provision, which is designed to accommodate existing business practices
typical of venture capital funds, may contribute to efficiency,
competition and capital formation.
---------------------------------------------------------------------------

    \563\ Rule 203(l)-1(a)(3).
    \564\ Oak Investments Letter; SVB Letter.
---------------------------------------------------------------------------

    The final rule excludes from the definition of qualifying portfolio
company any company that borrows or issues debt if the proceeds of such
borrowing or debt are distributed to the venture capital fund in
exchange for the fund's investment in the company. This will allow
qualifying funds to provide financing on a short-term basis to
portfolio companies as a ``bridge'' between funding rounds.\565\ In
addition, a portfolio company can obtain financing for working capital
or expansion needs from typical lenders, effect shareholder buyouts and
conclude a simultaneous debt and equity offering, without affecting the
adviser's eligibility for the venture capital exemption. For the
foregoing reasons, commenters maintained, and we agree, that this
approach would facilitate compliance with the rule without restricting
a portfolio company's access to financing or other capital.\566\ We
believe that this provision of the final rule will benefit venture
capital funds and their investors because it restricts a portfolio
company's ability to incur debt that may implicate Congressional
concerns regarding the use of leverage and effectively distinguishes
advisers to venture capital funds from advisers to leveraged buyout
private equity funds for which Congress did not provide an
exemption.\567\
---------------------------------------------------------------------------

    \565\ See, e.g., supra note 181 and accompanying and following
text.
    \566\ See, e.g., NVCA Letter; SVB Letter.
    \567\ As discussed above, we have imposed this limitation on
qualifying portfolio companies because of the focus on leverage in
the Dodd-Frank Act as a potential contributor to systemic risk as
discussed by the Senate Committee Report, and the testimony before
Congress that stressed the lack of leverage in venture capital
investing. See supra notes 174 and 175.

---------------------------------------------------------------------------

    Our final rule clarifies that an adviser seeking to rely on the
venture capital exemption may treat as a private fund any non-U.S. fund
managed by the adviser that does not offer its securities in the United
States or to U.S. persons.\568\ This treatment will enable an adviser
to rely on the exemption when it manages only funds that satisfy the
venture capital fund definition, regardless of the funds' jurisdiction
of formation and investor base. We believe that this treatment
facilitates capital formation and competition because it would allow an
adviser to sponsor and advise funds in different jurisdictions in order
to meet the different tax or regulatory needs of the fund's investors
without risking the availability of the exemption.
---------------------------------------------------------------------------

    \568\ See note accompanying rule 203(l)-1.
---------------------------------------------------------------------------

    The final rule includes several other characteristics that provide
additional flexibility to venture capital advisers and their funds. For
example, a qualifying fund cannot provide its investors with redemption
or other liquidity rights except in extraordinary circumstances.
Although venture capital funds typically do not permit investors to
redeem their interests during the life of the fund,\569\ the approach
of the final rule allows a venture capital fund to respond to
extraordinary events, including redeeming investors from the fund,
without resulting in a registration obligation for the fund's adviser.
Under the final rule, a venture capital fund must affirmatively
represent itself as pursuing a venture capital strategy to its
investors, a criterion designed to preclude advisers to certain private
funds from claiming an exemption from registration for which they are
not eligible. We believe that this element will allow the Commission
and the investing public (particularly potential investors) to
determine and confirm an adviser's rationale for remaining unregistered
with the Commission.\570\
---------------------------------------------------------------------------

    \569\ See supra notes 255-256 and accompanying text.
    \570\ See Merkl Letter (stating that a description of the
investment strategy is a key element of any private placement
memorandum).
---------------------------------------------------------------------------

    Because it takes into account existing business practices of
venture capital funds and permits some flexibility for venture capital
funds (and their managers) to adopt, or adapt to, new or evolving
business practices, we believe that the final rule will facilitate
advisers' transition to the new exemption. The rule generally limits
investments of a qualifying fund, but creates a basket that will allow
these funds flexibility to make limited investments that may vary from
typical venture capital fund investing practices. The final rule also
provides an adviser flexibility and discretion to structure
transactions in underlying portfolio companies to meet the business
objectives of the fund without creating significant risks of the kind
that Congress suggested should require registration of the fund's
adviser. We expect that this flexibility will benefit investment
advisers that seek to rely on the venture capital exemption because
they will be able more easily to structure and operate funds that meet
the definition now and in the future, but will not permit reliance on
the exemption by private fund advisers that Congress did not intend to
exclude from registration.
    Our final rule also should benefit advisers of existing venture
capital funds that fail to meet the definition of venture capital fund.
Our grandfathering provision permits an adviser to rely on the
exemption provided that each fund that does not satisfy the definition
(i) has represented to investors that it pursues a venture capital
strategy, (ii) has initially sold interests by December 31, 2010, and
(iii) does not sell any additional interests after July 21, 2011.\571\
We expect that most advisers to existing venture capital funds that
currently rely on the private adviser exemption would be exempt from
registration in reliance on the grandfathering provision.\572\ As a
result of this provision, we expect that advisers to existing venture
capital funds that do not meet our definition will benefit because they
can continue to manage existing funds without having to (i) weigh the
relative costs and benefits of registration and modification of fund
operations to conform existing funds with our definition and (ii) incur
the costs associated with registration with the Commission or
modification of existing funds. Advisers to venture capital funds that
were launched by December 31, 2010 and meet the July 21, 2011 deadline
for sales of all securities also would benefit from the grandfathering
provision because they would not have to incur these costs. We believe
that the grandfathering provision will promote efficiency because it
will allow advisers to existing venture capital funds to continue to
rely on the exemption without having to restructure funds that may not
meet the definition.\573\ It also will allow advisers to funds that
were launched by December 31, 2010 and can meet the other requirements
of the grandfathering provision to rely on the exemption without the
potential costs of having to renegotiate with potential investors and
restructure those funds within the limited period before the rule is
effective. After the effective date, advisers that seek to form new
funds will have sufficient time and notice to structure those funds to
meet the definition should they seek to rely on the exemption in
section 203(l) of the Advisers Act.
---------------------------------------------------------------------------

    \571\ Rule 203(l)-1(b).
    \572\ A number of commenters specifically inquired about the
scope of the holding out criterion and noted that under existing
business practice venture capital funds may refer to themselves as
private equity funds. As we discuss in greater detail above, we do
not believe that the name used by a fund is the sole dispositive
factor, and that satisfying the holding out criterion will depend on
all of the facts and circumstances. See supra Section II.A.7. This
criterion is similar to our general approach to antifraud provisions
under the Federal securities laws and our rules.
    \573\ Many commenters supported the grandfathering provision,
and one specifically cited the benefit of avoiding the need to alter
fund terms to the potential detriment of fund investors. AV Letter.
---------------------------------------------------------------------------

    Finally, we believe that our definition would include an additional
benefit for investors and regulators. Section 203(l) of the Advisers
Act provides an exemption specifically for advisers that ``solely''
advise venture capital funds. Currently none of our rules requires that
an adviser exempt from registration specify the basis for the
exemption. We are adopting, however, rules that would require exempt
reporting advisers to identify the exemption(s) on which they are
relying.\574\ Requiring that venture capital funds represent themselves
as such to investors should allow the Commission and the investing
public (particularly potential investors in venture capital funds) to
determine, and confirm, an adviser's rationale for remaining
unregistered with the Commission. This element is designed to deter
advisers to private funds other than venture capital funds from
claiming to rely on an exemption from registration for which they are
not eligible.
---------------------------------------------------------------------------

    \574\ See Implementing Adopting Release, supra note 32, at n.175
and accompanying text.
---------------------------------------------------------------------------

    We believe that existing venture capital funds would meet most, if
not all, of the elements of the final definition of venture capital
fund. Nevertheless, we recognize that some advisers to existing venture
capital funds that seek to rely on the exemption in section 203(l) of
the Advisers Act might have to structure new funds differently to
satisfy the definitional criteria under the final rule. To the extent
that advisers choose not to

change how they structure or manage new funds they launch, those
advisers would have to register with the Commission,\575\ which offers
many benefits to the investing public and facilitates our mandate to
protect investors. Registered investment advisers are subject to
periodic examinations by our staff and are also subject to our rules
including rules on recordkeeping, custody of client funds and
compliance programs. We believe that in general Congress considered
registration to be beneficial to investors because of, among other
things, the added protections offered by registration. Accordingly,
Congress limited the section 203(l) exemption to advisers solely to
venture capital funds.
---------------------------------------------------------------------------

    \575\ See infra text following notes 585, 597-600 and
accompanying text for a discussion of potential costs for advisers
that would have to choose between registering or restructuring
venture capital funds formed in the future.
---------------------------------------------------------------------------

