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News May 23, 2011 Issue

Proposed Form PF Comments Are In

It’s all about the systemic risk.

And to keep better tabs on it, the Dodd-Frank Act is requiring certain market participants to be a bit more forthcoming to regulators. One of those efforts focuses on the activity of private funds.

Form PF was proposed earlier this year to require registered advisers to report private fund and commodity pool information to the SEC and/or CFTC. The reported information will be kept confidential, only to be used by those regulators and the Financial Stability Oversight Council (FSOC) to more fully evaluate systemic risk.

Advisers would report basic information about their operations and the private funds they advise, including information on leverage, credit providers, investor concentration and fund performance. The information reported will be non-public, protected by the confidentiality provisions of new Advisers Act Section 204(b), and outside the reach of Freedom of Information Act (FOIA) requests.

The largest private fund advisers, those managing $1 billion or more in assets, would report on Form PF on a quarterly basis. Certain more tailored information would flow monthly to regulators from these advisers. Everyone else would be considered "smaller" private fund advisers and would report annually within 90 days of the adviser’s fiscal year end.

The type and amount of information would be scaled, too. Large private fund advisers would report more information than smaller private fund advisers, and hedge fund advisers would disclose more information than liquidity fund advisers, which in turn would report more information than private equity fund advisers.

Here’s an overview of industry assessments of the proposed Form PF:

The big picture.

Delay any rulemaking until the FSOC defines "systemic risk," said Fidelity Management and Research general counsel Scott Goebel. "When it comes to defining ‘systemic risk’ there appears to be consensus on only two points: (1) there is not yet a consensus definition and (2) providing a clear definition (or at least clear guidance on the regulatory perspective) is a critical first step in identifying and mitigating such risk effectively and efficiently," said Goebel. There is limited value in the creation of a disclosure reporting structure for assessing systemic risk without first articulating its elements, he said.

"We believe that, in light of the structure of hedge funds and the market and regulatory changes regarding counterparty risk management, leverage and use of collateral," said Managed Funds Association CEO Richard Baker, "applying the criteria … set out in the Proposed Rule to hedge funds should lead to the conclusion that it is highly unlikely that any hedge fund is systemically significant at this time."

Coalition of Private Investment Companies (CPIC) chairman James Chanos summed up CPIC’s view this way: "In view of the volume of information that will be newly required of the largest private funds, we believe the Commission will need to develop a workable, flexible reporting schedule, particularly for initial reports. We also urge the Commission to take all steps necessary to protect the confidential proprietary information filed by private funds with the Commission under its proposed rules, as Congress clearly intended and required."

The definition of hedge fund is overbroad.

Instead of capturing funds that "may" use certain strategies, the definition should require that a fund actually use leverage or engage in short sales above a de minimis amount before being deemed a hedge fund, said Investment Adviser Association assistant general counsel Monique Botkin.

The rule as proposed, "if finalized as is, would have the unintentional consequence of mis-categorizing certain private equity funds as hedge funds," said Lone Star U.S. Acquisitions general counsel Michael Thomson. As a result, private equity funds would be required to report "detailed metrics" that generally don’t apply to them.

The proposed private fund definitions are "fundamentally flawed," said Private Equity Growth Capital Council (PEGCC) president Douglas Lowenstein. Instead of defining a private equity fund by what it is not – not a hedge fund, liquidity fund, real estate fund, securitized asset fund, or venture capital fund, and does not provide redemption rights in the ordinary course – define it by what it is. "PEGCC believes that it would be more straightforward and more accurate to define a private equity fund affirmatively based on the structural characteristics of the typical private equity fund," he said.

The American Bar Association’s (ABA) Federal Regulation of Securities Committee (FRSC), together with the Private Equity and Venture Capital Committee (the Committees) supported distinguishing between hedge funds and private equity funds for reporting purposes. However, the Committees suggested a different approach for making the distinction.

