(Article from Registered Funds Alert, May 2016)
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The Investment Company Act of 1940 has contained from its enactment a number of prohibitions on transactions between a registered fund and its affiliates, including prohibiting joint transactions that are disadvantageous to a registered fund participant. Over the past 25 years, the Staff of the Securities and Exchange Commission’s Division of Investment Management has granted relief in the form of no-action letters from certain of these prohibitions by allowing registered funds to engage in “co-investment” transactions with their affiliates, so long as they comply with certain restrictive conditions. Under these no-action letters, a registered fund is permitted to co-invest alongside an affiliated entity in transactions involving publicly traded securities and in private transactions where there is no negotiation of a term other than price and allocations of such opportunities are made fairly and pursuant to board-approved policies.
Of course, some private co-investment opportunities do require negotiation of additional terms other than price, and in certain instances registered funds have obtained specific exemptive relief from the SEC to enter into such transactions, subject to the conditions therein. Six years ago, Apollo Investment Corporation and its related entities (“Apollo”) applied for such co-investment relief, but notably requested a modified version of the more “standard” relief that had been granted to other registered funds and their affiliates.[1] The Apollo application sought relief that would be more adaptable to the complex interactions between affiliates often encountered by larger asset managers with multiple types of investment product offerings. In late March 2016, after seven rounds of amended applications, the SEC granted Apollo’s longstanding request. By granting Apollo’s application the SEC has demonstrated that it may be open to reconsidering long-standing positions in order to provide more practical exemptive relief, if it reflects the realities of the asset management industry.
Until Apollo’s application was granted, the typical application and order for co-investment relief has followed a virtually identical framework, regardless of the relative size, complexity, or sophistication of the applicant. The SEC has historically required 13 or 14 conditions that control how the applicant must behave with respect to sharing investment opportunities if they are to be granted the ability to allow registered funds to engage in co-investment transactions with affiliates. Generally, the conditions specify that all investment opportunities presented to an affiliated adviser that fall within a registered fund’s investment objectives must be shared with the adviser of the registered fund so that the registered fund can make an independent decision about how much it will invest (i.e., quantity of securities to be purchased). Once all participating affiliated entities make their independent determinations as to quantity (as determined by the adviser to each participating entity), the transaction is processed centrally and allocated accordingly. If the requested quantity exceeds what is available, the investment opportunity is allocated among all of the co-investing entities on a pro rata basis, based on criteria specified in each application. Over three dozen applicants have received relief that follows this formula since the early 1990s.
Apollo’s application followed the broad strokes of the standard framework, but it introduced several key changes to make the process more workable for large-scale operations and sought to expand the universe of allowable transactions further than what had previously been permitted by the SEC. Of particular note, Apollo sought to curtail the command that all investment opportunities within the scope of a registered fund’s general investment strategy must be shared with that fund’s adviser. Given the size and presence of larger asset managers, the proverbial firehose of investment opportunities that would have to be shared with the registered fund’s adviser under the standard relief could quickly become prohibitively burdensome to evaluate. Apollo’s solution was to create “Board-Established Criteria,” which act as an adjustable filter to control the flow of investment opportunities presented to the registered fund. Apollo’s application allows each registered fund’s adviser the opportunity to recommend to the fund board criteria that describe the characteristics of potential co-investment transactions that are closely aligned with the registered fund’s then-current focus, so that the fund may elect to request its adviser only be notified of matching co-investment opportunities. Apollo’s application specifies that the criteria must be objective and testable, and that it must be approved by a majority of the independent directors of the fund’s board before going into effect. Relatedly, Apollo also sought the flexibility for affiliated funds to close on co-investment transactions within 10 days of each other, provided they all commit on the same day.
The order also granted Apollo the ability to allow registered funds to co-invest in follow-on transactions even where the original transaction was not evaluated pursuant to the conditions of the relief. Under the standard relief, follow-on investments are arguably only permitted if the securities at issue were acquired in a co-investment transaction that was completed in compliance with the conditions of the exemptive order. For example, under the standard relief, if a registered fund and an affiliate separately acquired securities from the same issuer before exemptive relief was obtained and then a follow-on opportunity arises after exemptive relief was obtained, the registered fund potentially might not be able to participate jointly in the follow-on. Under Apollo’s order, however, so long as the transaction is successfully put through an “enhanced review,” a concept introduced by Apollo in its application, the registered fund may participate in the follow-on opportunity alongside affiliates. The enhanced review is a multi-step procedure that requires each registered fund’s board to confirm, with the advice of independent counsel, the presence of certain conditions that are designed to ensure that the follow-on opportunity is fair, in the best interest of the registered fund, and otherwise in compliance with the 1940 Act.
Similarly, the Apollo order broadens the range of permissible joint dispositions to include those where the affiliated funds did not first obtain the securities in reliance on the relief. Under the Apollo order, should any affiliate elect to sell, exchange or otherwise dispose of securities also held by a registered fund, they must alert the registered fund’s adviser of the potential transaction and the opportunity to participate proportionally. If the registered fund’s adviser recommends joining the transaction, the registered fund’s board must then complete an enhanced review of the transaction analogous to the procedure for follow-on investments described above.
In sum, Apollo’s relief (and presumably Ares’ soon to be granted relief) is broader and more scalable than the standard relief and is a better reflection of the realities facing certain types of larger asset managers. Though Apollo’s application took six years to approve, and significantly longer than contemporaneous requests for the standard co-investment relief, the fact that the order was eventually granted is positive news and shows the SEC may be willing to engage with the industry to tailor exemptive relief to address specific needs. Whether this is indicative of a thaw in the SEC’s general hesitancy to grant novel relief remains to be seen.
[1] An application for similar relief was filed by Ares on November 11, 2008. Ares filed an amendment on March 29, 2016 that closely tracked the final application submitted by Apollo. The SEC has not yet published a notice of an intent to grant Ares’ application.