    As noted above, we proposed, and are retaining in the final rule,
certain elements in the portfolio company definition because of the
focus on leverage in the Dodd-Frank Act as a potential contributor to
systemic risk as discussed by the Senate Committee report,\576\ and the
testimony before Congress that stressed the lack of leverage in venture
capital investing.\577\ We expect that distinguishing between venture
capital funds and other private funds that pursue investment strategies
involving financial leverage that Congress highlighted for concern
would benefit financial regulators mandated by the Dodd-Frank Act (such
as the Financial Stability Oversight Council) with monitoring and
assessing potential systemic risks. Because advisers that manage funds
with these characteristics would be required to register, we expect
that financial regulators could more easily obtain information and data
regarding these financial market participants, which should benefit
those regulators to the extent it helps to reduce the overall cost of
systemic risk monitoring and assessment.\578\ We believe that investors
will benefit from enhanced disclosure and oversight of the activities
of private fund advisers by regulators, which in turn could contribute
to a more efficient allocation of capital.
---------------------------------------------------------------------------

    \576\ See supra note 174.
    \577\ See supra note 175.
    \578\ See S. Rep. No. 111-176, supra note 6, at 39 (explaining
the requirement that private funds disclose information regarding
their investment positions and strategies, including information on
fund size, use of leverage, counterparty credit risk exposure,
trading and investment positions and any other information that the
Commission in consultation with the Financial Stability Oversight
Council determines is necessary and appropriate to protect investors
or assess systemic risk).
---------------------------------------------------------------------------

2. Costs
    Costs for advisers to existing venture capital funds. As we
discussed in the Proposing Release and above, we do not expect that the
definition of venture capital fund would result in significant costs
for unregistered advisers to venture capital funds currently in
existence and operating.\579\ We estimate that currently there are 791
advisers to venture capital funds.\580\ We expect that all these
advisers, which we assume currently are not registered in reliance on
the private adviser exemption, would continue to be exempt after the
repeal of that exemption on July 21, 2011 in reliance on the
grandfathering provision.\581\ We anticipate that such advisers to
grandfathered funds will incur minimal costs, if any, to confirm that
existing venture capital funds managed by the adviser meet the
conditions of the grandfathering provision. We estimate that these
costs would be no more than $800 to hire outside counsel to assist in
this determination.\582\
---------------------------------------------------------------------------

    \579\ Proposing Release, supra note 26, at text immediately
preceding text accompanying n.273.
    \580\ See NVCA Yearbook 2011, supra note 152, at Fig. 1.04
(providing the number of ``active'' venture capital advisers, as of
December 2010, that have raised a venture capital fund within the
past eight years; 456 of the total number of venture capital
advisers manage less than $100 million in capital).
    \581\ We estimate that these advisers (and any other adviser
that seeks to remain unregistered in reliance on the exemption under
section 203(l) of the Advisers Act or rule 203(m)-1 thereunder)
would incur, on average, $2,311 per year to complete and update
related reports on Form ADV, including Schedule D information
relating to private funds. See Implementing Adopting Release, supra
note 32, at section V.B.2. This estimate includes internal costs to
the adviser of $2,032 to prepare and submit an initial report on
Form ADV and $279 to prepare and submit annual amendments to the
report. These estimates are based on the following calculations:
$2,032 = ($4,064,000 aggregate costs / 2000 advisers); $279 =
($558,800 aggregate costs / 2,000 advisers). Id. at nn.579-581 and
accompanying text. We estimate that approximately two exempt
reporting advisers would file Form ADV-H annually at a cost of $189
per filing. Id., at n.596 and accompanying text. We further estimate
that three exempt reporting advisers would file Form ADV-NR per year
at a cost of $188 per year. Id., at nn.598-602 and accompanying
text. We anticipate that filing fees for exempt reporting advisers
would be the same as those for registered investment advisers. See
infra note 598. These estimates, some of which differ from the
estimates included in the Proposing Release, supra note 26, are
discussed in more detail in the Implementing Adopting Release, supra
note 32, at section V.B.2.
    \582\ As discussed in the Proposing Release, we expect that a
venture capital adviser would need no more than 2 hours of legal
advice to learn the differences between its current business
practices and the conditions for reliance on the proposed
grandfathering provision. We estimate that this advice would cost
$400 per hour per firm based on our understanding of the rates
typically charged by outside consulting or law firms. See Proposing
Release, supra note 26, at n.293. We did not receive any comments on
these cost estimates.
---------------------------------------------------------------------------

    We recognize, however, that advisers to funds that were launched by
December 31, 2010 but have not concluded offerings to investors may
incur costs to determine whether they qualify for the grandfathering
provision. For example, these advisers may need to assess the impact on
the fund of selling interests to initial third-party investors by
December 31, 2010 and selling interests to all investors no later than
July 21, 2011.\583\ We do not expect that the cost of evaluating the
grandfathering provision would be significant, however, because we
believe that most funds in formation represent themselves as funds that
pursue a venture capital strategy to their potential investors \584\
and the typical fundraising period for a venture capital fund is
approximately 12 months.\585\ Thus, we do not anticipate that venture
capital fund advisers would have to alter typical business practices to
structure or raise capital for venture capital funds being formed.
Nevertheless, we recognize that after the final rule goes into effect,
exempt advisers of such funds in formation may forgo the opportunity to
accept investments from investors that may seek to invest after July
21, 2011 in order to comply with the grandfathering provision.
---------------------------------------------------------------------------

    \583\ We did not receive any comments on the dates specified in
the grandfathering provision. See also supra note 307.
    \584\ See supra note 572.
    \585\ See Breslow & Schwartz, supra note 241, at 2-22 (``Once
the first closing [of a private equity fund] has occurred,
subsequent closings are typically held over a defined period of time
[the marketing period] of approximately six to twelve months.'').
See also Dow Jones Report, supra note 242, at 22.
---------------------------------------------------------------------------

    To the extent that an existing adviser could not rely on the
grandfathering provision with respect to funds in formation, we also
expect that the adviser would not be required to modify its business
practices significantly in order to rely on the exemption. Our final
rule includes many modifications requested by commenters, such as the
non-qualifying basket, and as a result, we expect that these
modifications would reduce some of the costs associated with modifying
current business practices to satisfy the proposed definitional
criteria that commenters addressed.\586\ As we

discuss above, we believe that the final rule better reflects venture
capital activity conducted by venture capital advisers that are likely
to seek to rely on the exemption, and provides flexibility that will
allow these funds to take advantage of new investment opportunities. To
the extent that some commenters expressed concerns that they would have
to divert personnel time from other functions to monitoring inadvertent
failures to meet the definitional elements, we believe that the greater
investment flexibility provided by the rule would offset most of these
compliance costs.
---------------------------------------------------------------------------

    \586\ See, e.g., Charles River Letter; Gunderson Dettmer Letter;
NVCA Letter (arguing that as proposed the rule would have required
venture capital fund advisers to modify their business practices in
order to be eligible for the exemption). See also ABA Letter; Davis
Polk Letter; Oak Investment Letter; SVB Letter (discussing the
potential costs associated with complying with various elements of
the proposed rule such as managerial assistance, venture capital
fund leverage and solely investing in qualifying portfolio
companies).
---------------------------------------------------------------------------

    Our rule does not provide separate definitional criteria for non-
U.S. advisers seeking to rely on the exemption. These advisers might
incur costs to the extent that cash management instruments they
typically acquire may not be ``short-term holdings'' for purposes of
the definition.\587\ We expect that these costs would be mitigated,
however, to the extent that these advisers can continue to acquire
these instruments using the non-qualifying basket.
---------------------------------------------------------------------------

    \587\ See, e.g., EFAMA Letter (asserting that a non-U.S. fund
could not invest in non-U.S. equivalent cash holdings under the
proposed rule).
---------------------------------------------------------------------------

    Costs for new advisers and advisers to new venture capital funds.
We expect that existing advisers that seek to form new venture capital
funds and investment advisory firms that seek to enter the venture
capital industry will incur one-time ``learning costs'' to determine
how to structure new funds they may manage to meet the elements of our
definition. We estimate that on average, there are 23 new advisers to
venture capital funds each year.\588\ We expect that the one-time
learning costs would be no more than between $2,800 and $4,800 on
average for an adviser if it hires an outside consulting or law firm to
assist in determining how the elements of our definition may affect
intended business practices.\589\ Thus, we estimate the aggregate cost
to existing advisers of determining how the definition would affect
funds they plan to launch would be from $64,400 to $110,400.\590\ As
they launch new funds and negotiate with potential investors, these
advisers would have to determine whether it is more cost effective to
register or to structure the venture capital funds they manage to meet
the definition. Such considerations of legal or other requirements,
however, comprise a typical business and operating expense of
conducting new business. New advisers that enter into the business of
managing venture capital funds also would incur such ordinary costs of
doing business in a regulated industry.\591\
---------------------------------------------------------------------------