"In lieu of the currently proposed ‘hard-and-fast’ definitional distinction between hedge funds and private equity funds, which could have unintended consequences, the Committees believe that an adviser should be able to make its own good faith judgment as to whether a particular fund is a hedge fund or a private equity fund." The Committees then outlined ten examples of distinguishing characteristics they found "compelling" in setting forth criteria for advisers to use in determining the nature of a fund. Advisers would record in writing the basis for each determination, similar to the process for memorializing decisions regarding the materiality of certain disciplinary events, they said.

SIFMA’s Asset Management Group also offered up examples of distinguishing characteristics of hedge funds and private equity funds, although it kept the characteristics separated by each type of fund.

The definition of parallel managed account is overbroad.

The proposed definition of parallel managed account (which would be aggregated with private fund reporting information) appears to include registered investment companies, observed Investment Company Institute (ICI) general counsel Karrie McMillan. Mutual funds are already highly regulated, operate under restrictions to borrowing, leverage, and exposure to certain counterparties, and are subject to extensive disclosure requirements. "Capturing RIC assets in a form designed to assess the systemic risk of private funds, however, is unnecessary to achieve the stated goals of the Dodd-Frank Act, and may skew the reporting in a way that lessens the effectiveness of the data available to regulators," said McMillan. To avoid unnecessary and burdensome regulatory overlap, the ICI strongly urged the SEC and CFTC to exclude all registered investment companies from the definition of parallel managed accounts.

The IAA suggested that parallel managed accounts should not be included at all. While acknowledging the SEC’s stated concern that advisers may attempt to restructure their activities to avoid reporting requirements, the IAA suggested that the scenario had a low probability of arising in connection with the Form PF filing requirement. "It is highly unlikely that advisers would liquidate funds and require investors to establish separate accounts or create registered investment companies simply to avoid Form PF reporting requirements," said IAA’s Botkin. Because the currently proposed definition captures accounts that should not be viewed collectively with private funds for purposes of systemic risk analysis, she said, the IAA is concerned that "this overbroad reporting will result in inconsistent and misleading data about an adviser’s overall private fund business and potential impact on the market."

The $1 billion threshold for large private fund advisers is too low.

"Because private fund advisers that fall into this category face significantly increased reporting costs and burdens, the CCMC contends that a $1 billion threshold is too low and proposes that the Commission adopt a $5 billion threshold to define both large private fund advisers and qualifying funds," said Center for Capital Markets Competitiveness CEO David Hirschmann.

The SEC pointed to a $500 million threshold used in the United Kingdom as a reference point, said Fidelity’s Goebel. But that number should be made commensurate with the size of the U.S. markets. Advisers of that size or greater represent 0.014 percent of the London Stock Exchange’s market capitalization. A similar threshold in the U.S. equity markets would equate to $2.4 billion, he said.

Don’t reduce the reporting burdens on private equity fund advisers.

CPIC’s Chanos urged the SEC to resist requests for broad exemptions for private equity funds, because private equity funds can also present systemic risk. Chanos noted that the SEC acknowledged this in its rule proposal. "The release enumerates several risks of the private equity business model that may be cause for concern, including the reliance on banks to provide bridge financing for leveraged private equity transactions who could be forced to hold the financing if market conditions worsen, and the prospects for leveraged buyouts of systemically important entities," he said.

Chanos observed that the SEC and other members of the FSOC believe that monitoring private equity financing transactions and their interconnected impact on lending institutions could be useful in providing a more complete picture of the financial services marketplace. "We agree," he said.

Reduce the reporting burdens on private equity fund advisers.

Bridge financings do not present systemic risk, said PEGCC’s Lowenstein. And for that matter, neither do favorable financing terms or portfolio company leverage, either. "To the extent a problem exists, it is with lending practices generally, not one created by one particular class of borrowers or a particular type of loan." This concern – if valid – is best addressed through prudential regulation of the lenders, not by imposing reporting burdens on private equity funds and their sponsors, said Lowenstein.

Extend the reporting deadline for large private fund advisers.

The proposed rule would require Form PF to be filed not later than 15 days after the end of each calendar quarter. Many commenters agreed that 15 days does not provide enough time for advisers to obtain and process the information requested after allowing the needed time for underlying private fund investments to be valued.

