Alert June 30, 2011

Advisers Act Alert Part 8: Calculating Assets Under Management and Its Implications

The amount of an adviser’s “assets under management” is critical to determining whether the adviser is permitted to register (or must register) with the SEC and whether the investment adviser qualifies for the Private Fund Adviser Exemption or the Foreign Private Adviser Exemption. The new rules adopt a consistent approach of defining assets under management for each of these purposes. Advisers Act Section 203A(a)(2) defines “assets under management”17 as the “securities portfolios” with respect to which an adviser provides “continuous and regular supervisory or management services.”18 Form ADV’s instructions contain the balance of the rules regarding the calculation of assets under management.

Securities Portfolios. Except in the case of “private funds,” discussed below, the new instructions do not alter the existing rule for determining what constitutes a “securities portfolio.” The instructions to Form ADV provide that an account is a securities portfolio if at least 50% of the total value of the account consists of securities.19 For this purpose, cash and cash equivalents “may” be treated as securities, suggesting that it is also permissible to treat cash and cash equivalents as other than securities. If an account is a securities portfolio, its entire value is included in calculating assets under management.

Until the amendment of Form ADV and its instructions by the Implementing Release, advisers had the option of including or excluding family or proprietary accounts, accounts managed without receiving compensation and accounts of foreign clients in calculating their “assets under management.” The new rules require that all of these types of accounts be included when determining “assets under management”. The objective of the revision is to avoid allowing advisers to opt in or out of regulation by calculating their assets under management in a manner designed to exceed or avoid exceeding a threshold.

Private Funds. An adviser that exercises continuous and regular supervisory or management services with respect to a “private fund” must include the value of all of the assets of the private fund, regardless of their nature, in its “regulatory assets under management” (i.e., the 50% rule described above that applies to securities portfolios does not apply to private funds). In addition, the amount of any uncalled capital commitments must be added to the value of the fund’s assets. Private fund assets must be valued at market value, or fair value if market value is not available.

Calculating the Value of “Securities Portfolios”

  • Market Value and Fair Value. For non-private fund assets, advisers should continue to value assets under management based upon the “market value” of those assets used to report to clients or to calculate fees.20 Under the new rules, private fund assets must also be valued at “market value,” or where market value is unavailable, at “fair value.” The new rules do not specify the methodology for reporting fair value beyond requiring that investment advisers report consistently and in good faith, but noted that the use of appraisers, pricing services or other third parties is not required. The Implementing Release indicates that an adviser that calculates fair value for financial reporting purposes is expected to use the same basis for reporting for fair value to determine its regulatory assets under management, whether that basis is GAAP or something else. There is a limited exception to the requirement that assets be valued at fair value for real estate assets where fair valuing of real estate assets is not required for financial reporting purposes under accounting principles used by the private fund that otherwise require fair value for assets. If the exception applies, real estate assets may be valued for purpose of computing assets under management as the private fund does for financial reporting purposes.
  • Gross Assets. The revised instructions to Form ADV direct an adviser to calculate its regulatory assets under management on a gross basis without deducting any outstanding indebtedness or other accrued but unpaid liabilities. The Implementing Release suggests that a gross assets calculation would help to ensure that leverage is not used to avoid registration and help to ensure that highly leveraged funds do not avoid systemic risk reporting. The Implementing Release also indicates that an adviser may choose to report net assets in Part 2 of Form ADV, which constitutes the brochure it provides to clients.
  • Open Questions. As expected, the new rules regarding calculating assets under management raise certain interpretive questions. For example, one question not specifically addressed by the new rules is how to treat subsidiary debt for purposes of calculating the gross value of a fund’s assets. An approach consistent with other discussions in the Implementing Release would be to perform the calculation consistent with how the fund reports for financial reporting purposes (i.e., if the assets and debt of the subsidiaries are consolidated on the fund’s balance sheet, the gross assets of the subsidiaries would be used for purposes of determining assets under management). Additional questions are likely to arise as advisers contemplate the facts and circumstances relating to their client portfolios.

