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Staff Offers Guidance On Private Investment Entities 

Hedge fund advisers that are required to register under the SEC's new rule should have submitted their applications to the Commission by December 15 to ensure that the staff had 45 days before declaring their registration effective. However, the Division of Investment Management responded in December to a number of questions raised by the American Bar Association about the SEC's rule 203(b)(3)-2 and related amendments (SEC No-Action Letters Ind. & Summaries (WSB) #1212200501 (December 8, 2005)). In order to give private fund advisers and their counsel time to review the staff responses, the staff extended until January 9 the date by which to file initial applications for registration as investment advisers and pledged to attempt to act upon those applications by February 1, the date by which advisers must have their registrations declared effective under the new rule.

The ABA Subcommittee on Private Investment Entities submitted to the staff last June a list of interpretive issues and recommendations for resolution. The staff responded to most of the issues, but advised that it was unable to address certain suggestions for future rulemaking that would require additional facts.

In order to resolve questions about when an applicant's first annual updating amendment will be due, the staff advised that it would not declare any Form ADV filings made on or after November 20, 2005 effective before January 3, 2006, unless otherwise requested. This will ensure that new registrants' first annual updating amendment will be due March 31, 2007 rather than March 31, 2006.

Hedge funds generally offer their investors liquidity access after an initial lock-up period, which is typically for less than two years. The SEC adopted a two-year cut-off period to distinguish hedge funds from other types of funds. The ABA cited reports of staff concerns that some hedge fund managers may seek two year lock-ups from investors, so will interpret the two-year redemption period to mean and least two years and one day.

The staff advised that an owner that is permitted to redeem before the second anniversary of the date of investment will cause the fund to be a private fund under the new rule. If an owner purchases an ownership interest in a fund on January 1, 2007 and redeems it on December 31, 2008, he will have redeemed the interest within two years of the purchase, according to the staff. January 1, 2009 would be the first day outside the two-year redemption period in that example in which to redeem the ownership interest without causing the fund to be a private fund.

The staff disagreed with the ABA 's interpretation that advisers, general partners and knowledgeable employees should be permitted to redeem their ownership interest in a fund within two years of the purchase of ownership interests without causing the fund to be a private fund. The SEC did not adopt an exclusion for insiders because it may have encouraged them to take preferential liquidity terms for themselves that are not extended to the investors to whom the insiders owe a fiduciary duty.

Although the staff disagreed with the ABA's view that advisers and affiliates are not owners of the fund, it will not recommend enforcement action against an adviser that fails to register solely because it did not treat the adviser's or its affiliated general partner's withdrawal of deferred incentive fees or accrued incentive allocations within two years of the date of deferral or accrual as redemptions for purposes of the definition of private fund. The fees would be viewed as compensation, according to the staff, and the two-year redemption period is intended to apply to contributions of capital, not to distributions made as compensation for services.

The staff advised that a transfer from one class of a fund to another class of the fund would not be considered a redemption under the rule if the two classes share the same underlying portfolio of investment securities and provide the same redemption rights. Where the classes have only "substantially similar" investment objectives, the transaction may involve a redemption. The staff also believes that that no redemption would be involved where an investor moves from one feeder fund that invests all of its assets in a master fund to another feeder fund that invests all of its assets in the same master fund and offers the same redemption rights. The two-year holding period would start from the date of the purchase of the old interest in the original class.

The staff advised that the dissolution or liquidation of an owner may be considered an extraordinary event that would permit investors to redeem their interests within two years if the entity ceases to operate and the adviser reasonably believes that the dissolution or liquidation is bona fide and is not designed to avoid the two-year redemption period. The bankruptcy of an owner would also be deemed an extraordinary event.

The staff did not agree that a significant withdrawal of the proprietary investments of the adviser can be viewed as analogous to the death or incapacitation of the adviser's key personnel. Unlike the death or incapacity of key personnel, a significant withdrawal of an investment by an adviser is within the adviser's discretion. A fund whose investors have negotiated for redemption rights that would be triggered in the event of a significant withdrawal by the adviser or its personnel would meet the definition of a private fund and the adviser would have to register with the SEC, according to the staff.

The staff agreed that after two years from the date of an original investment, an investor would be able to redeem his original investment and any gains or income, and subsequent appreciation on those gains or income, without triggering the definition of a private fund.

The ABA proposed conditions under which certain subadvisers to private funds, including discretionary asset managers, should be exempted from registration if the adviser is registered. The staff was unable to provide the relief that the ABA proposed for subadvisers located in the U.S. , but took a different approach for subadvisers located offshore. The staff will not recommend enforcement action against an offshore subadviser that does not register with the SEC as an investment adviser solely because it advises a private fund, provided that the subadviser is hired by the the registered adviser of a private fund. The subadviser must not otherwise be required to register with the SEC and must not control or be controlled by the fund's primary adviser. The fund must disclose that a portion of its assets may be managed by one or more unregistered offshore subadvisers. Finally, the subadviser must not manage more than 10% of the fund's total assets. The 10% threshold cannot be used as a materiality safe harbor for whether the offering memorandum must identify and discuss the subadviser, the staff added.

A fund that allows non-U.S. investors to redeem their ownership interests within two years of purchase would be a private fund, according to the staff. If a fund permits any owner to redeem its interest within two years of purchase, the fund meets that portion of the definition of private fund, the staff concluded.