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News October 22, 2012 Issue

Considerations When Tackling Form PF

Private fund advisers everywhere, especially new private fund adviser registrants, are struggling with the significant burdens associated with the Form PF filing obligation. With up to 7,000 requested data points, a plethora of assumptions to make, and a firm-wide effort needed to pull it all together, a CCO can use all the help he or she can get.

At the recent ACA Fall 2012 Compliance Conference in San Diego, a panel of experts offered tips, takeaways, and guidance for making the Form PF filing process as painless as possible. ACA Compliance Group principal consultant Jack Rader, Proskauer Rose special regulatory counsel Gregory Merz, Canyon Capital Advisors CCO Doug Anderson, and Sidley Austin partner Jon Miller each provided unique insights, while universally agreeing thereís no easy way to get through Form PF.

Take the formís definitions, for example, they are not at all intuitive, said Merz. You may think of yourself as private equity or a real estate fund, but you meet the definition of a hedge fund and should respond to the form in that category. Most people donít think of things in the context that Form PF requires it, said Anderson.

Merz said hedge funds basically are defined as those private funds that:

  • Charge a performance fee;
  • Have the ability to borrow or leverage in excess of 50 percent of fund assets; and
  • Have the ability to short securities, even if the fund does not short securities in practice.

Funds that reserve the ability occasionally to short securities as a hedging technique will fall into the hedge fund definition. If your documents are silent as to the fundís ability to short, you still may be a hedge fund, said Merz.

The SEC has posted helpful FAQ guidance on Form PF, said Miller. FINRA, which runs the Private Fund Reporting Depository (PFRD) filing system for the SEC, has set up a user support area on the web page to assist with Form PF preparation. Also, remember that commodity pools must be treated as hedge funds for purposes of Form PF, he said.

In the Form PF filing process, some firms have realized their Form ADV fund classification is inconsistent, said Rader. Those firms are amending their Form ADV to align the fund's classification with the fund's classification on Form PF.

Yes, said Miller, you have to amend your Form ADV from private equity fund to hedge fund, for example. The Form PF filing system wonít accept certain data if the wrong box is checked on your Form ADV.

In general, Form PF takes a very broad view of assets under management, said Merz.

A firm may file one aggregated Form PF or separate forms for individual related entities, but all must identify themselves in the general "aggregated" category.

Operational independence comes into play here, said Miller. An entity must meet five factors to be considered operationally independent.

If you share space with an entity, even though you believe youíre unrelated, you cannot pass the operational independence test, said Anderson.

The things the SEC will challenge you on are threshold issues. Have you classified your funds correctly? Have you aggregated assets correctly?

For parallel managed funds, thereís a specific definition, said Miller. Are the funds operated in tandem or not? Just say you have a close call situation and your aggregated assets under management are $300 million. Extra effort may be involved, but consider reporting the funds separately. If you report the funds as parallel when that isnít necessary and you reach $500 million in assets, then you are subject to greater disclosure requirements.

The SEC may come out with more guidance, but for now it appears to be more of a judgment call, he said.

Merz could not agree more. These are very difficult determinations. The conservative approach is to report each fund separately.

Look at your marketing materials, suggested Anderson. Do they describe the funds differently? Or do they combine the funds for purposes of advertising assets under management in this strategy? If it is the latter, it will be more difficult to separate the funds.

Also, ask your separately managed accounts if they are filing separately. They may be relying on you to aggregate them, and you donít want to be surprised by that, said Anderson.

The hedge fund-of-funds structure is generally disregarded for Form PF reporting purposes, said Merz. The trick is to make sure you have a real fund-of-funds structure.

The definition is very restrictive, said Rader. Fund-of-fund interests that are not equity in an underlying hedge fund prevent meeting the fund-of-funds definition. Managed account interests must be looked through to the underlying securities.

Forms CPO-PQR and CTA-PR.

If youíre a registered adviser and commodity pool operator with private funds, your filing task is going to be heinously complicated, said Merz. The devil is in the details, and these two forms can be tricky. For registered advisers with commodity pools that are not private funds, the adviser can file a single form. All commodity pools are treated as hedge funds on Form PF, he said.

Commodity pools that are private funds must file two forms. The forms donít work in lockstep, said Miller.

What to include in Item 4 as assumptions and methodologies.

Some firms provide five pages of disclosures in Item 4, other firms provide thirty pages of disclosures, said Miller. Whatever information you provide on Form PF, it is essential to maintain internal records of your assumptions, he said.

Firms need to think carefully about what to include in Item 4. His general thought was that the better practice is not to over-volunteer information. Miller said heíd heard of some administrators taking a template approach for disclosing Item 4 assumptions Ė that is not a good idea. You may think it is labor saving, but the assumptions made in responding to Form PF are individual to the way your business is run and to your methodologies. Itís a very organic process and how the form fits your business is not a one-size-fits-all approach, said Miller.

Yes, agreed Merz. Instruction 15 lets you use your methodologies and firms can take advantage of that and use common sense approaches. Definitely do not over-volunteer information, said Merz. He didnít see any benefit in doing that, provided good records are kept within the firm.

Sunshine is the best disinfectant.

Anderson favored a broader disclosure approach. He said his firm tends to disclose more under Item 4 and he is comfortable with that. "Everything on Form PF after your firmís name has some sort of assumption baked into it," he said. Which assumptions are external, and which are internal? His firmís disclosures are not the kitchen sink, but somewhere in the middle.

Just remember that detailed internal records are critical, said Merz. How much your firm discloses on Form PF is different.

Is the SEC going to challenge a firm for insufficient Item 4 disclosures?

Hereís an example, said Anderson. "Beneficial owner" is not defined under Form PF. It is important to us that we make clear how we reached that number, he said.

