Regulatory Resources

Regulatory Resources for SBIA Members

Recent SEC Guidance for Private Equity Advisers

Private Funds And the Application of The Custody Rule To Special Purpose Vehicles & Escrows (IM Guidance Update No. 2014-07)

​The SEC has also issued guidance providing relief under the custody rule for SEC-registered investment advisers utilizing special purpose vehicles (SPVs) to make investments and escrow accounts when selling interests in portfolio companies.

A) Special Purpose Vehicles

The SEC acknowledged in the release adopting the Advisers Act Custody Rule, Rule 206(4)-2 in 2009, that investment advisers to private funds may use SPVs to facilitate investment of their funds in certain securities.

This release stated that the adviser could either treat the SPV as a separate client (where the adviser has custody of the SPV's assets) or treat the SPV as assets of their fund (where the adviser has custody of the SPV's funds indirectly) in order to comply with the provisions of Rule 206(4)-2(c), the "Delivery to Related Person" section.

If choosing the former, and treating the SPV as a separate client, with the adviser choosing the audit provision (which requires an annual independent audit of the fund), the adviser must separately distribute audited financial statements to the beneficial owners of the pooled investment vehicles that own the SPV.   If the adviser chooses the latter, treating the SPV's assets as assets of the funds for which it has custody indirectly, the assets must be considered within the scope of the audit of the fund itself.

In the guidance, the SEC provides a response to a variety of scenarios for which an SPV might be used and for which advisers might be unclear about how to comply with the custody rule in terms of the treatment of assets.  These scenarios include:

- The use of an SPV vehicle to purchase a single investment on behalf of a single pooled investment vehicle (Single purpose vehicle);

- The use of an SPV vehicle to purchase a single investment on behalf of  multiple pooled investment vehicles (Multi-fund single purpose vehicle);

- The use of an SPV vehicle to purchase multiple investments on behalf of one or more pooled investment vehicles (Multi-purpose vehicle);

- The use of an SPV  to purchase one or more investments on behalf of one or more pooled investment vehicle clients and third parties that are not pooled investment vehicles controlled by the adviser or the related persons of the adviser (Investment fund). The investment fund then in turn invests in one or more investments.

B) Escrow Accounts

The SEC also addresses concerns about the use of private fund advisers with respect of the application of the custody rule to escrow accounts. These accounts are typically used for a limited period of time in connection with the sale of a portfolio company owned by one or more pooled vehicles.

The guidance from the SEC focuses on the use of the sellers of the portfolio company (the advisers pooled investment vehicle clients and non-client owners of the portfolio company) often appoint a "sellers representative" that act on the behalf with respect to a portion of the sales proceeds held in an escrow account following the closing of the sale or merger.  This escrow account is to hold a percentage of sale proceeds to be used in the event of indemnification or an adjustment to the sale price of a portfolio company.  Typically, the escrow account exists for a limited period of time and the funds remaining after that time are distributed on a predetermined formula to the sellers, including the clients of the adviser's pooled investment vehicle.

The custody rule requires investment advisers to maintain funds and securities with a qualified custodian in a separate account of each client in the client's name, or in accounts that contain only the adviser's clients funds and securities that are maintained in the adviser's name as agent or trustee for clients. Due to the co-mingled nature of the funds in the escrow accounts, the limited duration of the accounts and the narrow purpose of the accounts, the cost to establish and maintain several escrows in order to comply with the custody rule would be significant and would be borne by investors in the private equity fund.

As such, the SEC would not object if advisers maintains client funds in an escrow account with other client and non-client assets, so long as:
  1. the client is a pooled investment vehicle that relies on the audit provision and includes the portion of the escrow account attributable to the pooled investment vehicle in its financial statements;
  2. the escrow account is in connection with the sale or merger of a portfolio company owned by the client (i.e. for indemnification or to adjust the purchase price);
  3. the escrow account contains an amount of money that is agreed upon as part of a bona fide negotiation between the buyer and sellers;
  4. the escrow account exists for a period of time that is agreed upon as part of a bona fide negotiation between the buyer and sellers;
  5. the escrow account is maintained at a qualified custodian; and
  6. the sellers' representative is contractually obligated to promptly distribute the funds remaining in the escrow account at the end of the escrow period on a predetermined formula to the sellers, including private equity fund clients.
Privately Offered Securities Under the Investment Advisers Act Custody Rule (IM Guidance Update No. 2013-04)

In August 2013, the SEC released updated guidance on the Investment Advisers Act Custody Rule (Rule 206(4)-2, which resolved questions as to whether advisers to audited pooled investment vehicles must maintain a qualified 3rd party custodian for certain types of privately issued securities, in particular, non-transferable stock certificates or "certificated LLC interests" that were obtained in a private placement.

