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Private Funds Face Regulatory Face-Lift

Registration, Reporting Requirements Could Alter Business Methods

While it may be too late for the Securities and Exchange Commission to pass any new regulations before the end of the year, financial experts anticipate major financial legislation and regulation to occur sometime in early 2010.

The main issues facing money managers are Congressional proposals to require private funds to register with the SEC, a Supreme Court ruling on fund fees, a proposal to regulate money market funds and regulatory proposals or guidance on valuation.

"A lot of events in the marketplace have created a high level of anxiety in Washington," said Cary Stier, a managing partner and national practice leader at Deloitte. "The events of the last 12 months are definitely getting a very high level of attention."

Stier said the mutual fund industry saw a similar wave of strict compliance requirements in the fallout from market-timing and late-trading incidents in 2003. Proposed changes to advisor registration requirements could rattle some money managers who are unprepared, and with the results still uncertain, many private funds are contemplating whether to register now or wait until they're required to.

Private funds-including hedge funds, private equity funds and venture capital funds-are worried that a proposed Senate bill could require them to register and report under the Investment Advisers Act of 1940, the same act that governs mutual funds.

Private funds have thrived for decades due to their ability to conduct business in the shadows, but several high-profile fraud cases that came to light in the last 12 months have persuaded the world's leaders to clamp down on this activity.

The Obama Administration has recommended that the U.S. implement the Group of Twenty nations' commitment to require hedge funds or their managers to register and disclose information necessary to assess systemic risk, but the original timeline of 2009 may be a little too soon.

"The Obama whitepaper was a call to action," said Elizabeth Krentzman, a partner and chief advisor to Deloitte & Touche's regulatory consulting practice for the investment management industry.

"The Administration did not want to see exceptions," she said. "They did not want hedge funds exempted."

The proposed disclosure requirements aim to help regulators determine if any funds present systemic risk. Reporting their records to a systemic risk regulator or council would allow such an agency to monitor this activity, Krentzman said.

"This is the starting point, but many managers worry that this could gain a life of its own," she said. "The SEC has been given additional authority for rulemaking and could ask for more and more information. This creates the potential for anti-competitive or negative consequences."

An early version of the "Private Fund Investment Advisers Registration Act of 2009" has already passed the House, led by Rep. Barney Frank (D-Mass.). The Frank bill requires registration of all advisors to private funds, unless the fund has less than $150 million in assets under management.

The bill also exempts venture capital funds from registration, but requires advisors of these funds to be subject to reporting and recordkeeping requirements. Advisors to small business investment companies would be exempt from registration, as would some foreign advisors.

The House bill authorizes the SEC to mandate additional reporting requirements for private fund advisors as the Commission sees fit. The SEC could require advisors to provide reports, records and other documents to investors and prospective investors of any private fund they advise, Krentzman said.

A separate Senate bill, sponsored by Sen. Christopher Dodd (D-Conn.), is pending, and differs from the House bill in several key areas.

The Dodd bill requires all advisors to private funds to register under the '40 Act without regard to assets under management. Venture capital funds would be exempted, as would private equity funds and family offices. The Dodd bill also requires additional reporting of information about valuation methodologies and any side-letter arrangements, Krentzman said.

The Senate bill would also require all advisors to use an independent custodian, which many advisor groups have balked at, calling it prohibitively expensive.

SEC Agenda

The SEC has yet to schedule a year-end meeting, but most industry experts don't anticipate any big surprises before January, other than some surprise inspections.

"The SEC inspections typically follow the political news and a political agenda," Krentzman said. "This list has not changed too much."

In addition to a registration requirement for private funds, she said the items on the SEC's agenda for 2010 include new custody rules, "pay-to-play" arrangements, short-selling practices, securities-lending arrangements, securities valuations and imposing safeguards to protect trading on inside information.

Firms have seen an increase in inspections since last year's incident with Bernie Madoff, but it's difficult to know if this inspection increase is a trend or not, said Domenick Pugliese, a partner in the corporate development practice at the international law firm Paul Hastings.