    \588\ This is the average annual increase in the number of
venture capital advisers between 1981 and 2010. See NVCA Yearbook
2010, supra note 150, at Fig. 1.04; NVCA Yearbook 2011, supra note
152, at Fig. 1.04.
    \589\ We expect that a venture capital adviser would need
between 7 and 12 hours of consulting or legal advice to learn the
differences between its current business practices and the
definition, depending on the experience of the firm and its
familiarity with the elements of the rule. We estimate that this
advice would cost $400 per hour per firm based on our understanding
of the rates typically charged by outside consulting or law firms.
    \590\ This estimate is based on the following calculations: 23 x
$2,800 = $64,400; 23 x $4,800 = $110,400. We did not receive any
comments on these cost estimates.
    \591\ For estimates of the costs of registration for those
advisers that would choose to register, see infra notes 597-600.
---------------------------------------------------------------------------

    In the Proposing Release, we stated that we believed that existing
advisers to venture capital funds would meet most, if not all, of the
elements of the proposed definition.\592\ As discussed above, most
commenters generally acknowledged that the proposed definition would
generally encompass most venture capital investing activity that
typically occurs.\593\ Several noted, however, that they might deviate
from typical investing patterns on occasion or wanted the flexibility
to invest small amounts of capital in investments that would be
precluded by the proposed definition.\594\ Under the final rule,
venture capital funds that qualify for the definition may invest in
non-qualifying investments subject to availability of the non-
qualifying basket, including investments specified by some commenters.
As a result of these modifications, the final definition is more
closely modeled on current business practices of venture capital funds
and provides advisers with flexibility to take advantage of investment
opportunities. As a result, we do not anticipate that many venture
capital fund advisers would have to change significantly the structure
of new funds they launch.
---------------------------------------------------------------------------

    \592\ Proposing Release, supra note 26, at Section V.A.1.
    \593\ See supra note 51.
    \594\ See supra note 52.
---------------------------------------------------------------------------

    We also recognize that some existing venture capital funds may have
characteristics that differ from the criteria in our definition. To the
extent that investment advisers seek to form new venture capital funds
with these characteristics, those advisers would have to choose whether
to structure new venture capital funds to conform to the definition,
forgo forming new funds, or register with the Commission. In any case,
each investment adviser would assess the costs associated with
registering with the Commission relative to the costs of remaining
unregistered (and hence structuring funds to meet our definition in
order to be eligible for the exemption). We expect that this assessment
would take into account many factors, including the size, scope and
nature of an adviser's business and investor base. Such factors will
vary from adviser to adviser, but each adviser would determine for
itself whether registration, relative to other choices, is the most
cost-effective or strategic business option.
    The final rule may have effects on competition and capital
formation. To the extent that advisers choose to structure new venture
capital funds to conform to the definition, or choose not to form new
funds in order to avoid registration, these choices could result in
fewer investment choices for investors, less competition and less
capital formation.\595\ For example, to the extent that new venture
capital funds do not invest in non-qualifying investments in excess of
the 20 percent basket in order to meet the definition, the final rule
could decrease competition and capital formation. If venture capital
funds invest less in non-qualifying investments or more in qualifying
portfolio company securities that are qualifying investments, this
could increase competition among qualifying portfolio companies or
private funds that invest in such companies. To the extent that funds
invest more in less risky but lower yielding non-qualifying
investments, this could decrease competition among investors that seek
to invest in qualifying investments. To the extent that advisers choose
to register in order to structure new venture capital funds without
regard to the definitional criteria or in order to expand their
businesses (e.g., pursue additional investment strategies beyond
venture capital investing or expand the potential investor base to
include investors that are required to invest with registered
advisers), these choices may result in greater investment choices for
investors, greater competition and greater capital formation.\596\
---------------------------------------------------------------------------

    \595\ See, e.g., Lowenstein Letter; NVCA Letter; Venrock Letter.
    \596\ See, e.g., ``Asia's Cash-Poor Small Hedge Funds Vulnerable
to U.S. Rules,'' Bloomberg.com (Feb. 23, 2011) (identifying two fund
of funds managers that either require or prefer to allocate client
assets to advisers registered with the Commission).
---------------------------------------------------------------------------

    Investment advisers to new venture capital funds that would not
meet the definition would have to register and

incur the costs associated with registration (assuming the adviser
could not rely on the private fund adviser exemption). We note that the
costs of registration for advisers that do not qualify for the venture
capital fund adviser exemption flow from the Dodd-Frank Act, which
removed the private adviser exemption on which they currently rely.
    We estimate that the internal cost to register with the Commission
would be $15,077 on average for a private fund adviser,\597\ excluding
the initial filing fees and annual filing fees to the Investment
Adviser Registration Depository (``IARD'') system operator.\598\ These
registration costs include the costs attributable to completing and
periodically amending Form ADV, preparing brochure supplements, and
delivering codes of ethics to clients.\599\ In addition to the internal
costs described above, we estimate that for an adviser choosing to use
outside legal services to complete its brochure, such costs would be
$5,000.\600\
---------------------------------------------------------------------------

    \597\ This estimate is based upon the following calculations:
$15,077 = ($9,627,871 aggregate costs to complete Form ADV / 750
advisers expected to register with the Commission) + ($8,509,000
aggregate costs to complete private fund reporting requirements /
3,800 advisers expected to provide private fund reports). See
Implementing Adopting Release, supra note 32, at nn.612-618 and
accompanying text for a more detailed discussion of these costs.
This also assumes that the performance of this function would most
likely be equally allocated between a senior compliance examiner and
a compliance manager. See id., at n.608. Data from SIFMA's
Management & Professional Earnings in the Securities Industry 2010,
modified to account for an 1,800-hour work-year and multiplied by
5.35 to account for bonuses, firm size, employee benefits and
overhead, suggest that costs for these positions are $235 and $273
per hour, respectively.
    \598\ Filing fees paid for submitting initial and annual filings
through the IARD currently range from $40 to $225 based on the
amount of assets an adviser has under management. The current fee
schedule for registered advisers may be found on our Web site at
http://www.sec.gov/divisions/investment/iard/iardfee.shtml. See
Implementing Adopting Release, supra note 32, at n.566-567 and
accompanying text (assuming for purposes of the analysis that exempt
reporting advisers will pay a fee of $225 per initial or annual
report).
    \599\ Part 1 of Form ADV requires advisers to answer basic
identifying information about their business, their affiliates and
their owners, information that is readily available to advisers, and
thus should not result in significant costs to complete. Registered
advisers must also complete Part 2 of Form ADV and file it
electronically with us. Part 2 requires disclosure of certain
conflicts of interest and could be prepared based on information
already contained in materials provided to investors, which could
reduce the costs of compliance even further.
    \600\ See Implementing Adopting Release, supra note 32, at
n.729.
---------------------------------------------------------------------------

    New registrants would also face costs to bring their business
operations into compliance with the Advisers Act and the rules
thereunder. These costs, however, will vary significantly among
advisers depending on the adviser's size, the scope and nature of its
business, and the sophistication of its compliance infrastructure, but
in any case would be an ordinary business and operating expense of
entering into any business that is regulated.
    We estimated in the Proposing Release that the one-time costs to
new registrants to establish a compliance infrastructure would range
from $10,000 to $45,000, while ongoing annual costs of compliance and
examination would range from $10,000 to $50,000.\601\ Some commenters
suggested that these estimates are too low. Commenters identifying
themselves as ``middle market private equity fund'' advisers estimated
that they would incur one-time registration and compliance costs
ranging from $50,000 to $600,000, followed by ongoing annual compliance
costs ranging from $50,000 to $500,000.\602\ Commenters identifying
themselves as advisers to venture capital funds, however, provided much
lower estimates for one-time registration and compliance costs ranging
from $75,000 to $200,000, followed by ongoing annual compliance costs
ranging from $50,000 to $150,000.\603\
---------------------------------------------------------------------------

