The RIA tipping point

Registering with the US Securities and Exchange Commission as an investment advisor is a necessary evil for the big players in the private equity industry. But how does a smaller, growing firm know when to take the plunge?
The official rule is that a general partnership must register as an investment advisor if it is managing more than 14 “clients,” which for private equity firms means funds, simultaneously. The conservative approach is to also count co-investment vehicles and side funds as separate clients, says Richard Ginsberg, co-chair of DLA Piper’s fund formation practice. But in practice, not everyone takes the conservative view.
“I think that when you create a co-investment vehicle for your investors and receive incremental compensation for managing that vehicle, then the co-investment vehicle would be treated as a separate client,” Ginsberg says. “When you create a parallel fund structure, it is arguably the case that the parallel vehicles will not be treated as separate clients because the investment objectives of the parallel entities are all the same. Although it is unsettled law and the SEC has provided little guidance in this area, I think that has been the practice.”
Occasionally a firm will decide to register as an investment advisor even if it hasn’t yet crossed the 14-client threshold. “I think that some fund sponsors register because certain of their institutional investors, particularly pension funds, prefer it. Although it isn’t a Good Housekeeping seal of approval by the SEC, it is often viewed that way.” A firm that wants to take in a large amount of private pension fund money might want to be a Qualified Planned Asset Manager in order to obtain a QPAM exemption from Employee Retirement Income Security Act regulations, says Kevin Scanlan, a partner in Dechert’s financial services practice.

All cons, no pros?
The registration process itself isn’t terribly burdensome, Scanlan says.
The firm must fill out an application for registration – or Form ADV – as well as create a brochure describing its business practices.
The more significant costs of registering as an investment advisor are that the firm will then be subject to numerous provisions under the Investment Advisors Act of 1940, including anti-fraud provisions, principal and agency cross-transaction rules and books and records requirements. If the firm holds any publicly traded securities, it will be subject to proxy voting measures, and the firm will need to formulate a code of ethics regarding how its employees can buy and sell those securities. The firm must hire a chief compliance officer to handle all of these measures, and the firm must write up an often-lengthy compliance manual.
“It’s a big undertaking, and all of the employees basically have to participate in it, because they’re all going to have to comply with some of these rules,” Scanlan says.

Keeping it simple
Still, most firms already practice many of these record-keeping and compliance measures, notes Henry Kahn, a partner in Hogan & Hartson’s investment management and fund formation practice.
The difference is that as a registered investment advisor, a firm is subject to random inspections by the SEC.
“The record-keeping and compliance procedures don’t vary that much from what you do as common sense,” Kahn says, “But why have the SEC have the ability to put its nose under your tent if you don’t need to?”
The best way to avoid having to register is of course to limit the number of funds you’re managing at one time, he says.
“The number-one prophylactic that you can do is not create too many funds.
So think twice about setting up a fund that holds only one investment,” Kahn says. “Think twice when you’re raising a fund about having a side fund – people used to think well we can have ultimate flexibility by having a 3(c)1 fund, a 3(c)7 fund side by side. Think about whether you can manage your investor base so that when you raise one everybody comes into a single fund.”
Scanlan notes that larger, more institutionalized firms like The Blackstone Group and Kohlberg Kravis Roberts are far better equipped to handle the burdens of registration. It’s the middle market, up-and-coming firms that have a harder time, he adds. Says Scanlan: “The small to medium sized advisors generally will have a more difficult time deciding whether to do it, and whether it’s worth it. They’re smaller and they might have multiple employees that serve more than one purpose in the operational structure without any single employee that possesses the specific skill set needed to comply with registration. For instance, they might not have a chief compliance officer. They’d have to hire that person, and it’s a competitive market for those people.”