(Davis Polk & Wardwell Letterhead)
January 20, 1998
Proposed Amendments to Performance Fee Rules
File No. S7-29-97
Mr. Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
Dear Mr. Katz:
We are writing in response to the Commissions request for comments in Release No. IA-1682 (November 13, 1997) on proposed amendments to modify the eligibility criteria for clients entering into performance fee contracts with investment advisers. We commend the Commissions initiative in providing greater flexibility to investment advisers in structuring performance fee arrangements with eligible clients. In particular, we agree that elimination of the compensation formula and disclosure requirements will greatly facilitate the administration of performance fee arrangements and will not impair the Commissions general policies to ensure appropriate investor protection and disclosure.
We also support the addition of qualified purchasers as an alternative eligibility criteria, because this will avoid the need for further investigation when an adviser has recently or concurrently made a "qualified purchaser" evaluation of its clients. However, we would strongly oppose the Releases suggestion to make this the only criteria for determining client eligibility. That type of restriction would have a materially adverse effect on the feasibility of establishing a private investment company (a "3(c)(1) fund") that relies on Section 3(c)(1) of the Investment Company Act of 1940, which we do not believe is a desirable result. As you know, performance-based fees have been common for private investment companies (many of which could not also meet the Section 3(c)(7) requirements) for many years. If the "qualified purchaser" test becomes the only standard for investor eligibility, 3(c)(1) funds would effectively be prohibited from charging performance fees. This would have a significant adverse effect on small venture capital funds and hedge funds who provide needed capital and liquidity to small businesses. Accordingly, we strongly urge the Commission not to eliminate the net worth and assets under management tests in the final version of Rule 205-3.
We submit that the revised eligibility tests as drafted in the proposed amendments sufficiently ensure the requisite level of financial sophistication. The marginal benefit of a more detailed financial analysis, such as indexing to reflect the effect of inflation, would be outweighed by the additional costs, complexity and burdens of applying the test to each client. The result of this part of the proposal would be inconsistent with the Commissions overall objective of providing greater flexibility in the administration of performance fee arrangements.
We are reluctant to agree that the proposed increases for the net worth and assets under management tests would not have a significant adverse effect on the types of clients that will be eligible for performance fee arrangements. [ In light of the fact that performance-based fees have been common for many years for funds with institutional and high net worth clients, we hope that the Commission will re-examine the availability of performance-based fees for funds with retail clients. We believe that retail clients would benefit from access to investment opportunities where the adviserís economic interests are linked to the performance of a fund. Furthermore, the nature of the asset management industry, where low performance results cause advisers to lose far more than just their fees (e.g., client assets, reputational value), provides strong incentives for advisers to maintain steady performance without taking undue risks and more than outweighs the purported incentive to make risky investments to try to increase fees. ] In our view, increased thresholds are not necessary to ensure adequate client sophistication and any increases beyond the amounts suggested in the proposed amendments would be inappropriate and inconsistent with the Commissions stated intention not to reduce the number or alter the types of clients that will be eligible for performance fees.
In addition, we recommend that the Commission include an exemption for knowledgeable employees for 3(c)(1) funds. Rule 3c-5 of the Investment Company Act currently allows knowledgeable employees to invest in qualified purchaser funds and, as acknowledged by note 36 of the Release, pay the performance fees. The same rationale for allowing an adviser to charge performance fees to knowledgeable employees investing in qualified purchaser funds should, in our view, also apply to knowledgeable employees investing in 3(c)(1) funds, and we see no rational basis for allowing knowledgeable employees to invest in qualified purchaser funds, while not allowing them to invest in 3(c)(1) funds. Thus, we urge that the proposed subparagraph (d)(1)(ii)(B) be revised to read:
"(B) At the time the contract is entered into is either (I) a qualified purchaser as defined in section 2(a)(51)(A) of the Investment Company Act of 1940 (12 U.S.C. 80a-2(a)(51)(A)) or (II) a knowledgeable employee as defined in Rule 3c-5 (Reg. §270.3c5-(a)(4)) under the Investment Company Act of 1940 of a private investment company entering into the contract."
Finally, we note with approval, as confirmed by notes 29 and 36 of the Release, the Commissions position that when the advisory contract is with an entity exempted by Section 3(c)(7), the "look through" requirement of proposed paragraph (b) will not apply. Any other result would, in our view, be totally inconsistent with the National Securities Markets Improvements Act of 1996.
We appreciate the opportunity to comment on these proposed amendments. Please feel free to contact me at the number above, Yukako Kawata at (212) 450-4896 or Sarah Kim at (212) 450-4583 if the Staff would like to discuss any of these points in greater detail.
Very truly yours,
/s/ Pierre de Saint Phalle
Pierre de Saint Phalle