Implications for Advisers

  • Private Fund Advisers. The new rule for calculating the assets under management of private funds (i.e., include all assets regardless of their nature and include uncalled commitments) and the rules with respect to calculating assets under management (i.e., include gross value) narrows the group of advisers to private funds that will be able to qualify for the Private Fund Adviser Exemption available to advisers managing private fund assets of less than $150 million.
  • Other Fund Advisers. An adviser with less than $25 million in assets under management is not permitted to register as an investment adviser with the SEC.21 In addition, an adviser with between $25 million and $100 million in assets under management that is required to register as an investment adviser with the state in which it maintains its principal office and place of business and, if registered, is subject to examination as an investment adviser in that state, is not permitted to register as an investment adviser with the SEC.22

    Advisers to funds that do not qualify as “private funds” and that manage assets that are predominantly not “securities” may fall within one of these prohibitions. For example, a real estate fund manager who only manages funds and accounts that only acquire fee title to real property (directly or indirectly through wholly owned non-corporate subsidiaries) may qualify for one of these prohibitions and thus may be prohibited from registering as an investment adviser with the SEC. The critical questions in this analysis are whether the funds and accounts managed by the adviser qualify as “private funds” and if not, whether less than 50% of the total value of each fund or account that is not a private fund consists of “securities.” If a non-private fund has less than 50% of its total value in “securities,” then it is not a “securities portfolio” and therefore contributes $0 to the calculation of the adviser’s assets under management. A portfolio that consists of approximately 50% “securities” with an aggregate value that may fluctuate above and below the 50% mark presents particular challenges under this “all or nothing” approach.

Determining whether funds or accounts managed by an adviser qualify as “private funds” will, in certain cases, involve complexity and uncertainty depending on the nature of the adviser’s assets. Many advisers that may be able to take the position that one or more of their funds or accounts is not a private fund have not previously undertaken this analysis because they have relied on the exclusions from the definition of “investment company” provided by either Section 3(c)(1) or 3(c)(7) of the 1940 Act. Determining whether an account or fund falls within the definition of “investment company” under the 1940 Act, or qualifies for a definitional exclusion outside of 3(c)(1)/(7)(thereby excluding the fund or account from the definition of “private fund”) may require a detailed analysis of the investments held by the account or fund and the manner in which they are held. Similarly, where a fund invests in non-corporate private market investments, determining whether less than 50% of the total value of a fund that is not a private fund consists of “securities” can require a detailed analysis of the terms of the investments that may not yield a clear answer.

Advisers that fall within one of the prohibitions on registration with the SEC should also bear in mind that they must continually analyze whether their funds and accounts continue not to be “private funds, ” and whether the allocations or values of investments of their non-private funds has changed sufficiently, such that the non-private fund has become a “securities portfolio.” For example, a real estate fund adviser that increases its investment in debt securities in a fund may find that the fund no longer has less than 50% of its total value in securities.

The chart available here summarizes certain principles regarding how assets under management affect registration and ERA reporting requirements.

17 Form ADV now refers to assets under management as “regulatory assets under management,” to distinguish the term from the assets under management that must be disclosed in Part 2 of Form ADV. Assets under management need not be calculated in the same way for purposes of Part 2 (i.e., the “client brochure”). For example, the Implementing Release notes that an adviser may continue to disclose a net amount of assets under management in its client brochure.

18 The definition of “continuous and regular supervisory or management services” appears in the instructions for Part 1A of Form ADV.

19 “Securities” is broadly defined by the Advisers Act. Some examples of assets that would not constitute “securities” include, in most cases, fee title to real estate (held directly or indirectly through wholly owned, non-corporate subsidiaries), general partner interests or managing member interests, commodities and collectibles.

20 See Form ADV: Instructions for Part 1A, instr. 5.b.(4).

21 Section 203A(a)(1) of the Advisers Act. The adviser must also be regulated or required to be regulated in the state in which it maintains its principal office and place of business. All states regulate investment advisers, except Wyoming.

22 Section 203A(a)(2) of the Advisers Act.