This newsletter discusses recent key guidance releases, regulatory changes, noteworthy news and certain upcoming compliance deadlines.

Topics include:

• 10 Things You Should Know About Opportunity Zones
• ILPA Recommends Heighted Standards of Conduct for Private Fund Advisers
• Will Congress Expand the Definition of Investors Eligible to Invest in Private Funds?
• SEC Announces 2019 Examination Priorities
• Recent SEC Enforcement Action Against Private Fund Adviser for Improper Fee and Expense Allocations

10 Things You Should Know About Opportunity Zones

As part of the Tax Cuts and Jobs Act of 2017, the U.S. Treasury Department designated over 8,000 economically distressed areas across the United States as “Opportunity Zones” where investments through newly created Opportunity Zone funds (“OZ Funds”) could spur economic development and job creation.  Opportunity Zones have generated substantial interest among developers who are seeking to raise capital for projects, private equity real estate managers, and investors who have realized capital gains and are seeking to re-deploy the proceeds and defer or reduce taxes.

Investments must be in certain property located in a designated Opportunity Zone.  To confirm whether a tract is included in an Opportunity Zone, you can use the Census Bureau’s online Geocoder tool to determine the census tract for a specific address and then use the U.S. Department of the Treasury’s Opportunity Zone mapping system or  list of designated Qualified Opportunity Zones to determine the status of that tract.

The Opportunity Zone rules are complex and evolving, as Congress left much of the new legislation to be implemented through regulations.   The IRS issued proposed regulations on October 19, 2018 and April 17, 2019 addressing some aspects of the new law.  The regulations address many, but not all, of the areas of uncertainty, and do so in a manner that is generally investor friendly, and at least somewhat responsive to the needs of the typical private equity fund model.  The IRS has requested comments on several issues, and has indicated that additional proposed regulations will be forthcoming.

The potential tax benefits from an Opportunity Zone Investment include:

• By re-investing capital gains in a qualified OZ Fund, investors can defer tax on capital gains until the earlier of the date on which the OZ Fund interest is sold or exchanged, or December 31, 2026.   The deferred gain, less amounts excluded as described below, will be recognized in 2026.
• If the OZ Fund interest is held for longer than 5 years, 10% of the deferred gain is permanently excluded.  If held for more than 7 years, an additional 5% will be excluded (i.e., 10% becomes 15%).  
• If the investor holds the investment in the OZ Fund for at least 10 years, any post-investment appreciation in the OZ Fund interest may be tax free.

Here are 10 things for investors, developers and fund managers to consider in evaluating whether to launch an OZ Fund:

1. Only Capital Gains Qualify – But Any Capital Gains Qualify. The tax benefits are available only on investments of capital gains realized on other investments.  But unlike the “like kind exchange” rules, any type of capital gains can be invested in an OZ Fund – including not only gains on real estate, but also gains on stocks and other investment assets.

2. Timing is Critical.

• The investor must invest capital gains within 180 days after the date the capital gains are realized (although a longer period can be available on gains recognized by partnerships or net capital gains on business property).
• An OZ Fund generally has 180 days after it receives funds in which to acquire qualifying assets.
• The tax benefits (other than deferral of the reinvested gain) are available only if the taxpayer satisfies the 5, 7 and 10 year holding period requirements.

3. The OZ Fund Must Meet Certain Requirements.

• An OZ Fund must hold at least 90% of its assets in qualified opportunity zone property. An OZ Fund must meet this 90% asset requirement each year, including the first year.  The testing is done twice each year, so there are approximately 6 months for an OZ Fund to acquire qualifying assets.
• An investment in the OZ Fund must be an equity interest, not a debt interest.
• The OZ Fund may hold the qualifying property directly, or through a separate qualifying entity.
• Cash held directly by the OZ Fund does not qualify. Generally, the OZ Fund cannot simply raise cash and hold it until suitable assets are identified, but it must deploy the investors’ funds within 180 days.   
• Property that is not “new” property must be “substantially improved” over a 30-month period. This generally requires an additional investment at least equal to the initial investment.  The regulations provide guidance on how these rules apply to land and other real estate investments.
• Assets purchased from related parties do not qualify

