(Article from Registered Funds Alert, October 2018)
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A key issue facing our clients, and the asset management industry generally, is developing ways for retail investors to access investment strategies typically reserved for institutional and other wealthy investors. Based on recent remarks by SEC Chair Jay Clayton and related media reports, the SEC plans to issue a concept release seeking public comment on ways to increase the ability of retail investors to invest in private companies. Allowing registered funds (i.e., an investment company or business development company (“BDC”)) to co-invest with affiliated funds is a critical first step toward accomplishing these goals. Unfortunately, co-investing is prohibited for registered funds except in certain limited circumstances, either by relying on narrow no-action letters or going through an expensive and time-consuming exemptive application process that still restricts such co-investment dramatically.
In this Alert, we provide background on the ability of registered funds to co-invest with affiliated funds and describe the evolution of co-investment exemptive orders that have been granted by the SEC. We then propose that the SEC should revise its historical approach and take steps to allow registered funds to engage in a broader range of co-investments without requiring specific exemptive relief.
Overview and Background
One of the major problems that the Investment Company Act of 1940 (the “1940 Act”), sought to address and regulate was the ability of investment advisers and other affiliates to take advantage of investment funds through affiliated transactions (either with the affiliate on the same side of the negotiating table as the fund or as an opposing counterparty). In this Alert, we focus on transactions where a fund and its affiliate(s) are on the same side of the negotiating table, typically referred to as a joint transaction or co-investment. Sections 17(d) and 57(a)(4), and Rule 17d-1 under the 1940 Act (collectively, the “Joint Transaction Regulations”) set forth the restrictions governing joint transactions among registered funds implemented to protect investors from the potential harms associated with self-dealing and overreaching by advisers and other affiliates.
Over time, it has become clear that there are transactions that are technically prohibited by the Joint Transaction Regulations, but do not present the dangers of self-dealing and overreaching that animate the Joint Transaction Regulations. For decades, the SEC and the staff of the SEC’s Division of Investment Management (the “Staff”) have taken the position that a registered fund should be permitted to engage in certain limited types of co-investment transactions with its affiliates without violating the Joint Transaction Regulations. Since it was first adopted in 1957, Rule 17d-1 has explicitly contemplated exemptive orders that would permit co-investments that would otherwise be prohibited by the Joint Transaction Regulations. In 1992, after reviewing the efficacy of existing regulation, the Staff went so far as to recommended that Rule 17d-1 be amended to permit certain joint transactions where the registered fund participates on the same terms as its affiliates.[1] Resource constraints and other higher priority rulemaking initiatives have prevented such an amendment to Rule 17d-1 from materializing and will likely continue to do so for the foreseeable future, but the Staff has taken no-action positions and issued exemptive orders to lessen the restrictiveness of the Joint Transaction Regulations, consistent with the recommendations it gave in the 1992 Report.
Under the relevant line of no-action letters, a registered fund is permitted to co-invest alongside an affiliated entity in transactions where all of the affiliated parties participate on the same terms and there are no terms negotiated other than price (“Non-Negotiated Co-Investments”) and allocations of opportunities are made fairly and pursuant to board-approved policies.[2] Essentially, the Staff’s position has been that because there are no negotiations through which affiliates could manipulate the terms of a Non-Negotiated Co-Investment and potentially place a registered fund at a disadvantage relative to another client, a Non-Negotiated Co-Investment does not pose the risks that the prohibitions in the Joint Transaction Regulations are designed to address.
For joint investment opportunities that involve negotiation of terms other than price (“Negotiated Co-Investments”), the SEC has required registered funds to request specific relief through the exemptive order process. To obtain such relief, the SEC has historically required applicant funds and their advisers agree to more than a dozen conditions that restrict how the funds and advisers behave with respect to identifying, entering into, allocating and approving Negotiated Co-Investments. These conditions form the guide rails of what becomes each set of applicants’ “Co-Investment Program.”
While some aspects of co-investment exemptive applications have evolved over time, there are several elements of each Co-Investment Program that are generally consistent across the board. One key condition that is universally included in co-investment exemptive applications is that all participating affiliates must invest on the same terms and (more or less) at the same time. This condition mitigates the overreaching concern that a registered fund could be disadvantaged relative to its affiliates with respect to a specific transaction.
Another key condition is that Negotiated Co-Investments considered for any affiliated fund in the Co-Investment Program must also be considered for a registered fund. That is to say, if the adviser is considering a Negotiated Co-Investment opportunity for any affiliated private fund or one specific registered fund in the Program, it must also consider whether the opportunity would be appropriate for all other registered funds in the Program. From the view of the SEC, this condition exists to ensure that registered funds are not only brought in to participate on less lucrative deals, or to absorb overflow, but instead have full access to any deals available to the other funds participating in the Co-Investment Program.