    \601\ See Proposing Release, supra note 26, at n.303 and
accompanying text. Our estimate was based on the expectation that
most advisers that might choose to register for business reasons
have already built compliance infrastructures as a matter of good
business practice. Nevertheless, we expect advisers will incur costs
for outside legal counsel to evaluate their compliance procedures
initially and on an ongoing basis. We estimate that the costs to
advisers to establish the required compliance infrastructure will
be, on average, $20,000 in professional fees and $25,000 in internal
costs including staff time. These estimates were prepared in
consultation with attorneys who, as part of their private practice,
have counseled private fund advisers establishing their
registrations with the Commission. We included a range because we
believe there are a number of unregistered advisers of private funds
whose compliance operations are already substantially in compliance
with the Advisers Act and that would therefore experience only
minimal incremental ongoing costs as a result of registration. In
connection with previous estimates we have made regarding compliance
costs for registered advisers, we received comments from small
advisers estimating that their annual compliance costs would be
$25,000 and could be as high as $50,000. See, e.g., Comment Letter
of Joseph L. Vidich (Aug. 7, 2004). Cf. Comment Letter of Venkat
Swarna (Sept. 14, 2004) (estimating costs of $20,000 to $25,000).
These comment letters were submitted in connection with the Hedge
Fund Adviser Registration Release, supra note 14, and are available
on the Commission's Internet Web site at http://www.sec.gov/rules/proposed/s73004.shtml.
    \602\ See, e.g., Comment Letter of Atlas Holdings (Jan. 21,
2011) (``Atlas Letter'') (estimating $500,000 in 2011 and $350,000
per year thereafter for compliance manuals and oversight, employee
trading records, legal documentation, and the hiring of additional
compliance employees); Comment Letter of Sentinel Capital Partners
(Jan. 16, 2011) (``Sentinel Letter'') (estimating between $500,000-
$600,000 in 2011 and more than $375,000 per year thereafter for
compliance manuals and oversight, employee trading records, legal
documentation, and the hiring of additional compliance employees);
Comment Letter of Charlesbank Capital Partners (Jan. 21, 2011)
(``Charlesbank Letter'') (``[A]lthough impossible to quantify at
this point given the absence of regulations, we anticipate a
substantial cost associated with ongoing compliance.''); Comment
Letter of Crestview Advisors, LLC (Jan. 19, 2011) (``Crestview
Letter'') (estimating annual costs of $300,000-$500,000); Comment
Letter of Azalea Capital (Feb. 17, 2011) (``Azalea Letter'')
(estimating $50,000 to $100,000 per year); Comment Letter of Gen Cap
America, Inc. (Jan. 21, 2011) (``Gen Cap Letter'') (estimating
$150,000-$250,000 per year). See also Memorandum to File No. S7-37-
10, dated March 17, 2011, concerning a meeting with certain private
fund representatives, avail. at http://www.sec.gov/comments/s7-37-10/s73710-124.pdf (``File Memorandum'') (estimating that costs for
small firms range from $100,000-$200,000 (exclusive of salary costs
for a CCO)).
    \603\ See VIA Letter (estimating an initial cost of $75,000 or
more and ongoing costs of $50,000 to $150,000 per year); Pine Brook
Letter (estimating initial costs of $125,000 to $200,000 and ongoing
compliance costs of $100,000-150,000 per year).
---------------------------------------------------------------------------

    Although some advisers may incur these costs, the costs of
compliance for a new registrant can vary widely among advisers
depending on their size, activities, and the sophistication of their
existing compliance infrastructure. Advisers, whether registered with
us or not, may have established compliance infrastructures to fulfill
their fiduciary duties towards their clients under the Advisers Act.
Generally, costs will likely be less for new registrants that have
already established sound compliance practices and more for new
registrants that have not yet established sound practices.
    For example, some commenters specifically included in their cost
estimates compensation costs for hiring a dedicated chief compliance
officer (``CCO'').\604\ Our compliance rule, however, does not require
advisers to hire a new individual to serve as a full-time CCO, and the
question of whether an adviser can look to existing staff to fulfill
the CCO requirement internally is firm-specific.\605\
---------------------------------------------------------------------------

    \604\ See, e.g., Katten Foreign Insurance Letter (``In addition,
there are added salary costs for hiring a chief compliance officer.
In all, costs could be expected to total hundreds of thousands of
dollars and hundreds of hours of personnel time for each new
registrant.''); Comment Letter of Cortec Group (Jan. 14, 2011)
(``Cortec Letter'') (``Furthermore, the Act requires we add a
compliance officer (who has to be a senior-level executive), at a
minimum annual compensation of $200,000, yet we do not engage in any
activity the Act wishes to monitor.''). Other commenters may have
included such costs in their estimates although they did not provide
details on individual components. See, e.g., Crestview Letter (``As
part of these new regulations, we are required to develop a
compliance program; hire a compliance officer; custody our private
company stock certificates, which are worthless to any party not
part of the original purchase agreement; and register with the
SEC.'')
    \605\ See Advisers Act rule 206(4)-(7) (requiring, among other
things, an adviser registered or required to be registered under the
Advisers Act to designate an individual (who is a supervised person)
responsible for administering the policies and procedures). In
determining whether existing staff can fulfill the CCO requirement,
advisers may consider factors such as the size of the firm, the
complexity of its compliance environment, and the qualifications of
current staff.

---------------------------------------------------------------------------

    Although we recognize that some newly registering advisers will
need to designate someone to serve as CCO on a full-time basis, we
expect these will be larger advisers--those with many employees and a
sizeable amount of investor assets under management. Because there is
no currently-available comprehensive database of unregistered advisers,
we cannot determine the number of these larger advisers in operation.
These larger advisers that are not yet registered likely already have
personnel who perform similar functions to a CCO, in order to address
the adviser's liability exposure and protect its reputation.
    In smaller advisers, the designated CCO will likely also fill
another function in the adviser, and perform additional duties
alongside compliance matters. Advisers designating a CCO from existing
staff may experience costs that result from shifting responsibilities
among staff or additional compensation, to the extent the individual is
taking on additional compliance responsibilities or giving up other
non-compliance responsibilities. Costs will vary from adviser to
adviser, depending on the extent to which an adviser's staff is already
performing some or all of the requisite compliance functions, the
extent to which the CCO's non-compliance responsibilities need to be
lessened to permit allocation of more time to compliance
responsibilities, and the value to the adviser of the CCO's non-
compliance responsibilities.\606\
---------------------------------------------------------------------------

    \606\ Although some commenters noted that requiring existing
employees to assume compliance-related responsibilities would
involve costs, they did not provide sufficient information on which
we could estimate these costs.
---------------------------------------------------------------------------

    Some commenters asserted that the costs of ongoing compliance would
be substantial.\607\ We anticipate that there may be a number of
currently unregistered advisers whose operations are already
substantially in compliance with the Advisers Act and that would
therefore experience only minimal incremental ongoing costs as a result
of registration. There likely are other currently unregistered
advisers, however, who will face additional ongoing costs to conduct
their operations in compliance with the Advisers Act, and these costs
may be significant for some of these advisers.
---------------------------------------------------------------------------

    \607\ See supra note 602.
---------------------------------------------------------------------------

    We do not have access to information that would enable us to
determine these additional ongoing costs, which are predominantly
internal to the advisers themselves. Incremental ongoing compliance
costs will vary from adviser to adviser depending on factors such as
the complexity of each adviser's activities, the business decisions it
makes in structuring its response to its compliance obligations, and
the extent to which it is already conducting its operations in
compliance with the Advisers Act. Indeed, the broad range of estimated
costs we received reflects the individualized nature of these costs and
the extent to which they may vary even among the relatively small
number of commenters who provided cost estimates.\608\
---------------------------------------------------------------------------

    \608\ Compare Azalea Letter (estimated ongoing compliance costs
of $50,000 to $100,000 per year) with Crestview Letter (estimated
ongoing compliance costs of $300,000 to $500,000 per year). See also
Charlesbank Letter (stating that costs associated with ongoing
compliance are impossible to quantify at this point).
---------------------------------------------------------------------------

    Some commenters expressed concern that compliance costs would be
prohibitive in comparison to their revenues or in relation to their
size or activities.\609\ We note, however, that an adviser is required
to adopt policies and procedures that take into consideration the
nature of that adviser's operations.\610\ We have explained that,
accordingly, we would expect smaller advisers without conflicting
business interests to require much simpler policies and procedures than
larger advisers that, for example, have multiple potential conflicts as
a result of their other lines of business or their affiliations with
other financial service firms.\611\ The preparation of these simpler
policies and procedures and their administration should be much less
burdensome.\612\
---------------------------------------------------------------------------

    \609\ See, e.g., Crestview Letter (``The cost of complying with
these new regulations is estimated to be $300,000-$500,000 per year,
which is a significant sum for a firm that invests in two to three
private companies each year in relation to the benefit it
provides.''); Azalea Letter (``The cost of complying with these new
regulations is estimated to be $50,000 to $100,000 per year, which
is a significant sum for a firm that invests in two to three private
companies each year.''); Gen Cap Letter (``The cost of complying
with these new regulations is estimated to be $150,000-$250,000 per
year, which is a significant sum for a firm that invests in two to
three private companies each year in relation to the benefit it
provides.'').
    \610\ See Compliance Programs of Investment Companies and
Investment Advisers, Investment Advisers Act Release No. 2204 (Dec.
17, 2003) [68 FR 74714 (Dec. 24, 2003)], discussion at section
II.A.1.
    \611\ Id. See also id. at n.13 (noting that even small advisers
may have arrangements, such as soft dollar agreements, that create
conflicts; advisers of all sizes, in designing and updating their
compliance programs, must identify these arrangements and provide
for the effective control of the resulting conflicts).
    \612\ Id., discussion at section II.A.1.
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    We also note that approximately 570 smaller advisers currently are
registered with us.\613\ These advisers have absorbed the compliance
costs associated with registration, notwithstanding the fact that their
assets under management are likely to be smaller than those of an
adviser managing one venture capital fund of average size (e.g., with
$107.8 million in venture capital under management \614\) that may be
required to register because it cannot rely on the venture capital
exemption or the private fund adviser exemption. Moreover, as we
explained in the Proposing Release, in connection with previous
estimates we have made regarding compliance costs for registered
advisers, we received comments from small advisers estimating that
their annual compliance costs would be $25,000 and could be as high as
$50,000.\615\ Finally, as we noted in the Proposing Release, to the
extent there would be an increase in registered advisers, there are
benefits to registration for both investors and the Commission.\616\
---------------------------------------------------------------------------