4. Greater Flexibility on Investments. The April regulations give greater flexibility and better guidance on investments in a qualifying OZ Fund, and on investments by an OZ Fund in its assets. Specifically:

• Investors can contribute property other than cash to an OZ Fund. If property is transferred is a nonrecognition transaction, the investment will qualify for the potential tax benefits only in an amount equal to the lesser of the investor's basis in the property or the fair market value of the property.
• An OZ Fund will have 180 days to deploy invested funds, even if funds are received less than 180 days before the applicable testing date for the 90% asset test.
• The April regulations provide more clarity, and some flexibility, on how the rules apply to an operating business.

5. Indirect Investments May Be Desirable. It may be easier for an OZ Fund to invest through separate qualifying entities, rather than hold assets directly, because the rules give those entities greater flexibility in some circumstances.  A qualifying entity must hold only 70%, rather than 90%, of its assets as qualifying property.  Also, a qualifying entity held by an OZ Fund may have greater flexibility to hold cash under rules for working capital.

6. Plan for Exit. The April 2019 regulations provide greater flexibility in selling investments. The legislation suggested that the exclusion of future gains following the 10-year holding period would be available only if the taxpayer sold the interest in the OZ Fund, and not if the OZ Fund sold the underlying asset.  The April regulations make the 10-year exclusion available upon a sale by the OZ Fund of individual assets, thereby making it easier for a multi-asset OZ Fund to both realize the full tax benefits and exit its investments efficiently.  Future regulations may address whether this flexibility is extended to partnerships in which the OZ Fund invests.

7. Not Your Typical Private Equity Fund.

• Private equity funds typically buy a diversified portfolio of assets, grow them, sell the assets during the fund's life cycle as the opportunity arises, and liquidate within five to seven years.
• In contrast the OZ Fund investor will only receive the full tax benefits only if it holds the OZ Fund interest for at least 10 years. Further, based upon the legislation and prior to issuance of the April regulations, OZ Funds were frequently organized as single asset vehicles due to the apparent requirement that the OZ Fund interest be sold in order to realize the tax benefits.
• The April regulations give the OZ Fund the flexibility to sell individual assets after 10 years, rather than OZ Fund interests, while preserving the benefit of the 10-year exclusion for the investors. This would require that the OZ Fund hold the qualifying assets directly, or succeed in selling interests in partnerships or other entities that hold the investments.

8. Guidance on Distributions. The April regulations provide much needed guidance on distributions from an OZ Fund to its investors:

• Generally, cash distributions that do not exceed an investor's basis in an OZ Fund interest will not require an investor to recognize deferred gains, if the distributions do not exceed the investor's basis in the interest. Because an investor's basis in the interest in the OZ Fund is initially zero, other events will be necessary to increase an investor's basis in order to support distributions.
• The basis of an investor's interest in an OZ Fund can be increased by profits allocated to the investor and by the investor's share of the fund's indebtedness. If an investor's basis is increased, distributions of an investor's share of debt may be permitted.
• If an investor makes the investment in the OZ Fund by contributing property, subsequent distributions could cause the investment to be subject to the "disguised sale" rules, with the result that the transfer of property is treated as a sale, not a contribution. As a result, depending upon the circumstances, any distribution made within two years could disqualify the investment.
• Distributions should be evaluated in light of anti-abuse rules, particularly in the case of leveraged distributions in the early years following formation of the OZ Fund.

9. Limited Opportunities for Carried Interests. It will be difficult to structure an investment in an OZ Fund, or an investment by an OZ Fund in another entity, that is both a carried interest and a qualifying investment.  An interest in an OZ Fund received for services does not qualify, so investments in an OZ Fund for a combination of cash and services qualify only to the extent of the interest received for the cash investment.  Similarly, an investment by an OZ Fund in another entity qualifies only to the extent the investment is made for cash.

10. Be Careful With Transfers and Restructurings.  The April regulations define several "inclusion" events, which would require an investor to recognize some or all of the deferred gain prior to December 31, 2026.  These events include certain transfers of interests in an OZ Fund, restructurings of an OZ Fund or the interests in the fund, certain distributions from the OZ Fund, etc.  Investors and fund managers should carefully evaluate any proposed transactions to avoid inadvertently causing deferred gain to be recognized.

