In April of last year, David Blass, chief counsel for the Division of Trading and Markets at the U.S. Securities and Exchange Commission, gave a speech in which he warned that private equity funds might be required to register as broker-dealers in connection with their fundraising activities as well as charging transaction-related fees from their portfolio companies.
On the fundraising side, the speech raised concerns that private equity funds were employing full-time marketing staff whose compensation was directly tied to their fundraising success. With respect to transaction fees, the speech raised the issue that funds which charge portfolio companies transaction-related fees in connection with acquisitions, dispositions, recaps, etc. could be engaging in traditional investment banking activity—thereby triggering broker-dealer registration. Importantly, Blass said that if these fees are completely offset against management fees it would not raise broker-dealer concerns.
The speech sent shockwaves through the private equity community. Soon thereafter, the Association for Corporate Growth (ACG) formed an informal working group comprised of CFO/CCO/CLOs from several middle-market private equity funds to explain the industry’s position to the SEC. The working group is headed up by Richard Jaffe, a partner at Duane Morris and co-chair of the firm’s private equity practice, and myself.
In order to be able to provide the SEC with industry data, ACG surveyed a number of private equity firms and found no instance where the compensation of a firm’s full time marketing staff was tied to fundraising. Generally, compensation appears to be based upon the overall success of the fund, a key part of which is the investment performance.
Regarding transaction fees, ACG found that while many middle-market private equity funds do charge their portfolio companies transaction-related fees, these fees are clearly ancillary to the carried interest component, which comes from the fund actively adding value to the portfolio company. In other words, private equity funds act as managers or owners of their portfolio companies and not disinterested brokers. Moreover, there is a trend in the industry towards a 100 percent offset of fees due to limited partner pressure.
ACG met twice with David Blass and others from the Division of Trading and Markets to discuss this data and explain why private equity fund professionals should not be required to register as broker-dealers. Some takeaways from the meetings were:
– The SEC is further along on the fundraising issue than on transaction fees. The agency is working with the American Bar Association to develop guidance on the issue,
which they hope to release in the next few months and we understand substantial progress has been made;
– Regarding transaction fees, the SEC wanted to release its long-awaited no action letter on M&A brokers, which it did January 31, prior to delving into the issue. Now that the no action letter has been released (which unfortunately is likely to be of little value to most private equity funds), expect the SEC to increase its fact-gathering on the issue.
– Transaction-related fees that are offset 100 percent against management fees can be considered prepayment of the management fee and do not raise broker-dealer issues, nor do monitoring fees or other fees charged that do not relate to a transaction involving securities;
– The SEC became aware of the transaction fee issue as examiners began examining private equity funds and were told that the fees were “just typical investment banking fees.” Through the efforts of ACG and others, particularly the Private Equity Growth Capital Council (PEGCC), the SEC now has a deeper understanding of what the fees actually represent.
Last month ACG’s working group met with staff from the SEC’s Divisions of Investment Management and Corporate Finance and the Office of Compliance Inspections and Examinations to discuss a wide range of regulatory issues relevant to middle-market private equity funds. Topics included onerous recordkeeping requirements under the Investment Advisers Act (particularly trading records and email retention), the custody rule, issues with Form PF/ADV, ambiguity over what constitutes a general solicitation and concerns that have arisen during presence exams. We are continuing our dialogue with the SEC, and hope that it results in future guidance from the SEC that is favorable for the industry.
Scott E. Gluck is Counsel at Venable LLP
Photo courtesy of Shutterstock
(Correction: The SEC has made substantial progress on the issue of whether sponsors should be registered as broker-dealers to the extent they have in-house fundraisers; the original version of the article speculated on when the SEC might come to a decision.)