    \613\ See Implementing Adopting Release, supra note 32, at n.823
and accompanying text (noting that, based on data from the
Investment Adviser Registration Depository as of April 7, 2011, 572
advisers registered with the Commission were small advisers).
    \614\ See NVCA Yearbook 2011, supra note 152, at 9, Fig. 1.0.
    \615\ See Proposing Release, supra note 26, at n.303. See also
supra note 601.
    \616\ See supra text following note 575.
---------------------------------------------------------------------------

    We do not believe that the definition of venture capital fund is
likely to affect whether advisers to venture capital funds would choose
to launch new funds or whether persons would choose to enter into the
business of advising venture capital funds because, as noted above, we
believe the definition, as revised, reflects the way most venture
capital funds currently operate. Thus, for example, we eliminated the
managerial assistance criterion in the proposed definition, expanded
the short-term instruments in which venture capital funds can invest
and provided for a non-qualifying basket. These elements in the
proposal could have resulted in costs to advisers that manage venture
capital funds with business or cash management practices inconsistent
with those proposed criteria and that sought to rely on the
exemption.\617\ As a result, we expect that the definition is not
likely to significantly affect the way in which investment advisers to
these funds do

business and thus compete. For the same reason, we do not believe that
our rule is likely to have a significant effect on overall capital
formation.
---------------------------------------------------------------------------

    \617\ See supra notes 548, 586 and accompanying text.
---------------------------------------------------------------------------

    Other Costs. Some commenters argued in favor of a narrow definition
of venture capital fund in order to preclude advisers to other types of
funds from relying on the definition.\618\ One commenter expressed the
concern that the definition should be narrow so that advisers generally
would be subject to a consistent regulatory regime,\619\ and another
supported incorporating substantive Advisers Act rules, such as
custody, as a condition for reliance on the various exemptions in order
to protect investors.\620\ To the extent that our final rule includes
broader criteria and results in fewer registrants under the Advisers
Act, we acknowledge that this could have an adverse impact on
investors.\621\
---------------------------------------------------------------------------

    \618\ See supra note 43.
    \619\ CalPERS Letter. See also NASAA Letter (supported adding
substantive requirements to the grandfathering provision).
    \620\ CPIC Letter.
    \621\ See supra text accompanying and following note 575
(discussing benefits that result from registration).
---------------------------------------------------------------------------

    Moreover, to the extent that our final rule includes broader
criteria and results in fewer registrants, this also could reduce the
amount of information available to regulators with respect to venture
capital advisers relying on the exemption. Under the final rule,
immediately after it acquires any non-qualifying investment (excluding
short-term holdings), no more than 20 percent of a qualifying fund's
capital commitments may be held in non-qualifying investments
(excluding short-term holdings). As a result, initially, and possibly
for a period of time during the fund's term (subject to compliance with
the other elements of the rule), it may be possible for non-qualifying
investments to comprise most of a qualifying fund's investment
portfolio. The proposal would have required a qualifying fund to be
comprised entirely of qualifying investments, which would have enabled
regulators and investors to confirm with relative ease at any point in
time whether a fund satisfied the definition. Modifying the definition
to include a non-qualifying basket determined as a percentage of a
qualifying fund's capital commitments may increase the monitoring costs
that regulators and investors may incur in order to verify that a fund
satisfies the definition, depending on the length of the fund's
investment period and the frequency with which the fund invests in non-
qualifying investments.
    A number of commenters expressed concerns with certain elements of
the proposed rule, which we are not modifying. Several commenters
suggested that the rule specify that the leverage limit of 15 percent
be calculated without regard to uncalled capital commitments because
they were concerned about the potential for excessive leverage.\622\ We
acknowledge that a leverage limitation which includes uncalled capital
commitments could result in a fund incurring, in the early stages of
the fund's life, a significant degree of leverage by the fund relative
to the fund's overall assets. We believe, however, that the 120-day
limit would mitigate the effects of any such leverage that is incurred
by a venture capital fund seeking to satisfy the definition.
---------------------------------------------------------------------------

    \622\ AFR Letter; AFL-CIO Letter.
---------------------------------------------------------------------------

    Several commenters also argued that the definition of qualifying
portfolio company should include certain subsidiaries that may be owned
by a publicly traded company, such as research and development
subsidiaries, that may seek venture capital funding.\623\ As a result
of our final rule, these types of subsidiaries may have reduced access
to capital investments by qualifying funds, although this cost would be
mitigated by a qualifying fund's investments made through the non-
qualifying basket.
---------------------------------------------------------------------------

    \623\ BCLBE Letter; Dechert General Letter; Gunderson Dettmer
Letter.
---------------------------------------------------------------------------

    Other commenters argued that the definition of venture capital fund
should include funds of venture capital funds.\624\ We have not
modified the rule to reflect this request, because we do not believe
that defining the term in this manner is consistent with the intent of
Congress.\625\ To the extent that an adviser to a fund of venture
capital funds ceases business or ceases to offer new funds in order to
avoid registration with the Commission, this could reduce the pool of
potential investors investing in venture capital funds,\626\ and
potentially reduce capital formation for potential qualifying portfolio
companies.
---------------------------------------------------------------------------

    \624\ See, e.g., Cook Children's Letter; Merkl Letter; SVB
Letter.
    \625\ See supra notes 204-206.
    \626\ See generally Merkl Letter; SVB Letter.
---------------------------------------------------------------------------

B. Exemption for Investment Advisers Solely to Private Funds With Less
Than $150 Million in Assets Under Management

    As discussed in Section II.B, rule 203(m)-1 exempts from
registration under the Advisers Act any investment adviser solely to
private funds that has less than $150 million in assets under
management in the United States. The rule implements the private fund
adviser exemption, as directed by Congress, in section 203(m) of the
Advisers Act and includes provisions for determining the amount of an
adviser's private fund assets for purposes of the exemption and when
those assets are deemed managed in the United States.\627\
---------------------------------------------------------------------------

    \627\ See supra Sections II.B.2-3.
---------------------------------------------------------------------------

1. Benefits
    Method of Calculating Private Fund Assets. As discussed in Section
II.B.2 above and in the Implementing Adopting Release, we are revising
the instructions to Form ADV to provide a uniform method for
calculating assets under management that can be used for regulatory
purposes, including determining eligibility for Commission, rather than
state, registration; reporting assets under management for regulatory
purposes on Form ADV; and determining eligibility for the private fund
adviser exemption under section 203(m) of the Advisers Act and rule
203(m)-1 thereunder and the foreign private adviser exemption under
section 203(b)(3) of the Advisers Act.\628\ We believe that this
uniform approach will benefit regulators (both state and Federal) as
well as advisers, because only a single determination of assets under
management is required for purposes of registration and exemption from
Federal registration.
---------------------------------------------------------------------------

    \628\ See supra notes 332-336 and accompanying text.
---------------------------------------------------------------------------

    The instructions to Form ADV previously permitted, but did not
require, advisers to exclude certain types of managed assets.\629\ As a
result, it was not possible to conclude that two advisers reporting the
same amount of assets under management were necessarily comparable
because either adviser could have elected to exclude all or some
portion of certain specified assets that it managed. We expect that
specifying in rule 203(m)-1 that assets under management must be
calculated according to the instructions to Form ADV will increase
administrative efficiencies for advisers because they will have to
calculate assets under management only once for multiple purposes.\630\
In addition, we believe this

will minimize costs relating to software modifications, recordkeeping,
and training required to determine assets under management for
regulatory purposes. We also believe that the consistent calculation
and reporting of assets under management will benefit investors and
regulators because it will provide enhanced transparency and
comparability of data, and allow investors and regulators to analyze on
a more cost effective basis whether any particular adviser may be
required to register with the Commission or is eligible for an
exemption.
---------------------------------------------------------------------------

    \629\ See Form ADV: Instructions to Part 1A, instr. 5.b(1), as
in effect before the amendments adopted in the Implementing Adopting
Release, supra note 32.
    \630\ See supra Section II.B.2. As discussed below, we are
permitting advisers to calculate their private fund assets annually
in connection with their annual updating amendments to their Forms
ADV, rather than quarterly as proposed. Requiring annual, rather
than quarterly, calculations will be less costly for advisers.
---------------------------------------------------------------------------

