In December 2013, U.S. banking and securities regulators issued final regulations implementing the “Volcker Rule.” Mandated by the Dodd-Frank Act of 2010, the rule prohibits banking entities from engaging in certain risky activities, including short-term proprietary trading and sponsoring or owning interests in certain private funds.
The Volcker Rule’s sting will be felt primarily by banking entities, which include FDIC-insured depository institutions; companies that control those institutions (including foreign bank holding companies); and their affiliates or subsidiaries. But it will also indirectly — and potentially significantly — impact private fund managers, who may find themselves without a major source of capital.
The final regulations took effect April 1, 2014, but banking entities generally have until July 21, 2015, to come into full compliance. In the meantime, fund managers should familiarize themselves with the regulations so they can prepare for the potential loss of bank investors and consider alternative strategies for raising capital from banks.
The Volcker Rule covers a wide range of activities. But fund managers seeking investments from unaffiliated banks generally need to focus on one provision: With certain exceptions, the final regulations prohibit banking entities from acquiring an ownership interest — as a principal, rather than as agent, broker or custodian — in a covered fund.
Ownership interests include equity, partnership or other similar interests, such as rights to participate in fund management selection or to share in a fund’s profits. Covered funds include funds that are exempt from registration as investment companies under Sec. 3(c)(1) or Sec. 3(c)(7) of the Investment Company Act of 1940 (ICA). These exemptions, which are relied on by most hedge and private equity funds, apply to funds with no more than 100 holders and those sold only to qualified purchasers, respectively. Covered funds also include certain commodity pools and foreign funds.
Alternative Fund Structures
Despite these restrictions, funds continue to have limited opportunities to raise capital from banks by adopting such alternative structures as:
• Managed accounts. The Volcker Rule’s ban is limited to investments in covered funds. Nothing in the rule prevents asset managers from establishing and managing separate accounts for their banking entity customers, so long as these accounts don’t mirror a covered fund’s investments too closely.
• Registered Investment Companies. The rule doesn’t apply to funds registered under the ICA, including funds that elect to be treated as business development companies.
• Exempt entities. As noted above, the rule applies to funds exempt from registration under ICA Secs. 3(c)(1) or 3(c)(7). Funds that qualify for other exemptions, however, are not considered covered funds. These include ICA Sec. 3(c)(5)(C) (certain real estate funds), Sec. 3(c)(9) (certain oil and gas funds), and Rule 3a-7 (certain asset-backed securities issuers).
• Foreign funds. The regulations permit investments from non-U.S. banking entities, provided the fund is organized outside the United States and ownership interests are offered and sold only to non-U.S. persons. This may include parallel foreign funds that invest in tandem with covered funds. Note, however, that a foreign fund structured as a feeder for a master fund that’s a covered fund will likely be considered a covered fund. Other possible structures include foreign public funds and certain loan securitization and asset-backed commercial paper vehicles.
Handle with Care
The final regulations are quite complex, comprising more than 70 pages of rules and nearly 900 pages of supplementary information. In addition to the activities specifically banned by the rule, regulators have considerable leeway to prohibit transactions that would result in a material conflict of interest between a bank and its customers or otherwise expose the bank to excessive risk.
Asset managers wishing to raise capital from banking entities should consult their advisors to review their options and ensure that their funds are structured appropriately.