A potential tax benefit is not enough to make a bad investment a good deal.  Investors and real estate developers should do their homework first by conducting substantial due diligence on any proposed development in an economically distressed zone.

ILPA Recommends Heighted Standards of  Conduct for Private Fund Advisers

In February 2019, the Institutional Limited Partners Association (“ILPA”) submitted a letter to the SEC describing its recommendations for the Commission’s interpretation of the standards of conduct applicable to private fund advisers under the Investment Advisers Act of 1940 (“Advisers Act”). This was the third letter submitted by ILPA to the SEC in response to its request for comment on the SEC’s proposed interpretation of such standards.

ILPA is a trade organization representing over 470 institutional investors who collectively manage more than $2 trillion in assets, including public and private pension funds, insurance companies, university endowments and sovereign wealth funds. ILPA reported that its members increasingly are allocating capital to private equity and other alternative investment strategies as a means to diversify their portfolios and increase overall investment returns. ILPA expressed its concern to the SEC that, under currently regulatory guidance, private fund managers are able to circumvent the statutory fiduciary duties they owe to their investors – namely the duties of care, loyalty, and good faith.

Under Section 206(2) of the Advisers Act, an investment adviser can be found to have violated its fiduciary duties to its investors even if it only acted negligently. However, as noted by ILPA, a 2007 SEC no-action letter (the “Heitman Letter”) indirectly permits a fund manager to be indemnified by the fund (i.e., its investors) for acts involving simple negligence.  The practical consequence of the Heitman Letter, according to ILPA, is that a fund manager “effectively bears no risk” for acting negligently: if the SEC fines an fund manager for Section 206(2) violations, the fund could be required to indemnify the fund manager as long as the violations did not rise above the standard of care set forth in the fund’s governing document, which typically exculpates the manager unless the manager has been determined to have engaged in fraud, willful misfeasance or gross negligence.  In light of this conflict, ILPA has recommended that the SEC rescind the Heitman Letter and clearly state that the standard of care owed by private fund managers.

In addition to its recommendation regarding the standard of care, ILPA also recommended that the SEC (i) limit the ability of a private fund manager to “pre-clear” actual and potential conflicts of interest via disclosures in a fund’s offering documents, (ii) require private fund managers to explicitly disclose the standard of care owed to fund investors under both state law and the Advisers Act, and (iii) recommend that private fund managers, as a best practice, form a limited partner advisory committee (“LPAC”) for each fund and present all perceived conflicts to the LPAC for resolution.

While it is unclear whether the SEC will adopt any of ILPA’s recommendations, the letters provide meaningful insight into the issues that institutional investors consider important.

Will Congress Expand the Definition of Investors Eligible to Invest in Private Funds?

The 114^th Congress advanced a bill to the Senate called the Fair Investment Opportunities for Professional Experts Act (the “Act”). The Act lowered the requirements/standards on which persons are allowed to invest in private offerings. The current standard is the “accredited investor,” generally an individual who earns at least $200,000 in annual income ($300,000 joint with spouse) or that has a net worth in excess of $1 million (excluding the value of any equity in the investor’s primary residence). The accredited investor standard has been in place since 1982.

While the House moved quickly to pass this legislation, the Senate Committee on Banking, Housing and Urban affairs (the “Senate Banking Committee”) failed to advance the Act beyond introduction.  Catherine Mott, the CEO of Blue Tree Capital, located in Pennsylvania, recently testified in front of the Senate Banking Committee and argued the “accredited investor” standard unfairly limits the potential of entrepreneurs and private equity funds located in between the coasts of the United States from the opportunity to raise capital for private offerings.  She noted that the cost of living in the middle of the country can be significantly lower than cities such as New York or San Francisco, and as a result, annual salaries in the middle of the country may be lower than $200,000.  She argued that lowering the accredited investor standard to allow more investors in the middle of the country to participate in private equity and other capital raising activities would help spur economic growth, job creation and entrepreneurial activity in the region, which ultimately benefits the entire country.