In addition to governing the initial Negotiated Co-Investments, all Co-Investment Programs also govern the process by which dispositions and follow-on opportunities must be shared and the process by which those decisions must be made. Many Co-Investment Programs allow for dispositions and follow-on transactions to be conducted under the umbrella of the Co-Investment Program (i.e. to permit Program participants to jointly negotiate the terms of a follow-on investment or a disposition with respect to terms other than price) only if the initial investments were also made under the terms of the Co-Investment Program.
Once all relevant funds have had the opportunity to determine whether to participate in a Negotiated Co-Investment opportunity, and the participating affiliated entities have made their determinations as to their desired participation levels (as determined by the adviser to each participating entity), the opportunity is allocated accordingly. If the demand for the opportunity from participants exceeds what is available to the manager as a whole, the investment opportunity is allocated among all of the co-investing entities on a pro rata basis, based on criteria specific to each Co-Investment Program. The boards of each participating registered fund, including a majority of its independent directors, must approve of the transaction before the registered fund may participate.
Evolving Co-Investment Programs
For many years, Co-Investment Programs all followed a similar template, but certain variations in exemptive orders have evolved rapidly over the past few years. This evolution is primarily driven by the fact that asset managers are increasingly large and complex organizations, the one-size-fits-all presumptions of the standard relief have proven to be unworkable for numerous firms. For large asset managers who often have multiple advisers with a variety of registered funds and private funds, the conditions imposed under the standard form of exemptive relief require onerous amounts of information to be shared between affiliates and a substantial compliance framework to manage all of the regulatory obligations.
The wave of new innovation in Co-Investment Programs began with an order granted to Apollo Investment Corporation and its affiliates (“Apollo”) in 2016. After years of negotiation with the Staff, Apollo was successful in seeking a more scalable and flexible approach than had been historically granted, and better reflects the challenges facing certain types of larger asset managers.
One notable modification that arose out of Apollo’s relief was to add a mechanism that allows the board of a registered fund to set criteria that would limit the range of transactions that must be presented to that registered fund. As fund investment strategies are often broadly worded, this development allows an adviser to focus on opportunities that are the most likely to be appropriate for a registered fund and can significantly reduce the administrative burden on the adviser of documenting why a registered fund declined to participate in opportunities that are unlikely to fit its core strategy or target risk/return profile. The line of applications that have adopted this mechanism refer to this concept as “Board-Established Criteria.”
Apollo’s order also added the flexibility to allow disposition and follow-on transactions with respect to initial investments that were not made under the Co-Investment Program to be completed under the Co-Investment Program so long as certain conditions and board approvals are met and obtained. The newer applications that include this flexibility refer to these as “enhanced-review” dispositions and follow-ons.
Ultimately, however, Apollo’s application was tailored to reflect how Apollo’s business is structured, which does not necessarily reflect other potential applicants. The SEC has issued at least 45 co-investment exemptive orders since Apollo’s was granted in 2016. As the SEC and the industry have grappled with this reality, it has resulted in a patchwork of exemptive applications with varying representations, conditions and requirements as each applicant attempts to find a solution that works for its business model.
For example, there has been a divergence in exemptive applications since Apollo’s relief was granted regarding how investment allocations are made when an opportunity is oversubscribed. Prior to Apollo’s exemptive order, applications stated that in such circumstances allocations would be made pro rata on the basis of available capital (i.e., that the funds with the most cash on hand would get the largest allocation). Advisers found that the strict available capital requirement could lead to undesirable results. Apollo’s application took a different approach, instead basing allocations for over-subscribed investments on the relative size of “internal orders,” essentially reflecting the actual demand expressed by each affiliated fund. In more recent applications using this “internal order” approach, however, the SEC has begun to add additional requirements around the internal order process in an attempt to ensure that registered funds are not disadvantaged—even going so far as to require legal or compliance personnel to attend allocation committee meetings and take minutes.
Other recent applications have eschewed the internal order model and instead modified the definition of “available capital” to be a more nuanced concept that involves some discretion on the part of the adviser and variables, such as liquidity considerations, existing commitments and reserves, if any, the targeted leverage level, targeted asset mix, risk-return and target-return profile, tax implications, etc. It is unclear at this point how much of a difference exists between the “internal order” and the “modified available capital” approaches.
The Problem with Co-Investment Exemptive Relief
The growing patchwork of co-investment exemptive orders is a consequence of the SEC granting exemptive relief for individual Co-Investment Programs rather than taking a principles-based approach of blessing a wider variety of Negotiated Co-Investments.
