On March 31, scores of US private equity firms uploaded to the SEC website a new kind of document called “Part 2A of Form ADV”. It is unknown what percentage of these firms were happy to do so.
Despite its opaque name, Part 2A of Form ADV is meant to compel investment advisors to communicate with their clients in a plain-English, narrative format. It is supposed to be a “brochure,” albeit one that must be provided in a stipulated format.
The ADV brochure is part of a sweeping overhaul of the US financial regulatory system that proponents of reform hope will enhance transparency and guard against fraud and systemic risk.
Since most major private equity firms look set to be required to register as investment advisors with the SEC, a number of otherwise quiet firms have created these brochures and made them public, although the exact timing of SEC registration is still unknown.
In addition to needing to be written in straightforward language, the SEC mandates that the brochure deliver specific kinds of information, divided into specific sections. The required disclosures include:
Material changes to the firm
- A description of the advisory firm, including shareholders who own 25 percent or more of it
- A description of fees and compensation
- Details on performance-based fees
- Types of clients
- Other financial activities and affiliations
The Part 2A requirements are brand new, but this hasn’t prevented some in the private funds industry from openly wondering if the brochure might one day take on a life of its own. Will it go glossy? Will it become a backdoor to communicate with regulators, investors and a curious public at the same time?
The day when Form ADV Part 2A becomes something less obscure may lie ahead, but for the time being these documents deliver lifeless prose in stultifying legal formats. It is what you would expect from a collection of firms that want to err on the side of caution and not win any awards for originality from the SEC.
And yet because no one has created these brochures before, the first batch are all quite different from each other, stipulated format notwithstanding.
Where some firms devote pages and pages to spelling out ties to affiliates, others list a few names and generalize about what they describe as immaterial financial relationships. Some firms list just about every risk and potential conflict imaginable, while others list a few that are specific to their own strategy. The page counts are remarkably different across brochures.
The first batch of ADV brochures raises several interesting questions:
What is a client? The SEC requires investment advisors to disclose the kinds of clients they service, and clearly different firms have different answers. For example Cerberus Capital Management (see table) takes the view that its clients are its funds, non-human entities that pool capital from external investors. Other firms, such as TPG Capital, seem to acknowledge that information about the underlying limited partners is probably of more interest and value in this setting.
Can there be any promotional value to these brochures? What happens is a firm disseminates its ADV brochure to its contacts and the press as a marketing effort? Since the brochure must be disclosed, is there any prohibition against aggressively educating the market about your business? And how far can a firm go in describing its business in the best light possible? In the section describing the history of the firm, for example, is it permitted to disclose performance information as an example of the kinds of services delivered to investors? When presenting information in “Item 8: Methods of Analysis, Investment Strategies and Risk of Loss”, why not really get into detail about the proprietary and highly successful methods your firm has perfected to extract value from private equity deals?
The SEC has stated that investment advisors may “include information not required by an item in [the] brochure”, but only if the extra information does not obscure the required information. You know what, a GP might say, I think details about our top-quartile status and exciting investment thesis for the next decade will only enhance the required information.
How coy can the brochure be? The brochure “must be true and may not omit any material facts”, but where does the line between “material” and “immaterial” lie? In the opening “Item 2: Material Changes” section, does a firm need to disclose that three junior partners got into a shouting match about economics and control with the 68-year old founder? How about if the founder got divorced and now has a new set of personal financial circumstances? How about if a firm has just launched a major new fundraising, the success of which will determine the future health of the franchise? Isn’t it important to disclose how the fundraising is going? Or would that conflict with Regulation D prohibitions about general solicitation?
How will the outside world use these brochures? Beyond clients, is there any useful information to be harvested from the ADV brochures? Will they become due diligence documents for potential investee companies or new LPs? Can the information in the brochures be republished in a commercially viable manner?
Is a new FOIA battle ahead? In addition to Part 2A, there is a Part 2B that does not need to be publicly disclosed, but must be provided to clients. This includes information about “supervised persons” at the firm, including educational background, disciplinary information, other business activities and compensation. These client disclosures will no doubt add up to very rich details on the complex web of economic relationships, shareholder stakes and advisory gigs in private capital. If this information is provided to a public pension, can it be accessed through a state open-records request, sometimes referred to as a Freedom of Information Act (FOIA) request?
For now, the ADV brochures remained buried deep in the SEC website. It could be that many GPs prefer they stay there. But given the care and effort that has clearly gone into some of these brochures, there must be a few GPs that would be glad to share this information with the world.
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