Members on the Senate Banking Committee, such as Thom Tillis (R- N.C.), plan to reintroduce the Act to the 115^th Congress soon.  In addition to easing the restrictions on capital raising eligibility, the Senate’s previous version of the Act expanded the definition of accredited investors to add knowledgeable individuals with certain educational and professional credentials.

Tillis’ version of the Act in the 114^th Congress appeared to have bipartisan support – three of the five cosponsors were Democrats.  It is unclear if the Act would have such bipartisan support in the now-Democrat controlled House of Representatives. Representative Maxine Waters (D-CA), in her role as Chair of the House Financial Services Committee, repeatedly has stated that she is not in favor of reducing regulations related to the financial sector so long as she has her gavel.  In contrast, the Republican-controlled SEC may introduce rules to increase participation in private offerings which are quickly outpacing public offerings in recent years.

SEC Announces 2019 Examination Priorities

On December 20, 2018, the Office of Compliance Inspections and Examinations (“OCIE”) of the SEC announced its examination priorities for 2019, previewing the practices, products, and services that OCIE believes present heightened risk to investors or the integrity of the capital markets.  OCIE, with a staff of over 1,000 in Washington, DC and 10 regional offices, is responsible for examining over 13,000 advisers, of which 35% manage private funds.  OCIE reported that it actually examined 3,150 advisers in 2018, an increase of 10% over 2017.  The six themes for 2019 examinations are: (i) disclosures to retail investors, including information about fees, expenses, and conflicts of interest; (ii) securities exchanges, transfer agents and other registrants responsible for critical market infrastructure; (iii) municipal advisers that provide advice to issuers of municipal bonds; (iv) digital assets, including cryptocurrencies; (v) cybersecurity; and (vi) anti-money laundering (“AML”). 

With respect to private fund advisers, OCIE stated that it would focus on “side by side” management of private investment funds and registered mutual funds.  In connection with OCIE’s priority to protect retail investors, particularly seniors and those saving for retirement, OCIE will examine firms that provide products and services to these investors, including their disclosures related to fees and expenses and conflicts of interests.  OCIE will prioritize examinations of investment advisers that have never been examined, or have not been recently examined and may have substantially grown or changed business models.  In addition, OCIE will continue to focus on critical market registrants impacting the safety and operation of the financial markets, and evaluate the effectiveness of compliance with AML obligations.

As a result of the rapid growth in the digital asset market and market participants, OCIE stated that it will continue to monitor the offer and sale, trading, and management of digital assets and, where assets are “securities,” examine for regulatory compliance.  In particular, through high level inquiries, OCIE will take steps to identify market participants offering, selling, trading, and managing these assets or considering or actively seeking to offer these assets and then assess the extent of their activities.  For firms actively engaged in the digital asset market, OCIE will conduct examinations focused on, among other things, portfolio management of digital assets, trading, custody and safety of client funds and assets, pricing of client portfolios, compliance, and internal controls.

Cybersecurity protection also continues to be an examination focus, with an emphasis that includes proper configuration of network storage devices, information security governance generally, and policies and procedures related to retail trading information security.  Specific to investment advisers, OCIE will emphasize cybersecurity practices at advisers with multiple offices, including those that have recently merged with other investment advisers.  Here, there will be a continued focus on such areas as governance and risk assessment, access rights and controls, data loss prevention, vendor management, training, and incident response.

OCIE’s commitment to retail investors, digital assets, and cybersecurity mirror many of its 2018 priorities.  As has been the case in prior years, OCIE notes that its examination priorities are not exhaustive; and while the stated priorities drive many of OCIE’s examinations, the selection of registered entities to examine and the scope of risk areas to examine is determined through a risk-based approach that includes an analysis of the registrant’s operations, products offered, and other factors.  We encourage our clients to review OCIE’s report for a more thorough understanding of key areas of focus for 2019.

Recent SEC Enforcement Action Against Private Fund Adviser for Improper Fee and Expense Allocations

Private fund advisers should note a recent SEC enforcement action concerning a private equity fund manager’s improper disclosure and practices regarding its allocation of fees and expenses across parallel funds and co-investors.

