Private Equity Firms as Investment Advisors & The Custody Rule

Corproate By: Mark Tarallo 

As a result of changes brought about by the Dodd-Frank Act, many private equity firms are now required to register as investment advisers in connection with their activities.  Once registered as an investment adviser, private equity firms are subject to the rules and regulations generally applicable to investment advisers.  One such rule is the “Custody Rule,” Rule 206(4)-2, promulgated under Section 206(4) of the Investment Advisers Act.  The Custody Rule requires advisers, who have custody of client assets, to adopt procedural safeguards to prevent loss, misuse or misappropriation of those assets.  The Custody Rule frequently comes into play with private equity firms when those firms use special purpose vehicles (SPVs) for acquisitions, or where private equity firms are responsible for maintaining a post-transaction escrow, or serve as the “sellers’ representative”.  Since registering as investment advisors, many private equity firms did not contemplate that they would be required to comply with requirements like the Custody Rule, and very few of them had procedural safeguards consistent with the Custody Rule in place.  In response, the SEC has granted limited relief from full compliance with the Custody Rule, such relief requiring, in part, that the fund manager distribute audited financial statements to all beneficial owners of the private equity fund within 120 days of the fiscal year-end of the fund, or within 180 days of the fiscal year-end for a fund of funds.


On October 29, 2014, the SEC announced that it had filed charges against a registered investment advisor for failing to timely deliver audited financial statements to its investors, thereby violating the provisions of the Custody Rule.  The SEC sought a cease-and-desist order against the operators of the fund, noting that such an action was necessary to protect investor interests due to repeated failures by the fund to deliver the required audited financial statements.  Private equity firms that use SPVs in transactions or that act as a seller representative post-closing should clearly understand their compliance obligations, and what deliveries are required by them to investors, in order to avoid similar claims from the SEC.


Feel free to contact Mark with any questions on this topic.


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