The final version of the Volcker Rule included in the Dodd-Frank Wall Street Reform and Consumer Protection Act does not entirely prohibit all hedge and private equity fund activities by banking enterprises. Nonetheless, the restrictions in the Volcker Rule are substantial and become more restrictive after a transition period. Moreover, responding to the rule is further complicated by uncertainty in the statutory language and the need for implementing regulations.
Given the complexity of the Volcker Rule and the variations as to the types of relationships a banking enterprise may have with a hedge and PE fund complex, there is no single "silver bullet" to respond to its mandates. In the short term, passive investments may be sold, and arrangements presenting potential affiliate transactions may be restructured, but for full compliance with the rule after the four- to nine-year transition period, structural changes will likely ultimately be required for many banking enterprises.
A banking institution's approach to compliance with the rule will depend on a number of factors and might include (1) restructuring hedge and PE fund holdings to avoid "sponsor" status; (2) divesting or converting its insured bank; (3) adjusting existing sponsored hedge and PE fund arrangements to comply with the affiliate transaction rules and/or converting existing funds into fiduciary funds; and (4) divesting its passive, and possibly its sponsored, PE and hedge fund holdings
Stepping down as sponsor. Some banks might seek to divest enough of their interests in a hedge or PE fund so as to avoid the "control" (generally presumed for 25% voting share ownership, but reachable through management and other means as well). However, under Federal Reserve precedent, a bank holding company moving from a controlling to a noncontrolling position in an entity is often difficult. The Federal Reserve has subjected a bank holding company seeking to change its ownership of an insured bank from a controlling to a noncontrolling status to more stringent ownership and/or relationship limitations than would have been required if the bank holding company was seeking a noncontrolling stake in such an insured bank in the first instance. For example, the Federal Reserve has historically limited the ability of a banking enterprise to divest control of a company if it lends the potential acquirers the funds necessary for their purchase, and also limits the amount of equity that a banking enterprise may retain in any transfer. These and other divestiture precedents must be considered in any transaction when a bank holding company is seeking to retain some interest in a bank or manager.
Divesting/converting the insured bank. The Volcker Rule applies only to organizations that control an "insured depository institution" (and foreign banking organizations with a U.S. banking presence). For nonbank-centric organizations that have such entities as a noncritical part of their structure (as is the case, for example, for insurance companies, brokerage firms and other financial organizations that established limited-purpose federal savings banks in connection with the passage of the Gramm-Leach-Bliley Act in order to provide trust services), one possible solution is to sell or liquidate their banking institution, or perhaps to convert the thrift to an uninsured bank, if it has significant trust relationships that the institution desires to maintain.
A qualification to the foregoing is that the Volcker Rule requires the Federal Reserve to impose additional capital and quantitative limits on nonbank financial companies that the reserve deems systemically important and that engage in proprietary trading or investing in hedge or PE funds. As a result, even if a large financial firm disposed of or converted its insured bank, the firm may still find itself subject to some additional burdens under the rule. However, these burdens presumably will be less significant than the outright prohibition imposed on those institutions with insured banks or thrifts. Of course, given that a primary target of the Volcker Rule is Wall Street firms, large financial institutions that own an insured bank or thrift also may face regulatory reluctance to permit charter conversions or other changes that would allow them to avoid the rule.
Adjusting existing arrangements. While the transition period (and possible extensions) provides banks significant time to manage down their existing fund arrangements, the provisions prohibiting entering into "covered transactions" with an affiliated fund may apply from the rule's effective date -- meaning that some of the bank's outstanding arrangements may need to be modified, unless there is some clarification in the rulemaking process. For example, a bank will be prohibited from lending to a fund it advises, or to a third party for the benefit of the fund, which casts doubt not only on existing fund credit lines but also on arrangements such as leverage provided to employee co-investment funds (to the extent that such funds are covered as "private equity funds" by the rule). Although there is a strong argument that, since those arrangements were "entered into" prior to the effective date, the bank can continue to contribute capital when called in respect of its existing commitment to the co-investment fund, it is hoped that the rulemaking process will provide definitive guidance. In addition, banks often guarantee the "clawback" obligation of a fund's general partner, which is the obligation to return to the fund any overdistribution of carried interest received by the general partner. Given that the clawback payment is effectively a repayment of amounts to which the general partner was ultimately not entitled, the clawback payment itself is not likely to be viewed as a covered transaction under the rule. However, the guarantee by the bank of carried interest received by its employees may pose an issue that will either have to be permitted by rulemaking or addressed with the fund's limited partners.