Advisers need significantly more time than the proposed 15-day deadline to collect the data, assess the integrity of the data, and complete the filing of the data on a quarterly basis, said IAA’s Botkin. The IAA recommended extending the quarterly and annual reporting deadline for large private fund advisers to 90 days. "The need for accurate information outweighs the need for receiving the information quickly," said Botkin.

For private equity funds in particular, "[i]t will be virtually impossible to calculate, gather and process the needed information to file Form PF within 15 days after the end of the calendar quarter," said Lone Star’s Thompson. He suggested that a filing deadline of 60 days would be appropriate. Another private equity fund manager, ArcLight Capital Partners, suggested that a timeframe for filing of 120 calendar days would be appropriate.

BlackRock managing director Joanne Medero agreed. "In our view, the proposed 15-day timeframe would severely undercut any adviser’s ability to accurately gather data, determine net asset values and related metrics, and properly value assets," she said. Medero recommended an extension of the filing deadline for all reporting advisers to 120 days after the reporting period end.

"[T]o the extent that any quarterly reporting is required, the Commission must provide a time period of at least 90 days for a private equity sponsor to execute its rigorous valuation process," said PEGCC’s Lowenstein.

Although many private funds are already working to identify and test how they will meet the new reporting requirements, said CPIC’s Chanos, meeting the 15-day filing deadline could be difficult. "We suggest that the filing deadline for large private fund advisers be changed to within 45 days of the end of a calendar quarter, at least for the initial filings," he said.

Look to the reporting deadlines applicable to Form N-SAR and Form N-Q filings, suggested the ABA Committees. Both the Form N-SAR and Form N-Q allow 60 days after the relevant fiscal reporting periods to file the forms. "We believe that the Commission should consider holding private fund advisers to a reporting standard that is no more burdensome than the standards applied to registered investment companies by Form N-SAR and Form N-Q," said FRSC chairman Jeffrey Rubin.

The Committees went further than other commenters and suggested that not only is the 15-day filing timeline too short, but also the quarterly reporting requirement is too frequent. "Consider whether the FSOC will have the resources to analyze the large amounts of data it would receive on a quarterly basis, said Rubin. The Committees proposed that the SEC initially require Form PF to be filed every six months, and then evaluate whether more frequent reporting would be necessary.

Exempt all advisers with less than $150 million in private fund assets.

Under the proposed rule, the Form PF reporting requirement would not apply to exempt reporting advisers that solely advise private funds with less than $150 million in assets. However, SEC-registered advisers managing any private fund assets must file Form PF, observed IAA’s Botkin. "There is no compelling policy reason to require such advisers to do so," she said. Congress apparently determined privately managed assets of less than $150 million do not pose sufficient systemic risk. Registered advisers will already provide "census-type" information about those private fund assets on Form ADV Part 1. Registered advisers are subject to substantial regulation and oversight which further reduces the likelihood of systemic risk concerns. Also, said Botkin, the SEC has underestimated the burdens of the Form PF reporting obligation. For all these reasons, all advisers managing $150 million or less in private fund assets should be exempt from the Form PF filing obligation, she said.

Daily assessment of large private fund adviser status is too burdensome.

The ABA Committees, while acknowledging that some advisers do track valuation data daily, said that advisers investing in derivatives and illiquid or esoteric investments do not price all of their assets on a daily basis. "Furthermore, the availability of data is not a necessarily a good justification for using it for this purpose." Asset spikes happen, said FRSC’s Rubin, but "isolated spikes off of a relatively low base may not be a sufficient indicator of systemic risk to subject the adviser to the reporting required by large private fund advisers."

Valuations for illiquid fund assets are costly, time-consuming, and are often later revised, said BlackRock’s Medero. Daily valuation practices are not practical or cost-effective. Furthermore, she said, advisers that experience "transitory" breaches of the proposed threshold "should not be deemed to be systemically risky by virtue of that fact alone."

The SEC has underestimated the burdens and costs of filing Form PF.

"We do not necessarily agree that such burden estimates are realistic or even knowable at this point, and we believe the cost estimates are understated," said the IAA.

"We believe that the estimated time and costs to comply with the Proposed Rule … are grossly understated" for all advisers required to report on Form PF, said SIFMA.

