Transparency and its discontents

It appears that the safe harbour is getting smaller and less safe.

Since the inception of the private equity industry, fund managers have relied on a set of rules encoded in what is casually referred to as “Reg D” to raise capital without registering the fund with the Securities and Exchange Commission.

Now a new set of rules are certain to be imposed on the US private equity industry, but it is unclear whether some of the old strictures will be removed in the process.

There are currently bills under consideration in both chambers of Congress that would require private equity firms to register with the SEC. Registration would certainly include a much higher degree of disclosure to the public.

In the Senate, Chuck Grassley and Carl Levin are sponsoring the Hedge Fund Transparency Act, which would require fund-by-fund registration with the SEC, and thereafter disclosure of information including the value of the assets, the ownership structure and the number (but not the names) of LPs.

In the House, a separate bill has been put forward, HR 711, which would effectively require most private funds to register as investment advisors.

Increased required transparency will put private equity firms in an even tougher communicative bind than they have been.

From the Treasury comes a proposal to increase oversight of private firms that would include disclosing the names of investors (see p. 4)

In the meantime, as reported on p. 22 of this month's PEI Manager, the SEC has taken a step that makes fundraising information more widely available. Private investment managers have long been required to submit to the SEC a “Form D” as part of the several requirements for selling securities without registering them with the SEC. Form D filings were previously not available online, but now they are all listed daily on the SEC website.

The SEC has also taken a recent interest in the two largest publicly traded alternative investment firms in the US – Fortress Investment Group and The Blackstone Group. The SEC recently sent both a letter asking that they begin disclosing fund-level performance information in quarterly reports. Blackstone has refused, but Fortress has agreed to this request. The SEC request highlights the possibility that regulators may have a growing interest in monitoring the performance of private funds, although it is unclear whether anything along these lines will be inserted into current legislative initiatives.

If some form of transparency legislation is passed, and the public mood dictates that this will be the case, private equity firms will suddenly find themselves needing to submit many different types of information, in varying formats, through various channels and to various authorities. Add to this the increased transparency of the online Form D, and a bumper crop of new information will be available to the public about an industry that once prided itself for its privacy and discretion.

‘Solicitation’
Standing in contrast to this transparency momentum is Rule 506 of Regulation D of the Securities Act of 1933, which, among other things, requires that an issuer of unregistered securities not use “general solicitation” or “advertising” to market itself. Many legal experts have interpreted this to mean that a private equity firm (or hedge fund, or real estate fund) needs to put a tight lid on information made available to the public, such as via a web site, a press report or an announcement.

Increased required transparency will put private equity firms in an even tougher communicative bind than they have been. It will essentially require fund managers to provide a steady stream of information through regulatory channels without having the ability to freely tailor the message about themselves that they would like the public to see. For example, under one scenario, a GP would make public that it is raising a fund through Form D, it would register that fund with the SEC and detail its ownership structure. But its lawyers would prevent the GP from publicly correcting an erroneous press report out of an abundance of caution that doing so would blow the Reg D exemption.

As lawmakers ponder the best way to bring transparency to alternative assets, they should consider doing away with the “general solicitation” prohibitions, which have long kept the industry muzzled.

Many legal experts argue that the “solicitation” prohibition places time and energy on the wrong kind of safeguard. The goal of Regulation D is to prevent unqualified investors (widows, orphans) from winding up investing in unregistered securities, the risks of which may be hard for them to understand. But the way to prevent this from happening is to simply enforce the prohibition against fund managers accepting capital from these unqualified investors. Requiring a fund manager to try to hide fund marketing information from widows and orphans seems to make the assumption that these unqualified investors merely discovering the existence of a private equity fund constitutes a crime in and of itself.

No harm is done in letting a group of GPs accurately tell its story. These GPs would only run afoul of Regulation D rules if they allowed unqualified investors into their fund.

Operator, information
A potential change to ERISA rules would mean a new disclosure regime for real estate and hedge fund firms that don't register as ‘operating companies’.

Private equity firms many things to worry about, but one is not qualifying as an operating company. Real estate and hedge fund managers, however, may have to scramble to avoid getting caught in progressively more stringent disclosure demands required by the Employee Retirement Income Security Act of 1974 (ERISA)

The US Department of Labor (DOL) in 2007 rolled out a three-pronged initiative to put new fee disclosure requirements in place. While most aspects of the plan were not objectionable to private investment funds, some general partners are concerned about potentially being required to disclose all of their third party service providers and the cost of their services.

“It could be very burdensome if I am now having to disclose how much I pay every accountant or lawyer who was helping me manage a property,” says Haynes & Boone partner John Collins, who advises real estate fund management clients. However, there is good news for private equity under an exemption for “operating companies” that “significantly reduces the intrusive nature of those kinds of requirements”.

To qualify as an operating company, the fund must have at least 50 percent of its assets being “actively operated”. In the real estate market, this generally exclude passive core and core-plus strategies but encompass value-added and opportunistic strategies, the latter two being generally viewed as more akin to running a business, versus collecting rent.

Most funds previously avoided stringent reporting under an exemption for funds with less than 25 percent of their capital from ERISA funds. But that exemption is going away, explains Collins. This will likely lead to funds shifting towards attempting to formally register as operating companies.

Because the new disclosure requirements were proposed under US President George W Bush but were not finalised before the transfer of power to President Barack Obama, it is currently unclear whether or not they will move forward.