Treasury Blesses ‘Feeder Funds’ Under Volcker Rule

The Treasury Department’s guidance on the Volcker Rule, published this week, says regulators can allow banks to offer “feeder funds” for customers to invest in private equity and hedge funds. It also encourages regulators to eliminate loopholes that banks might try to use to get around restrictions on their direct private equity and hedge fund investments.

The 81-page report, released Tuesday by the department’s Financial Stability Oversight Council, fulfills a requirement of the Dodd-Frank financial reform law, which will ultimately be enforced by the Federal Reserve, the FDIC and other federal agencies. The report offers only a general discussion of the Volcker Rule, a provision of the law that bans banks from proprietary trading, as well as from making investments in third-party private equity and hedge funds. (Another key requirement of the law is that banks can commit no more than 3 percent of their core, “Tier One,” capital to their own sponsored private equity and hedge funds, and cannot provide more than 3 percent of the commitments to such funds.)

The report shows ways that banks can continue to play in the private equity and hedge fund game—by offering “feeder funds” through which customers can invest in these asset classes, and by offering management and advisory services, and acting as prime brokers or custodians for securities and valuables. “Banking entities may organize and offer funds that act as typical feeder funds, arrangements in which one fund invests in the shares of another fund,” the report said.

The PE industry has urged regulators to give banks the maximum time allowed under the law to divest their holdings in private equity and hedge funds to minimize disruptions in the market. Interpretations have varied. Some commentators believe it could be a decade or longer before the full impact of the rule takes effect.

Still, some banks already have taken steps. In August, for instance, the buyout shop Ridgemont Equity Partners was spun out of Bank of America Corp. That move involved a unit formerly known as Banc of America Capital Investors, and illustrates another aspect of the Volcker Rule: that a private equity or hedge fund cannot share a name in the future with the bank it was formerly associated with. The Volcker rule is named after Paul Volcker, a former Federal Reserve chairman and its chief advocate

Much of the report focused on high-turnover hedge fund type investing, rather than the slow money that characterizes private equity. And while much of the discussion involved record-keeping rules for the banks, to show that their trading activity was on behalf of customers and not their own proprietary interests, the council also urged the agencies to think broadly about private equity and hedge funds, including structures that may not meet the definitions of the Investment Company Act “but that engage in the activities or have the characteristics of a traditional private equity fund or hedge fund.”

Now the clock starts ticking for the agencies that must actually write the regulations to implement the Volcker Rule. They have nine months from the release of the report.