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Recent SEC Guidance to Registered Advisers to Private Investment Funds

07.18.14

The SEC’s Division of Investment Management recently released an IM Guidance Update to address two issues under the SEC’s “Custody Rule,” Rule 206(4)-2, under the Investment Advisers Act of 1940, as amended. Those issues concern investment advisers registered with the SEC (“Advisers”) that are sponsors or managers of private equity funds, hedge funds, and other private pooled-investment funds or vehicles (“Funds”).

Application of Audit Exemption to SPVs

The Custody Rule applies to an Adviser that serves, or has a related person that serves, as a Fund’s general partner, manager, or managing member, because the Adviser is deemed to have custody of the assets of the Fund. Such an Adviser, however, will typically rely on a provision of the Custody Rule that exempts from compliance with most of the Custody Rule’s requirements if the Fund:

  • is audited at least annually by an independent accountant or accounting firm that is registered with the Public Company Accounting Oversight Board, and
  • distributes the audited financial statements, prepared in accordance with GAAP, within 120 days of the end of the fiscal year to the Fund’s investors or their independent representative or representatives.

An Adviser to a Fund may, for legal, tax, or other regulatory purposes, use a special-purpose vehicle (controlled by the Adviser or a related person) to make and hold one or more securities investments by the Fund (“SPV”). The Division has received inquiries regarding how an Adviser can rely on the audit exemption when an SPV is involved: Assuming the SPV is considered a client of the Adviser, must the Adviser treat the SPV as a separate client over whose assets the Adviser has custody, or may the Adviser treat the SPV’s assets as those of the Fund or Funds over whose assets the Adviser has custody?

In the Guidance, the Division indicated that for the audit exemption:

  • if (a) an SPV is entirely owned by one or more Funds managed by the Adviser (directly or through a related person), the Adviser, or the Adviser’s related persons and (b) the SPV is within the scope of the audit of the Fund’s or Funds’ financial statements, then the Adviser may treat the SPV’s assets as assets of the Fund or Funds; and
  • if an SPV is owned not only by one or more Funds managed by the Adviser (directly or indirectly), the Adviser, or the Adviser’s related persons, but also by unaffiliated third parties, then the Adviser must treat the SPV as a separate client and, therefore, obtain separate audited financial statements for the SPV and comply with the corresponding financial-statement-distribution requirements of the Custody Rule.

Post-closing Escrow Accounts with Sale Proceeds

The Division also addressed an Adviser’s compliance with the Custody Rule in connection with the sale of a portfolio company by a Fund or Funds, especially a private equity fund. The Custody Rule requires an Adviser to maintain funds and securities over which it has custody with a qualified custodian either in a separate account for each client in the client’s name or in one or more accounts containing only clients’ funds and securities that are maintained in the adviser’s name as agent or trustee for the clients.

In a sale of a portfolio company, a temporary escrow account is typically created and maintained to hold a portion of the sale proceeds to be available to satisfy post-closing purchase-price adjustments or indemnification claims under the acquisition agreement, and a “sellers’ representative” is typically appointed to act on behalf of the sellers. The sellers may include not only one or more Funds managed by the Adviser, but also other unaffiliated parties. Advisers have argued that, in such circumstances, the Adviser’s compliance with the separate-account requirements of the Custody Rule may be relatively expensive, without affording any significant additional protection, for the Fund’s investors.

In the Guidance, the Division indicated that it would not object if an Adviser maintains client funds in an escrow account with assets of other clients and non-clients if:

  • the client is a Fund relying on the audit exemption of the Custody Rule and includes the portion of the escrowed assets attributable to the Fund in its audited financial statements,
  • the escrow account is in connection with the sale or merger of a portfolio company owned by the Fund, established to satisfy a potential post-closing purchase-price adjustment or indemnification claim,
  • the escrow account contains an amount of money agreed upon as part of a bona fide negotiation between the buyer and the sellers,
  • the escrow exists for a time period agreed upon as part of a bona fide negotiation between the buyer and the sellers,
  • the escrow account is maintained at a qualified custodian, and
  • the sellers’ representative is contractually obligated to promptly distribute to the sellers (including the Fund) the funds remaining in the escrow account at the end of the escrow period based on a predetermined formula.

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