Divesting passive private fund holdings. The Volcker Rule makes clear that banking institutions must divest their passive hedge and PE fund holdings. However, the transition period for compliance has reassured many industry players who feared that a rush of forced divestitures by banks would flood the secondary market and depress purchase prices (and possibly hedge and PE fund valuations). Mature fund interests need not be sold, so long as the hedge or PE fund is wound up and liquidated before the end of the transition period and permitted extensions. (Of course, PE funds often continue well beyond the stated "10 plus two" term in order to deal with lingering illiquid assets or unmatured liabilities, and banks will have to be vigilant to ensure they have truly exited their investments in a timely fashion.) Newer fund interests should be able to be redeemed (for hedge funds) or transferred in an orderly manner over the next several years, and some institutions have started taking these steps already.
Divesting sponsored funds. While the de minimis fiduciary funds rules seem to provide an ability for a banking institution to maintain a hedge or PE fund sponsorship business in some form (the contours of that exception should become clearer with regulation), some banks may decide to exit the business, and others may reallocate their private hedge or PE fund resources and shed one or more strategies or teams. Divestiture will likely take the form of a sale to a strategic buyer or a spinout of the group to create an independent firm. Putting aside the fact that the number of potential strategic buyers will be significantly reduced as a result of the Volcker Rule, and the general risk allocation, strategic and commercial issues associated with any M&A transaction, dispositions of asset management businesses present certain other unique challenges, some of which are exacerbated by the application of the rule.
Disposition of a fund business will generally trigger an assignment of the fund's investment advisory agreement from the existing manager to the successor investment adviser. Under the Investment Advisers Act of 1940, advisory contracts must require a consent right for such an assignment, which in practice usually results in a vote of the fund's investors. In the PE fund context, investors may take advantage of the consent requirement to request significant concessions as a condition to their consent. In addition, investors may demand terms typical of boutique funds (but not institutional funds), such as "key person" provisions giving investors termination rights in the event of the departure of certain management team members. These concessions, if agreed to, can have a meaningful impact on the value of the business if it is being sold to a third-party buyer.
An even bigger concern in light of the Volcker Rule is how to deal with continuing economics in the sold or spun-out entity. Reflecting in part the illiquid nature of a private fund's assets and the uncertainty of cash flows to a fund manager and general partner over time, the purchase price for a fund business often includes a component of participation in the future profits of the managed funds. Under the rule, the form and substance of that component will require careful scrutiny to ensure that it does not rise to the level of a prohibited investment. In the context of a spinout, where the continued support of the former sponsor (including as a lead investor in the fund and as lender to the fund) is typically available for some period while the new firm develops economic and functional independence, this concern is greatly heightened. Because the management team generally does not have the means to buy out the sponsor's funded interest, ongoing economic and governance rights (associated with the bank's funded capital interest and carried interest share) are normally the largest, and sometimes the only, component of the purchase price in a spinout. Structuring the rights and obligations of the selling institution without tripping over the Volcker Rule's prohibitions would be difficult and may push banks to seek a third-party buyer for their economic interest.
Joint ventures and other strategic relationships. Banks that have invested in private fund managers and general partners, either as joint venture partners or as part of a larger strategic relationship, will need to look closely at the substance and structure of their arrangements to determine whether and to what extent they will be subject to the Volcker Rule generally, and whether they also trigger the affiliate transaction restrictions discussed above.
Even absent an investment (direct or indirect) in the underlying fund, if the bank has "control" over the operations or investment activities of an investee entity that controls a fund, the rule will likely apply. Although ownership of 25% or more of the voting securities of the investee entity is one way to evidence control under the Bank Holding Company Act, the full package of the banking institution's rights and obligations will need to be evaluated to determine whether a control relationship exists with respect to a fund, even where the bank has a smaller level of ownership.
Although the Volcker Rule has set forth some new parameters for insured banks' role in the PE arena, it has also raised almost as many questions about the way in which those rules will be interpreted. As the rulemaking evolves, the real scope of the limitations will become clearer. In the meantime, all affected banks, and those who invest in PE with them, will be focused on adapting their PE programs in anticipation of that clarity and the effective date of the rule.
Jennifer J. Burleigh, Gregory J. Lyons and Rebecca F. Silberstein are partners in the New York office of Debevoise & Plimpton LLP. A version of this article originally appeared in the spring issue of the Debevoise & Plimpton Private Equity Report.