt-to-equity ratios of portfolio companies, indebtedness of portfolio companies broken down by maturity, PIK and zero-coupon debt, debt defaults by the fund or its portfolio companies, bridge loans and bridge loan lenders. The next group of questions focuses on the fund’s investments.
The adviser must disclose whether the fund has invested in financial industry portfolio companies, and if so, they must disclose very detailed information about the identity of the financial institution, its debt to equity ratio, percentage of the portfolio company the fund owns, and the percentage of the fund that the portfolio company represents. This section also requires disclosure of investments by industry (based on NAICS codes) and a geographical breakdown of investments. The final question in this Section requires the manager to disclose the dollar amount of investments by the adviser and its related persons in portfolio companies held by the reporting fund.
The rationale for including private equity funds in the Form PF regime is not entirely clear. While it is conceivable that the activities of hedge funds could pose systemic risks (recall Long Term Capital Management), the activities of private equity funds seem much less likely to present any such risks. Moreover, information regarding significant private equity transactions is already available to regulators. For example, significant financial institutions are that are either portfolio companies of funds or lenders to funds or their portfolio companies are generally regulated. Also, significant private equity transactions that have the potential to cause systemic risks are generally required to be disclosed under the Hart-Scott-Rodino Antitrust Improvements Act.
Regardless, advisers to private funds will soon be required to disclose a surprising amount of information that has traditionally been considered proprietary.
Eric D. Young is an attorney with Morrison Cohen LLP specializing in all aspects of private fund organization, operation and compliance