Hedge fund, private equity firms feeling new registration push

A heightened focus by officials at the Securities and Exchange Commission on how fees are earned by hedge fund and private equity firms has some managers braced for more oversight, including a long-resisted move to make them register as broker-dealers.

Driven in part by the SEC's interest in fee-related activity, pension funds and other investors “have increased their expectations and requests for information,” said Ron Geffner, an attorney with Sadis & Goldberg, New York, and who serves on the Hedge Fund Association's regulatory and government advisory board. “The marketplace has become more sensitive to how people are compensated,” which is causing the hedge fund industry to “shrink a little.”

Hedge funds “have been weeded out by virtue of performance, and some of the fat has been trimmed by the regulatory butcher,” Mr. Geffner said.

Private fund managers knew they were in for more SEC scrutiny when the agency launched its new “presence exam” campaign in October, after the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 required them to register with the SEC. At the time, SEC officials said their priorities for the risk-based exams were portfolio management conflicts of interest, safety of client funds and asset valuations. The agency also launched a compliance outreach roadshow, with upcoming stops in Chicago, New York, Atlanta and San Francisco.

But as the exams continue to reveal more about how managers of hedge funds and private equity firms operate, SEC officials are raising more questions about fees, even questioning whether more managers should be registering as broker-dealers.

Private fund managers' antennae started tingling in April, when the issue of private funds registering as broker-dealers was raised in a speech by David Blass, chief counsel of the SEC's Division of Trading and Markets, which oversees broker-dealer activity. Private fund officials are acting as brokers, he said, if they participate in securities transactions “at key points in the chain of distribution,” including marketing shares or interests in a private fund, soliciting or negotiating transactions, and handling customer funds and securities.

Compensation based on the outcome of any transaction is “a hallmark” of being a broker, Mr. Blass said, but the absence of such fee arrangements doesn't rule out it out either.

“I believe that private fund advisers may not be fully aware of all of the activities that could be viewed as soliciting securities transactions,” said Mr. Blass, citing such examples as marketing departments, transaction fees or bonuses, investment banking-type fees for leveraged buyouts, and fees paid to general partners. “Taking the activity out of the private equity space and applying it in other contexts would leave little question about the need for broker-dealer registration,” said Mr. Blass.

While he encouraged private-fund managers to suggest situations where they could be exempt, he also warned that not registering “can have serious consequences,” including SEC sanctions and voided transactions. What some industry observers see as the first enforcement shot over the bow came in March, when private equity firm Ranieri Partners paid $375,000 to settle a case involving an unregistered placement agent, where the agency took the unusual step of charging Ranieri senior managing director Donald Phillips with “aiding and abetting” the outside agent.

Kenneth Berman, a partner of Debevoise & Plimpton LLP in the Washington office, expects that valuation of illiquid assets held by private equity and hedge funds will also remain a top priority. “The SEC staff is very interested in valuation methodologies and the process that the fund sponsor uses to value fund assets. The staff is looking to send a message that they take valuations seriously (and) firms are spending more resources to document their valuation process,” said Mr. Berman.

“Clearly, the prospect of an SEC exam has focused people's minds.”

The drumbeat over registering private funds continues as agency officials follow up on what they are learning from the presence exams. “We're starting to see the question come up in the comment letters coming out of the exams,” said Brynn Peltz, a partner in the financial institutions group at law firm Goodwin Procter LLP, New York. “When the SEC sees (managers) are getting fees other than the typical management fee, they are trying to understand why ... and they're giving the adviser the chance to explain. It's a fact-and-circumstances type of issue.”

To Jim Allen, head of capital markets policy for CFA Institute, Charlottesville, Va., the idea of having some managers register as broker-dealers “seems pretty straightforward. If it looks like a broker-dealer, and acts like one and gets paid like one, you should call it what it is. It ends up creating a false regulatory advantage that has less onerous rules. Institutional investors should have the means to make those distinctions,” said Mr. Allen.

David Kaleda, a fiduciary expert and partner with the Groom Law Group in Washington, sees the registration talk as part of a broader move by the SEC to synchronize and tighten fiduciary standards for everyone under their watch. “They want to make sure that everybody's wearing the right hat and doing the right thing,” he said.

Richard Morris, a partner at law firm Herrick, Feinstein LLP, New York, who represents private funds, agrees. “It all comes down to your fiduciary duty, and your radar better be on,” he said. “The SEC is getting a little more teeth.”

After learning more about how private funds work through presence exams and discussions with industry participants on the broker-dealer registration issue, SEC officials are now working on policy guidance to draw clear lines between activities within a firm that would and would not trigger the need to register.

For functions that put them on the broker side of the line, private fund managers will have to either revisit how they earn fees or prepare for some big changes when they register as broker-dealers. That registration subjects them to oversight by the Financial Industry Regulatory Authority and state regulators. “It's restructuring your entire business, and the capital requirements can be significant,” said Ms. Peltz. n