Following up on an earlier post, Rule 203(b) (3)-2, adopted by the SEC on October 26, 2004, requires most private fund advisers to register with the Commission. Advisers must consider the number of investors in their funds, rather than the number of funds, to determine whether they are eligible for the exemption from registration available to advisers with 14 or fewer clients. Advisers to private funds in which a registered fund invests (i.e. a fund of hedge funds) must go one step further and count the investors in the registered fund as clients. Advisers who are no longer eligible for the exemption will have to register with the SEC by February 1, 2006. The new registration requirements will give the SEC jurisdiction over many more hedge fund advisers, allowing the SEC greater access to information on advisers’ operations. All registered investment advisers (“RIAs”) are subject to examinations by SEC staff and must comply with the provisions of the Investment Advisers Act (“the Act”). Following is a summary of major provisions of the rule: Definition of a “private fund” The rule defines “private fund” as (1) one that would be an investment company but for the exceptions in Section 3(c) (1) or 3(c) (7) of the Investment Company Act; (2) permits investors to redeem their interests within two years of purchase; and (3) is offered based on the investment advisory skills, ability or expertise of the investment adviser. The definition specifically exempts advisers to offshore publicly offered funds that (1) have their principal office and place of business outside the U.S.; (2) make a public offering of their securities outside the U.S.; and (3) are regulated as a public investment company under the laws of a country other than the U.S. The two-year redemption test applies to each interest in the private fund and can be applied on a first in first out, or FIFO, basis. However, this requirement does not apply to interests acquired with reinvested dividends or to private equity and venture capital funds that allow redemptions under extraordinary circumstances. Effect on performance-based fees RIAs to private funds may charge performance-based fees to new investors only if they meet the standards of rule 205-3, which allows performance-based fees only for “qualified clients” (investors with a net worth of at least $1.5 million or at least $750,000 of assets under management with the adviser). The rule allows existing investors that are not “qualified clients” to retain their interest in that private fund and to add to that account. However, it does not give them an exemption to open new accounts in that or other hedge funds. Financial statements and required books and records RIAs to funds of hedge funds will be able to satisfy their requirement to deliver audited financial statements within 180 days of their fiscal year end, instead of the requirement that they be delivered within 120 days of their fiscal year end. Rule 204-2, which lists books and records requirements for all RIAs, will be amended to provide an exemption from the performance recordkeeping requirements for newly RIAs to private funds. Such RIAs will be required to retain whatever records they have that support the performance prior to their registration but will be excused from the recordkeeping rule to the extent that the records do not meet the requirements at the time of registration. Applicability to offshore advisers to private funds The rule does not require advisers to offshore funds that have U.S. investors to “look through” the fund for any purposes under the Act, other than (1) the anti-fraud provisions and (2) determining the availability of the private adviser exemption. The release included a reminder that U.S. advisers to private funds should not try to use the exception to evade the requirements of the Act by establishing a shell subsidiary in a foreign country to manage offshore hedge funds. Why? Because, under Section 208(d), advisers are prohibited from doing indirectly that which they cannot do directly. For more information, please see IA Release No. 2333 (Dec. 2, 2004) available here.