It takes an enormous amount of time for the SEC Staff to review and understand the internal interplay of increasingly large and complex asset managers, which takes valuable SEC resources away from other important areas of focus. Similarly, while the benefit of co-investment relief is that registered funds are allowed to participate in Negotiated Co-Investments from which they would otherwise be excluded, the complexity and restrictions of the applications and related conditions can discourage an asset manager from seeking the benefit of relief for its registered funds. Absent a co-investment order, registered funds are left out of Negotiated Co-Investments altogether.
While the SEC’s goal of protecting registered funds and their shareholders are well intentioned, the exclusion of registered funds from Negotiated Co-Investments is ultimately to the detriment of retail investors. Co-investments generally provide registered funds a host of benefits, including an increase in deal flow, the opportunity to participate in larger financing commitments and enhanced selectivity, and more favorable deal terms. All of these benefits have been recognized in the context of Non-Negotiated Co-Investments through no-action relief and in the context of Negotiated Co-Investments through exemptive orders, but there persist, in our view, unnecessary limitations on registered funds’ access to attractive co-investment opportunities.
The Path Forward
While the SEC’s willingness to grant the Apollo-style relief was a welcome departure from the historical one-size-fits-all relief, it has ultimately led the SEC down a path where the Staff must review complex and detailed exemptive applications that require a significant amount of customization for each individual applicant. The resulting patchwork of exemptive orders with sometimes meaningful variation in representations and conditions creates regulatory uncertainty and potentially competitive advantages (or disadvantages) for some asset management firms. As the SEC has recognized in the ETF context, variations in the regulatory structure that result from a complex web of exemptive orders can pose a problem and are ripe for simplification. Our view is that the SEC would be best served by exiting the business of granting exemptive orders for basic forms of Co-Investment Programs.
As discussed, the SEC’s overarching concern is that a registered fund could be disadvantaged in the co-investment context. As the Staff recognized in the 1992 Report, this aim clearly can be met while still permitting co-investment transactions under certain defined circumstances. The Staff could dramatically improve access co-investment opportunities for registered funds by taking a broad principle-based no-action position, as was the case with Non-Negotiated Co-Investments. All Co-Investment Programs are designed to ensure that both a registered fund’s adviser and board, each of which owes a fiduciary duty to the fund, vet a transaction with a focus on ensuring that the registered fund is not being disadvantaged. There does not seem to be any clear reason why a no-action position that incorporates the common restrictions and concepts underpinning Co-Investment Programs could not achieve the same regulatory purpose as individual exemptive orders.
We believe the Staff should take a no-action position stating that it will not recommend enforcement action under Section 17 or 57 of the 1940 Act if registered funds co-invest in portfolio companies with each other and with affiliated private funds pursuant to a program based on certain general characteristics, including several concepts currently included in existing Co-Investment Programs. Such principles might include concepts such as:
Fiduciary Duties
Each adviser will manage the assets of each of its clients in accordance with its fiduciary duty.
Same Terms
Each affiliated fund participating in a co-investment will invest on the same terms.
Allocation Process and Conflict Policies
Advisers should have policies and procedures adequately designed to ensure that as co-investment opportunities arise falling within a registered fund’s board-established criteria, the registered fund’s portfolio management team is notified of the opportunity and receives the same information as other private funds.
Board Reporting and Compliance
The independent directors of a registered fund should receive quarterly information regarding all potential co-investment transactions that fell within the registered fund’s board-established criteria, but were either declined by the registered fund or not made available to it.
Additionally, on an annual basis, each registered fund’s chief compliance officer and board of directors should review and evaluate the fund’s compliance with the no-action relief and the policies and procedures established to realize such compliance. However, the SEC should avoid dictating the requirements of a registered fund’s compliance program, retaining the flexibility for the fund and its adviser to create a program that is reflective of the organization’s unique structure.
Ethical Walls and Conflicts of Interest
Each adviser to a registered fund should adopt sufficient ethical wall policies to address conflicts of interest, insider information and confidentiality issues, including policies to address conflicts arising from investing in different parts of an issuer’s capital structure.
The rapid evolution of co-investment orders over the past few years has resulted in a situation where exemptive relief is no longer the best regulatory option for permitting Co-Investment Programs. The issuance of a no-action position described above would not remove exemptive orders from the SEC’s tool kit, but would instead allow the Staff to focus on more novel requests related to this complex issue.
[1] SEC Division of Investment Management, Protecting Investors: A Half Century of Investment Company Regulation (May 1992) (the “1992 Report”).
[2] Such transactions are commonly referred to as “Mass Mutual” transactions, a reference to the seminal no-action letter on this topic.