    Many commenters generally expressed support for the implementation
of a uniform method of calculating assets under management in order to
maintain consistency for registration and risk assessment
purposes.\631\ Indeed, even some commenters who suggested that we
revise aspects of the method of calculating regulatory assets under
management nonetheless recognized the benefits provided by a uniform
method of valuing assets for regulatory purposes.\632\
---------------------------------------------------------------------------

    \631\ See supra note 339.
    \632\ See, e.g., AIMA Letter (suggested modifications to the
method of calculating regulatory assets under management but also
stated ``[w]e agree that a clear and unified approach for
calculation of AUM is necessary and we believe that using as a
standard the assets for which an adviser has `responsibility' is
appropriate''); O'Melveny Letter (argued that the calculation of
regulatory assets under management as proposed ``does not provide a
suitable basis to determine whether a fund adviser should be subject
to the SEC's regulation'' but also ``agree[s] with the SEC that
`uniformity in the method for calculating assets under management
would result in more consistent asset calculations and reporting
across the industry and, therefore, in more coherent application of
the Advisers Act's regulatory requirements and of the SEC staff's
risk assessment program''').
---------------------------------------------------------------------------

    We believe that the valuation of private fund assets under rule
203(m)-1 will benefit advisers that seek to rely on the private fund
adviser exemption. Under rule 203(m)-1, each adviser annually must
determine the amount of its private fund assets, based on the market
value of those assets, or the fair value of those assets where market
value is unavailable.\633\ We are requiring advisers to fair value
private fund assets so that, for purposes of the exemption, advisers
value private fund assets on a meaningful and consistent basis. As we
stated in the Proposing Release, we understand that many, but not all,
advisers to private funds value assets based on their fair value in
accordance with GAAP or other international accounting standards that
require the use of fair value.\634\ We acknowledged in the Proposing
Release that some advisers to private funds may not use fair value
methodologies, which may be more difficult to apply when the fund holds
illiquid or other types of assets that are not traded on organized
markets.\635\
---------------------------------------------------------------------------

    \633\ See rule 203(m)-1(c) (requiring an adviser to calculate
private fund assets annually, in accordance with General Instruction
15 to Form ADV, which together with rule 204-4 requires advisers
relying on the exemption to determine their private fund assets
annually, in connection with the adviser's annual updating
amendments to its Form ADV). See also rules 203(m)-1(a)(2); 203(m)-
1(b)(2); 203(m)-1(d)(1) (defining ``assets under management'' to
mean ``regulatory assets under management'' in item 5.F of Form ADV,
Part 1A); 203(m)-1(d)(4) (defining ``private fund assets'' to mean
the ``assets under management'' attributable to a ``qualifying
private fund''). As discussed above, advisers are not required to
fair value real estate assets in certain limited circumstances. See
supra note 366 and accompanying text.
    \634\ See Proposing Release, supra note 26, discussion at
section V.B and n.196. See also ABA Letter (recommending that the
Commission consider using a standard of ``fair value'' for valuing
assets and further recommending that if assets were calculated on a
net basis, private funds should be required to prepare audited
annual financial statements in accordance with GAAP (or another
accounting standard acceptable to the Commission), and to maintain
such financial statements under section 203(m)(2)); O'Melveny Letter
(agreeing with the statement in the Proposing Release that many
private funds value assets based on fair value, and noting that
private equity funds in particular are among the private funds that
generally do not fair value).
    \635\ See Proposing Release, supra note 26, discussion at
section V.B. See also infra Section V.B.2.
---------------------------------------------------------------------------

    Frequency of Calculations and the Transition Period. Rule 203(m)-
1(c) specifies that an adviser relying on the exemption must calculate
its private fund assets annually, in accordance with General
Instruction 15 to Form ADV, rather than quarterly, as proposed.
Advisers registered with us and with the states, and now advisers
relying on rule 203(m)-1, must calculate their assets under management
for regulatory purposes annually in connection with their annual
updating amendments to Form ADV. We expect that requiring these types
of advisers to calculate their assets under management for regulatory
purposes on the same schedule, and using the same method, will increase
efficiencies for these advisers.
    The annual calculation also will allow advisers that rely on the
exemption to maintain the exemption despite short-term market value
fluctuations that might result in the loss of the exemption if, for
example, the rule required daily valuations or, to a less significant
extent, quarterly valuations as proposed.\636\ Annual calculations
should benefit these advisers by allowing them to avoid the cost of
more frequent valuations, including costs (such as third-party quotes)
associated with valuing illiquid assets, which may be particularly
difficult to value because of the lack of frequency with which such
assets are traded.\637\ Requiring annual, rather than quarterly,
calculations thus responds to concerns expressed by commenters who
argued that quarterly calculations would (i) impose unnecessary costs
and burdens on advisers, some of whom might not otherwise perform
quarterly valuations; and (ii) inappropriately permit shorter-term
fluctuations in assets under management to require advisers to
register.\638\
---------------------------------------------------------------------------

    \636\ See, e.g., ABA Letter (``[A] semi-annual or annual
measuring period would perhaps be more appropriate, and [] a longer
measuring period would provide an adviser that is exempt from
registration under the Private Fund Adviser Exemption assistance in
avoiding issues arising from temporary increases in asset
values.''); AIMA Letter (``Asset valuation is a substantial
administrative task and is currently undertaken annually for other
purposes (for example, Form ADV), so that a requirement for annual
valuation would appear to strike a fair balance between ensuring
that firms whose AUM is at or above the applicable threshold are
`captured' and avoiding both complications with short-term market
value fluctuations and over-burdening investment advisers.'').
    \637\ See, e.g., Dechert Foreign Adviser Letter (``[T]he Foreign
Asset Manager submits that a yearly calculation (rather than a
quarterly calculation) would be more appropriate, as some private
funds may not provide for quarterly calculations of their NAV.'');
Katten Foreign Advisers Letter (argued for annual calculations,
noting that ``[m]any advisers only determine their aggregate assets
under management on an annual basis''); NASBIC/SBIA Letter (``Unless
sought by the adviser, evaluations on whether to register should be
made no more often than an annual basis.''); Seward Letter (``We
believe that annual measurement of assets for purposes of
determining an adviser's ability to rely on the private fund adviser
exemption would be consistent with the approach established under
NSMIA.'').
    \638\ See AIMA Letter; Dechert Foreign Adviser Letter; Dechert
General Letter; EFAMA Letter; Katten Foreign Advisers Letter; Merkl
Letter; Seward Letter.
---------------------------------------------------------------------------

    An adviser relying on the exemption that reports private fund
assets of $150 million or more in its annual updating amendment to its
Form ADV will not be eligible for the exemption and must register under
the Advisers Act unless it qualifies for another exemption. If the
adviser has complied with all Commission reporting requirements
applicable to an exempt reporting adviser as such, however, it may
apply for registration under the Advisers Act up to 90 days after
filing the annual updating amendment, and may continue to act as a
private fund adviser, consistent with the requirements of rule 203(m)-
1, during this transition period.\639\
---------------------------------------------------------------------------

    \639\ See supra Section II.B.2.b; rule 203(m)-1(c) (requiring
advisers to calculate their private fund assets annually, in
accordance with General Instruction 15 to Form ADV); General
Instruction 15 to Form ADV; rule 204-4.

---------------------------------------------------------------------------

    The transition period should benefit certain advisers. As discussed
above, an adviser that has ``complied with all [Commission] reporting
requirements applicable to an exempt reporting adviser as such'' may
apply for registration with the Commission up to 90 days after filing
an annual updating amendment reflecting that the adviser has private
fund assets of $150 million or more, and may continue to act as a
private fund adviser, consistent with the requirements of rule 203(m)-
1, during this transition period.\640\ In addition, by requiring annual
calculations of private fund assets, we are allowing advisers to whom
the transition period is available 180 days after their fiscal year-
ends to register under the Advisers Act.\641\ We expect that providing
these advisers additional time to register will reduce the burdens
associated with registration by permitting them to register in a more
deliberate and cost-effective manner, as suggested by some
commenters.\642\
---------------------------------------------------------------------------

    \640\ See supra note 378 (explaining that the transition period
is available to an adviser that has complied with ``all [Commission]
reporting requirements applicable to an exempt reporting adviser as
such,'' rather than ``all applicable Commission reporting
requirements,'' as proposed).
    \641\ An adviser must file its annual Form ADV updating
amendment within 90 days after the end of its fiscal year and, if
the transition period is available, may apply for registration up to
90 days after filing the amendment. We proposed, in contrast, to
give advisers three months to register with us after becoming
ineligible to rely on the exemption due to an increase in the value
of their private fund assets as reflected in the proposed quarterly
calculations.
    \642\ See, e.g., Sadis & Goldberg Implementing Release Letter
(``Three (3) months provides an insufficient amount of time for an
investment adviser to (i) complete its ADV Parts 1, 2A and 2B,
including the newly required narrative brochure and brochure
supplement; (ii) submit its completed application to the Commission
through IARD; and (iii) receive its approval from the Commission,
which may take up to forty-five (45) days.''); Shearman Letter
(``Our experience is that registering an investment adviser firm in
a thoughtful and deliberate manner is often closer to a six-month
task (that can sometimes take even longer depending on the need to
engage new or additional service providers to the firm or its
funds), so that an at least 180-day transition period would be more
appropriate.'').
---------------------------------------------------------------------------

