The Obama Administration seems intent on requiring buyout firms to register as investment advisers with the Securities and Exchange Commission—an enormous burden on firms that arguably pose few risks to the economy, or to the fortunes of everyday investors. Unfortunately, the only organization that speaks exclusively for buyout shops, the Private Equity Council, has come out in favor of registration.
Some kind of registration requirement appears inevitable. In response to the financial crisis of 2008, the Obama Administration this summer proposed a number of changes to how key players in banking, investment management, and other financial services are governed.
One of the cornerstones of the effort is a piece of proposed legislation titled the Private Fund Investment Advisers Registration Act of 2009, designed in part to help the SEC identify developments that put the nation’s financial health at risk. Under the proposal, all U.S.-based advisers to buyout funds, venture capital funds, funds of funds and hedge funds with more than $30 million in assets under management would be compelled to register as investment advisers under the Investment Advisers Act of 1940.
So what’s the big deal? Aren’t a number of buyout shops already registered as investment advisers? Well, those registered tend to be large firms with ample resources to follow the many rules and regulations imposed by the SEC. And an in-depth interview with Ropes & Gray LLP Partners Raj Marphatia and Jason E. Brown suggests that registration would prove a heavy burden for hundreds of small and mid-sized buyout shops in the United States.
Perhaps the most onerous requirement would be that of building out a compliance function. Registered investment advisers must adopt written rules and procedures to ensure compliance with the Investment Advisers Act of 1940. They need to designate someone at their firm as a chief compliance officer. And they need to ensure the policies and procedures are followed.
Many firms will surely be tempted to tap a CFO or other partner as chief compliance officer, rather than hiring a full-time CCO. But that could prove short-sighted, given the complexity of the job, and the fact the SEC tends to stop by for examinations every two to four years. “One of the ways to get into big trouble is to adopt policies and procedures off-the-shelf and not to follow them,” cautioned Brown of Ropes & Gray.
Registering as investment advisers, following the compliance policies and procedures, dealing with regular inspections—all these activities absorb yet more time and energy. Among the main areas that firms would likely need to change how they do things:
• Books and records. Firms will need to keep a detailed paper trail on a number of activities, for a set period of time, including emails and instant messages;
• Code of ethics. The SEC requires principals of investment advisers to keep records of their personal securities transactions, including quarterly and annual holdings reports.
All the red tape no doubt sounds a little overdone for your run-of-the-mill buyout shop with, say, half a dozen partners trying to buy and build a collection of great companies for a living. But Brown of Ropes & Gray calls the legislation “pretty likely to pass” in light of how much support it has, both from the public and from trade organizations.
One of the voices opposing the legislation has been the National Venture Capital Association, which has argued that venture firms pose no systemic risk to the economy and should not be lumped in with those that do. A spokeswoman believes it could cost several hundred thousand dollars a year for member firms to comply with the Investment Advisers Act of 1940.
But organizations representing hedge funds and buyout firms have weighed in in favor of registration. In a hearing last month before the House Financial Services Committee, Douglas Lowenstein, president of the Private Equity Council, whose 12 members are among the largest, most diversified in the industry, did note the “considerable administrative and financial burdens” that come with registration, which “could be especially problematic for smaller firms.” But he quickly added: “We support registration because it will help restore confidence in the regulatory system and the financial markets. In the long run the benefits from more trust in the system will outweigh any burdens imposed by registration.”
Really? Would partners at most small and mid-sized buyout shops agree with that statement? It’s a shame that Congress may never find out.