Another important factor to consider, said Merz, is whether youíre using an assumption that is somewhat aggressive. That is one place it definitely makes sense to disclose what you did and the rationale.

There are no "right" or "wrong" answers, said Merz.

If he were still in-house, he would err on not disclosing more common approaches, he said. However, if youíre a private fund adviser with $7 billion in AUM and you determine that you have only one small hedge fund in all your operations, you might want to explain that.

The more information a firm discloses, the more areas it gives the SEC to test as well, said Rader.

Who pays the costs of preparing Form PF?

Is the cost of preparing Form PF a fund expense or a management expense?

Look at your fund documents, said Anderson. Often fund disclosures indicate that the fund will pay "reasonable operating expenses." If youíre showing Form PF to your clients, probably it is reasonable to include the expense of preparing it. If you are not doing that however, it should be a management expense.

Expense allocation is a big hot-button issue with the SEC, said Merz. Expect scrutiny.

The SEC has indicated its view that Form PF preparation is a legal obligation of the adviser. If you go the other way however, be clear and make sure it falls within the governing documents. It should be clear to investors and shown as a separate line item. Make sure that disclosure is out there, and that youíre talking about it at investor meetings.

If your business principals are uncomfortable with that disclosure, you probably shouldnít be charging the expense to the fund. You should be paying it yourself, he said.

An informal audience poll revealed that 80 percent of the firms present paid preparation costs themselves, 10 percent made preparation costs a fund expense with full disclosure, and 10 percent of firms allocated Ė or were in the process of changing fund disclosures to allocate Ė the costs between the firm and a fund or funds.

Who owns Form PF?

The firmís CCO owns the Form PF filing process, whether or not the firm uses a vendor, said Anderson.

Even for those new to regulatory compliance, Anderson suggested that CCOs should try to work through as much of Form PF as possible within the firm first. Save the "I have no idea" questions for your attorney or your accountant. It is a long and arduous task, he said.

Anderson said he first marked up Form PF noting source personnel for responsive information to each question, and how to collect the information. He built a spreadsheet listing the information item, the source of the data, and whoís responsible for it. For any calculations, he noted on the spreadsheet what calculations are involved and the formula.

Vendors can be helpful, but you have to tag things correctly for filing purposes, he said.

Make sure you record the process and the information, said Anderson. Take a snapshot of what you used. Watch for technical errors in filing, too. Sometimes you will enter "N/A" on the form, when it is looking for a zero. Sometimes thereís a dash response when is should be N/A.

"You need to measure twice and cut once on this project," said Merz. Get your team together. He stressed how critically important it is to settle interpretive issues before the data collecting process begins. Monitor the SECís Form PF FAQs, because new guidance may change your assumptions.

Pull the appropriate people into the room and flip through the Form PF, said Anderson. Everyone assumes it is the CCOís document and project. But you can see the light bulbs go off around the room as people recognize, for example, "this is my area, Iím responsible for borrowingsÖ" It helps you get a game plan in place, he said.

Who signs Form PF?

As CCO, youíre responsible to know and understand the Form PF requirements, said Anderson. However, the CFO is ultimately responsible for much of the information requested by Form PF. Only one signature is allowed on Form PF. Anderson said he signs the form as the firmís CCO, and he gets an acknowledgement from the CFO that the CFO is comfortable with the information the firm has submitted.

Tips for handling specific issues and responding to specific questions.

A common problem is how to present information on Form PF for "relying advisers," general partners, and special purpose vehicles (SPVs).

The SEC has an FAQ that notes information about those entities should be disclosed under Item 4, said Rader.

Question 16 - For beneficial owners in Question 16, thereís a carve-out for prior non-U.S. investors where the information requested canít be reasonably obtained, said Merz. A firm may provide good faith estimates, but going forward it is the adviserís responsibility to ascertain beneficial ownership. Amend your subscription documents to gather that information.

Question 17 Ė Private fund performance information should be a full year of performance. Providing the actual results for a single class of securities is preferable Ė in his opinion Ė to providing a blended or composite performance, said Miller.

For private fund-of-funds, which have 180 days to produce audited financials when Form PF is due 120 days after the fiscal year end, use a good faith estimate to respond, said Rader. Also, use your best efforts to categorize the fundís strategy.

Question 33 Ė What is "unencumbered" cash?, asked Merz. It is cash, cash equivalents, and overnight repo collateral that is government paper. And how do you treat a holdback of, for example, five to ten percent cash, where a firm is obligated to put it back? That could be encumbered or unencumbered, said Merz.

Unless it is subject to a legal lien with a security interest, Miller said he would be inclined to say the cash is unencumbered.

You can go either way on this, said Rader, just make sure you put your rationale in your Item 4 assumptions.

Question 43 Ė This question asks about borrowings, including synthetic borrowings. Not all derivatives are considered synthetic borrowings, said Miller.

Question 50 Ė Investor liquidity. This question asks for the notice period investors must provide, not the time it takes the fund to pay out. Read your side letters too Ė if an investor has liquidity with no trigger event, he would include that circumstance, said Anderson.

Bonus tips of the day.

To the extent possible, complete certain responses ahead of time. However, the PFRD system for filing Form PF purges data every 120 days. Donít get too much of a head start in building your filing, or your data will be gone, said Rader.

It is a good idea though, to create a test filing and get comfortable with the PFRD filing system.

Make sure your firm is set up to file through IARD/PFRD, and that the account is funded to pay filing fees ahead of time.

If you are examined by the SEC, expect them to request your Form PF filing and to test the assumptions that youíve made, said Merz. The testing is expected to focus on the reasonableness of your assumptions.

The staff might identify, for example, ten practices they donít like related to Form PF and dig into those, he said.