    Assets under Management in the United States. Under rule 203(m)-
1(a), all of the private fund assets of an adviser with a principal
office and place of business in the United States are considered to be
``assets under management in the United States,'' even if the adviser
has offices outside of the United States.\643\ A non-U.S. adviser must
count only private fund assets it manages at a place of business in the
United States toward the $150 million limit under the exemption.
---------------------------------------------------------------------------

    \643\ As discussed above, the rule looks to an adviser's
principal office and place of business as the location where it
directs, controls and coordinates its advisory activities. Rule
203(m)-1(d)(3).
---------------------------------------------------------------------------

    As discussed below, we believe that this interpretation of ``assets
under management in the United States'' offers greater flexibility to
advisers and reduces many costs associated with compliance.\644\ These
costs could include difficult attribution determinations that would be
required if assets are managed by teams located in multiple
jurisdictions or if portfolio managers located in one jurisdiction rely
heavily on research or other advisory services performed by employees
located in another jurisdiction. Most commenters who addressed the
issue supported the proposal to treat ``assets under management in the
United States'' as those assets managed at a U.S. place of
business.\645\
---------------------------------------------------------------------------

    \644\ See, e.g., Merkl Letter (stated that this interpretation
would be easier to apply than the alternative interpretation about
which we sought comment which looks to the source of the assets).
    \645\ See, e.g., Debevoise Letter (``In particular, it is our
view that the discussion of the proposed definition of the term
`assets under management in the United States' is a fair reflection
of the policy underlying Section 203(m) of the Advisers Act (as
amended by the Dodd-Frank Act) and is consistent with prior
Commission and Staff statements concerning the territorial scope of
the Advisers Act.''); MAp Airports Letter; Non-U.S. Adviser Letter
(``By adopting a very pragmatic and sensible jurisdictional approach
to regulation, the Commission is appropriately recognizing general
principles of international comity and the fact that activities of
non-U.S. advisers outside the United States are less likely to
implicate U.S. regulatory interests.''). Cf. Sen. Levin Letter
(stated that advisers managing assets in the United States of funds
incorporated outside of the United States ``are exactly the type of
investment advisers to which the Dodd-Frank Act's registration
requirements are intended to apply''). See also supra note 386.
---------------------------------------------------------------------------

    To the extent that this interpretation may increase the number of
advisers subject to registration under the Advisers Act, we anticipate
that our rule also will benefit investors by providing more information
about those advisers (e.g., information that would become available
through Form ADV, Part I). We further believe that this will enhance
investor protection by increasing the number of advisers registering
pursuant to the Advisers Act and by improving our ability to exercise
our investor protection and enforcement mandates over those newly
registered advisers. As discussed above, registration offers benefits
to the investing public, including periodic examination of the adviser
and compliance with rules requiring recordkeeping, custody of client
funds and compliance programs.\646\
---------------------------------------------------------------------------

    \646\ See supra text preceding, accompanying, and following note
575.
---------------------------------------------------------------------------

    Territorial Approach. Under rule 203(m)-1(b), a non-U.S. adviser
with no U.S. place of business may avail itself of the exemption even
if it advises non-U.S. clients that are not private funds, provided
that it does not advise any U.S. clients other than private funds.\647\
We believe that this aspect of the rule, which looks primarily to the
principal office and place of business of an adviser to determine
eligibility for the exemption, will increase the number of non-U.S.
advisers that may be eligible for the exemption. As with other
Commission rules that adopt a territorial approach, the private fund
adviser exemption is available to a non-U.S. adviser (regardless of its
non-U.S. advisory or other business activities) in recognition that
non-U.S. activities of non-U.S. advisers are less likely to implicate
U.S. regulatory interests and in consideration of general principles of
international comity. This aspect of the rule is designed to encourage
the participation of non-U.S. advisers in the U.S. market by applying
the U.S. securities laws in a manner that does not impose U.S.
regulatory and operational requirements on a non-U.S. adviser's non-
U.S. advisory business.\648\
---------------------------------------------------------------------------

    \647\ By contrast, a U.S. adviser may ``solely advise private
funds'' as specified in the statute. Compare rule 203(m)-1(a)(1)
with rule 203(m)-1(b)(1).
    \648\ See supra note 393 and accompanying text.
---------------------------------------------------------------------------

    We believe that our interpretation of the availability of the
private fund adviser exemption for non-U.S. advisers, as reflected in
the rule, will benefit those advisers by facilitating their continued
participation in the U.S. market with limited disruption to their non-
U.S. advisory or other business practices.\649\ This approach also
should benefit U.S. investors and facilitate competition in the market
for advisory services to the extent that it maintains or increases U.S.
investors' access to potential advisers. Furthermore, because non-U.S.
advisers that elect to avail themselves of the exemption would be
subject to certain reporting requirements,\650\ we believe that our
approach will increase the availability of information publicly
available to U.S. investors who invest in the private funds advised by
such exempt but reporting non-U.S. advisers.
---------------------------------------------------------------------------

    \649\ See supra Section II.B.3.
    \650\ See Implementing Adopting Release, supra note 32,
discussion at section II.B.
---------------------------------------------------------------------------

    Most of the commenters who considered this aspect of the rule
supported it, citing, among other benefits, that this interpretation
would effectively protect U.S. markets and investors and is consistent
with the Commission's overall territorial

approach to Advisers Act regulation.\651\ For example, one commenter
stated that the ``jurisdictional approach to only considering U.S.
activities for non-U.S. advisors is prudent as it focuses on what
causes systematic [sic] risks to the U.S.'' \652\ Another noted that
non-U.S. persons dealing with non-U.S. advisers would not expect to
benefit from the protections provided by the Advisers Act.\653\ Another
stated that this approach, together with our interpretation of ``assets
under management in the United States,'' will ``avoid the issues
associated with conflicting and overlapping regulation.'' \654\
---------------------------------------------------------------------------

    \651\ ABA Letter; Debevoise Letter; Dechert Foreign Adviser
Letter; Gunderson Dettmer Letter; Katten Foreign Advisers Letter;
MAp Airports Letter; Merkl Letter; Wellington Letter.
    \652\ Wellington Letter.
    \653\ Debevoise Letter. See also ABA Letter (``When, in the
private fund context, United States investors invest with a non-
United States-based investment manager, they understand they are not
being afforded the investor protection safeguards of the United
States Investment Advisers Act.''); Avoca Letter (``It is reasonable
to assume that U.S. investors who purchase shares of a private fund
(as defined in section 202(a)(29)) will not expect an investment
adviser that has no United States presence to be registered with the
U.S. SEC as an investment adviser.'').
    \654\ ABA Letter.
---------------------------------------------------------------------------

    Rule 203(m)-1(b) uses the term ``United States person,'' which
generally incorporates the definition of a ``U.S. person'' in
Regulation S.\655\ We believe that generally incorporating the
definition of a ``U.S. person'' in Regulation S will benefit advisers,
because Regulation S provides a well-developed body of law that, in our
view, appropriately addresses many of the questions that will arise
under rule 203(m)-1. Moreover, advisers to private funds and their
counsel currently must be familiar with the definition of ``U.S.
person'' under Regulation S in order to comply with other provisions of
the Federal securities laws. Commenters generally supported defining
``United States person'' by reference to Regulation S, confirming that
the definition is well developed and understood by advisers.\656\
---------------------------------------------------------------------------

    \655\ Rule 203(m)-1(d)(8) (defining a ``United States person''
as any person that is a ``U.S. person'' as defined in Regulation S,
except that any discretionary account or similar account that is
held for the benefit of a United States person by a dealer or other
professional fiduciary is a United States person if the dealer or
professional fiduciary is a related person of the investment adviser
relying on rule 203(m)-1 and is not organized, incorporated, or (if
an individual) resident in the United States). As discussed above,
two commenters that generally supported our incorporation of the
definition in Regulation S also urged us to modify our proposed
definition in certain respects. See supra notes 409-413 and
accompanying text. We decline to accept these suggestions for the
reasons discussed in Section II.B.4, and we continue to believe that
advisers will benefit from the efficiencies created by our general
incorporation of the definition of ``U.S. person'' in Regulation S.
    \656\ AIMA Letter; CompliGlobe Letter; Debevoise Letter; Dechert
General Letter; Gunderson Dettmer Letter; Katten Foreign Advisers
Letter; O'Melveny Letter.
---------------------------------------------------------------------------