Commenters cited a wide range of cost and burden sources, from modifying and expanding data tracking methods to developing filing systems compatible with as-yet-unknown regulatory filing requirements.

Take the example of portfolio turnover rate, said Fidelity’s Goebel. It may be a relevant consideration for investors, but it is not an effective or widely used measure of risk for hedge funds. Requiring private fund advisers to report such information would result in a real cost to advisers without any corresponding benefit in risk assessment to the FSOC, he said.

Extend the filing compliance date.

Initial reporting on Form PF by the first quarter of 2012 is not a "workable or realistic" timeline, said the IAA. The SEC must create and program a system to accept Form PF filings, and registrants must develop systems to collect the requisite information and prepare the filings. The SEC has yet to determine the format for the submissions, whether in XML (eXtensible Markup Language), XBRL (eXtensible Business Reporting Language), or another format. Without knowing that, it is difficult for advisers to assess or prepare to meet the reporting requirements.

The IAA urged the SEC to adopt a compliance deadline that is at least nine months after the final rule’s effective date, and to permit additional comment period on the proposed filing format "once the Form’s content and filing frequency have been established."

"The initial report should be due no sooner than nine months after the Form is adopted," said BlackRock’s Medero. Much of the information required by Form PF is not commonly tracked by the industry in the form requested, she said. Given the complexity of Form PF data, precise and predictable instructions and definitions will be critical. "These will need to be translated into systems to collect and calculate data, which in some cases may require significant technology developments and enhancements," she said.

In light of the SEC’s recent decision to postpone the implementation of the private fund adviser registration requirements, for which private fund advisers will be required for the first time to register under the Advisers Act, we believe it is increasingly sensible to delay implementation of the proposed rule," said SIFMA managing director Timothy Cameron.

Fidelity’s Goebel agreed. "The compliance deadlines in the proposed rule will likely precede the actual registration of private fund advisers, an incongruous result," he said. Goebel urged that any compliance deadlines for Form PF reporting be delayed until the compliance dates for private fund adviser registration are identified.

The filing certification should allow for good faith reporting.

Form PF requires data that cannot be calculated precisely, as well as subjective information based on hypothetical situations which will inevitably lead to a level of uncertainty, observed BlackRock’s Medero. The proposed certification standard is strict, requiring individuals to certify under penalties of perjury that the information submitted is "true and correct." It would be inappropriate, said Medero, to ask an adviser to certify as true and correct information it produces in its own interpretation of a question. "Advisers should instead confirm that they have made their assumptions or estimates in good faith based on the procedures used in their day-to-day business applied in a consistent manner."

The certification requirement is unreasonable, said SIFMA’s Cameron. It will likely spawn a new internal certification process that would need to occur within those funds within an unreasonably short period of time. "We believe that a statement indicating that certain estimates on Form PF have been made in good faith would be a reasonable alternative to a certification," he said.

PEGCC also believes the certification requirement is inappropriate. "At a minimum, the PEGCC believes that the Commission should allow an adviser to base the certification on knowledge and materiality qualifiers and should only require the certification at most annually."

Fidelity argued that the certification requirement should be removed entirely. Given the volume and complexity of the information required to be reported, and Commission authority to bring an enforcement action for misstatements made in a filing that would "necessarily be filed hastily" under the current proposal, Fidelity urged the SEC to drop the certification requirement regardless of any extension of the 15-day filing deadline.

The new reporting system for Form PF must be secure.

"Because of the irreparable harm that would inure to private funds if their confidential, proprietary information were to leak into the public domain or the possession of unauthorized users, the Commission must establish procedures and systems to protect information that is filed electronically on Form PF from hacking and any other means by which such information could leak into the hands of unauthorized persons or the public domain," said CPIC’s Chanos.

Standards of confidentiality across regulators, both domestic and foreign, and the FSOC must be consistent, noted several commenters, including SIFMA’s Cameron. He also noted the likelihood that investors, lenders and other parties will begin requesting the Form PF filings as part of their due diligence process. He asked the SEC to be "particularly mindful of the risk of such disclosure of information, and therefore, only request information on Form PF that is absolutely necessary for use by the FSOC."