What Happened

The SEC’s 2019 examination priorities include fees and expenses paid by investors. A case in point is the SEC’s recent enforcement action against Lightyear Capital LLC (“Lightyear”)¹, a registered investment adviser and private fund manager.  Lightyear is the general partner of several private equity funds (the “Flagship Funds”) having over $2 billion in assets under management, as well as several parallel funds established to enable Lightyear employees to invest alongside the Flagship Funds (the “Employee Funds”).  Lightyear also permits Flagship Fund investors to separately co-invest in particular investments alongside the Flagship Funds and Employee Funds (the “Co-Investors”).

Lightyear ran afoul of SEC regulations prohibiting investment advisers (including private fund advisers) from engaging in fraudulent, deceptive or manipulative acts and practices² (the “Anti-Fraud Rules”).  The Anti-Fraud Rules apply to all private fund advisers, whether or not they are registered as investment advisers.

Violation 1: Improper Expense Allocations Among Parallel Funds

Lightyear improperly allocated investment-related expenses among its funds. The Flagship Funds’ private placement memoranda, limited partnership agreements and investment advisory agreements (the “Organizational Documents”) disclosed that the Flagship Funds would pay investment-related expenses. And the Flagship Funds did.  The problem is that the Employee Funds and Co-Investors did not.  Nowhere in its Organizational Documents did Lightyear disclose that the Employee Funds and Co-Investors would not pay their proportionate share of the investment-related expenses.  As a result, the SEC determined that the Flagship Funds’ investors improperly shouldered expenses (nearly $400,000 between 2001 and 2016) that should have been allocated to the Employee Funds and Co-Investors.  Lightyear could have avoided a violation, the SEC acknowledged, if (1) the Organizational Documents disclosed that the Flagship Funds would be allocated the Employee Funds’ and co-investors’ share of expense, or (2) the Flagship Funds’ Advisory Committee approved the fee allocation practice. 

Violation 2: Failure to Properly Offset Management Fees and Seek Broken Deal Expenses

Lightyear also improperly failed to offset about $1 million of management fees with advisory fees paid by portfolio companies.  The Organizational Documents permitted Lightyear to receive advisory fees for services it rendered to portfolio companies on the condition that these advisory fees would offset management fees the Flagship Funds’ investors would otherwise be required to pay. However, Lightyear separately agreed to share with Co-Investors a portion of the portfolio companies’ advisory fees. These fee-sharing arrangements were not disclosed to the Flagship Funds’ investors. In all, Co-Investors received approximately $1 million of advisory fees (paid to them directly by portfolio companies) even though the Co-Investors did not render any advisory services.  The SEC determined that Lightyear violated the Anti-Fraud rules when it failed to disclose the fee-sharing arrangement in the Organizational Documents and failed to offset management fees with the advisory fees paid to Co-Investors .   

Violation 3: Failure to Adopt Written Policies and Procedures

Another violation arose from Lightyear’s statement in the Organizational Documents that it would seek to have broken deal fees paid by prospective portfolio companies. It did not make any such attempt according to the SEC.

As the SEC noted, registered investment advisers are required to adopt and implement written policies and procedures that are reasonably designed to prevent violations of the Investment Advisers Act and rules relating to how fees and expenses are allocated. The SEC found that Lightyear failed to adopt policies and procedures relating to the application of management fee offsets and its undertaking to seek to have broken deal fees paid by prospective portfolio companies.

Important Take-Aways

The SEC has given fair warning it will closely scrutinize fee and expense allocations and practices of private fund managers.  Private fund advisers are cautioned to properly disclose how fees and expenses will be allocated and ensure those allocations actually occur through implementing and monitoring appropriate policies and procedures.

1. In the Matter of Lightyear Capital LLC, Investment Advisers Act of 1940 Release No. 5096 (December 26, 2018) (a link to the Order is provided here)

2. Sections 206(2) and 206(4) of the Investment Advisers Act of 1940 and Rules 206(4)-7 and 206(4)-8 thereunder.

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