The SEC has determined that it is permissible for an adviser to not maintain these types of securities with a qualified custodian, so long as the following is accurate:
  1. the client is a pooled investment vehicle that is subject to a financial statement audit in accordance with paragraph (b)(4) of the custody rule;
  2. the private stock certificate can only be used to effect a transfer or to otherwise facilitate a change in beneficial ownership of the security with the prior consent of the issuer or holders of the outstanding securities of the issuer;  
  3. ownership of the security is recorded on the books of the issuer or its transfer agent in the name of the client;
  4. the private stock certificate contains a legend restricting transfer; and, 
  5. the private stock certificate is appropriately safeguarded by the adviser and can be replaced upon loss or destruction.

Recent SEC Guidance for Business Development Companies

Business Development Companies with Wholly-Owned SBIC Subsidiaries - Asset Coverage Requirements (IM Guidance Update No. 2014-09

In this release, the SEC has formalized exemptive relief to BDCs which grants limited relief from the asset coverage requirements in sections 18(a) and 61(a) of the Investment Company Act of 1940 ("'40 Act").  The guidance closed a loophole in which BDCs could have utilized a wholly owned SBIC subsidiary to avoid the asset coverage ratio requirements by leveraging the SBIC with non-SBA leverage, not subject to the family of funds cap of $225 million.  In this scenario, a BDC could wholly own an SBIC subsidiary and lever it with non-SBA guaranteed leverage to circumvent the asset coverage ratio.

The new formal guidance provides that "subject to representations and a condition described in the exemptive applications," a BDC may treat indebtedness that is held or guaranteed by the Small Business Administration in their Small Business Investment Company (SBIC) subsidiary not as indebtedness represented by senior securities for the purposes of determining the BDC's consolidated asset coverage.  This allows the BDC to deduct the SBA guaranteed indebtedness in the SBIC from the BDC's total assets and the amount of senior securities representing indebtedness for the purpose of the asset coverage calculation. This would not include indebtedness from private parties (non-levered SBICs borrowing capital from private sources in an effort to circumvent the asset coverage ratio).

SEC Examination Information for Private Equity Advisers:

On May 6, 2014, Andrew J. Bowden, the Director of the Office of Compliance Inspections and Examination of the Securities & Exchange Commission, gave a speech at Private Equity International highlighting the concerns the SEC has seen in their examinations of private equity funds since the registration requirement was instituted under the Dodd Frank Act. SBIA has composed a comprehensive outline and summary of the concerns highlighted by Director Bowden to help prepare our members for what to expect from SEC examinations.

The Compliance Update can be viewed here.
SBIA has compiled a spreadsheet of all the enforcement actions instituted against investment advisers that advise private equity and venture capital funds.  This spreadsheet will be updated periodically to track the trends and number of enforcement actions brought by the SEC.

The Spreadsheet can be viewed here.
SBIA has aggregated a list of states where investment advisers to private funds may have to register with their state securities commission.  Under Dodd-Frank and subsequent SEC rulemaking, investment advisers advising funds below $90-100 million in AUM are not permitted to register with the SEC and may be subject to registration requirements imposed at the state level where they are headquartered. Numerous states have exemptions from the registration requirements for these funds, while some require these advisers to register.  Notably, while there is an exemption for advisers to solely SBIC funds at the federal level, certain states do require SBIC advisers to register with the state securities commission if they are below $150 million in AUM.

The following spreadsheet provides the list of states where there is no exemption from the registration requirement (green), states that have a private equity fund adviser exemption (purple) and states that provide some relief in particular areas (blue).  The spreadsheet is Available Here. (Last Updated April 2014)

*Note: The resources provided by SBIA on this page do not constitute legal advice.  SBIA advises that you contact your legal counsel before proceeding based on the information provided on this website. If you have any questions about the content on this page, please contact SBIA's Government Affairs Team at