    We also are adding a note to rule 203(m)-1 that clarifies that a
client will not be considered a United States person if the client was
not a United States person at the time of becoming a client of the
adviser.\657\ This will benefit non-U.S. advisers, which might, absent
this note, incur costs in trying to determine whether they would be
permitted to rely on rule 203(m)-1 if one of their existing non-U.S.
clients that is not a private fund becomes a United States person, for
example if a natural person client residing abroad relocates to the
United States.\658\ The non-U.S. adviser could at that time be
considered to have a United States person client other than a private
fund.
---------------------------------------------------------------------------

    \657\ See supra Section II.B.4.
    \658\ See EFAMA Letter (argued that an analogous note in the
foreign private adviser exemption, revised consistent with its
comments, ``also should apply to the `private fund adviser
exemption' and the `venture capital fund exemption' ''); IFIC Letter
(``We ask for clarification from the SEC as to whether it will apply
the [analogous note to the foreign private adviser exemption] in
other contexts for purposes of compliance with the U.S. Federal
securities laws, including compliance with Rule 12g3-2(b) of the
1934 Act.'').
---------------------------------------------------------------------------

    Definition of a Qualifying Private Fund. We proposed to define a
``qualifying private fund'' as ``any private fund that is not
registered under section 8 of the Investment Company Act of 1940 (15
U.S.C 80a-8) and has not elected to be treated as a business
development company pursuant to section 54 of that Act (15 U.S.C. 80a-
53).'' \659\ We are modifying rule 203(m)-1 to also permit an adviser
to treat as a ``private fund,'' and thus as a ``qualifying private
fund,'' an issuer that qualifies for an exclusion from the definition
of ``investment company,'' as defined in section 3 of the Investment
Company Act, in addition to those provided by section 3(c)(1) or
3(c)(7) of that Act.\660\ Absent this modification, an adviser to a
section 3(c)(1) or 3(c)(7) fund would lose the exemption if the fund
also qualified for another exclusion.\661\ For example, an adviser to a
section 3(c)(1) or 3(c)(7) fund would lose the exemption if the fund
also qualified for another exclusion, even though the adviser may be
unaware of the fund so qualifying and the fund does not purport to rely
on the other exclusion.
---------------------------------------------------------------------------

    \659\ See proposed rule 203(m)-1(e)(5).
    \660\ Rule 203(m)-1(d)(5). An adviser relying on this provision
must treat the fund as a private fund under the Advisers Act and the
rules thereunder for all purposes (e.g., reporting on Form ADV). Id.
    \661\ A fund that qualifies for an additional exclusion would
not be a private fund, because a ``private fund'' is a fund that
would be an investment company as defined in section 3 of the
Investment Company Act but for section 3(c)(1) or 3(c)(7) of that
Act. See supra Section II.B.1.
---------------------------------------------------------------------------

    Expanding the range of potential ``qualifying private funds,''
therefore, should benefit advisers to funds that also qualify for other
exclusions by permitting these advisers to rely on the exemption.\662\
It also will prevent advisers from violating the Advisers Act's
registration requirements solely because their funds qualify for
another exclusion. In addition, advisers will not be required to incur
the time and expense required to assess whether the funds they advise
also qualify for an additional exclusion.
---------------------------------------------------------------------------

    \662\ See, e.g., Dechert General Letter (argued that advisers
should be permitted to treat as a private fund for purposes of rule
203(m)-1 a fund that qualifies for another exclusion from the
definition of ``investment company'' in the Investment Company Act
in addition to section 3(c)(1) or 3(c)(7), such as section
3(c)(5)(C), which excludes certain real estate funds).
---------------------------------------------------------------------------

2. Costs
    Assets under Management in the United States. As noted above, under
rule 203(m)-1, we look to an adviser's principal office and place of
business as the location where the adviser directs, controls or has
responsibility for the management of private fund assets, and therefore
as the place where all the adviser's assets are managed.\663\ Thus, a
U.S. adviser must include all of its private fund assets under
management in determining whether it exceeds the $150 million limit
under the exemption. We also look to where day-to-day management of
private fund assets may occur for purposes of a non-U.S. adviser, whose
principal office and place of business is outside of the United
States.\664\ A non-U.S. adviser therefore would count only the private
fund assets it manages at a place of business in the United States in
determining the availability of the exemption. This approach is similar
to the way we have identified the location of the adviser for
regulatory purposes under our current rules,\665\ and we believe it is
the way in which most advisers would have interpreted the exemption
without our rule.\666\
---------------------------------------------------------------------------

    \663\ See supra note 385 and accompanying text.
    \664\ See supra note 384 and accompanying text.
    \665\ See supra note 385 and accompanying text.
    \666\ We do not believe that the statutory text refers to where
the assets themselves may be located or traded or the location of
the account where the assets are held. In today's market, using the
location of assets would raise numerous questions of where a
security with no physical existence is ``located.'' Although
physical stock certificates were once sent to investors as proof of
ownership, stock certificates are now centrally held by securities
depositories, which perform electronic ``book-entry'' changes in
their records to document ownership of securities. This arrangement
reduces transmittal costs and increases efficiencies for securities
settlements. See generally Bank for International Settlements, The
Depository Trust Company: Response to the Disclosure Framework for
Securities Settlement Systems (2002), http://www.bis.org/publ/cpss20r3.pdf. An account also has no physical location even if the
prime broker, custodian or other service that holds assets on behalf
of the customer does. Each of these approaches would be confusing
and extremely difficult to apply on a consistent basis.

---------------------------------------------------------------------------

    We believe that our approach will promote efficiency because
advisers are familiar with it, and we do not anticipate that U.S.
advisers to private funds would likely change their business models,
the location of their private funds or the location where they manage
assets as a result of the rule. As noted in the Proposing Release, we
expect that non-U.S. advisers may, however, incur minimal costs to
determine whether they have assets under management in the United
States. We estimate that these costs would be no greater than $6,730
per adviser to hire U.S. counsel and perform an internal review to
assist in this determination, in particular to assess whether a non-
U.S. affiliate manages a discretionary account for the benefit of a
United States person under the rule.\667\
---------------------------------------------------------------------------

    \667\ We estimated in the Proposing Release that a non-U.S.
adviser would need no more than 10 hours of external legal advice
(at $400 per hour) and 10 hours of internal review by a senior
compliance officer (at $294 per hour) to evaluate whether the
adviser would qualify for the exemption provided by rule 203(m)-1,
for a total estimated cost of $6,940. We did not receive any
comments on these estimates. We are, however, decreasing this
estimate slightly, to $6,730, to account for more recent salary data
reflecting a $273 per hour wage for senior compliance officers. See
supra note 597. One commenter suggested that we presume for non-U.S.
advisers, like U.S. advisers, that all of their private fund assets
are managed at their principal office and place of business. Katten
Foreign Advisers Letter. We decline to adopt this suggestion for the
reasons discussed above. See supra notes 388-389 and accompanying
text. In addition, the commenter did not convince us that the costs
we estimate a non-U.S. adviser would incur in determining if it has
assets under management in the United States justify foregoing our
approach and its attendant benefits. To the extent the commenter
suggests that we adopt an alternative interpretation to conserve our
resources, we note that any interpretation that requires additional
advisers to register will contribute to our workload, and
registration provides benefits of its own, as discussed above.
---------------------------------------------------------------------------

    As noted above, because the rule is designed to encourage the
participation of non-U.S. advisers in the U.S. market, we believe that
it will have minimal regulatory and operational burdens on non-U.S.
advisers and their U.S. clients. Non-U.S. advisers may rely on the rule
if they manage U.S. private funds with more than $150 million in assets
at a non-U.S. location as long as the private fund assets managed at a
U.S. place of business are less than $150 million. This could affect
competition with U.S. advisers, which must register when they have $150
million in private fund assets under management regardless of where the
assets are managed.
    In contrast to the many commenters who supported our approach, one
commenter argued that treating U.S. and non-U.S. advisers differently
would disadvantage U.S.-based advisers by permitting non-U.S. advisers
to accept substantial amounts of money from U.S. investors without
having to comply with certain U.S. regulatory requirements, and would
cause advisers to move offshore or close U.S. offices to avoid
regulation.\668\
---------------------------------------------------------------------------

    \668\ Portfolio Manager Letter. See also Tuttle Implementing
Release Letter (argued that businesses may move offshore if they
become too highly regulated in the United States).
---------------------------------------------------------------------------

    As we explained in the Proposing Release, we believe that our
interpretation recognizes that non-U.S. activities of non-U.S. advisers
are less likely to implicate U.S. regulatory interests and is in
keeping with general principles of international comity.\669\ The rule
also is designed to encourage the participation of non-U.S. advisers in
the U.S. market by applying the U.S. securities laws in a manner that
does not impose U.S. regulatory and operational requirements on a non-
U.S. adviser's non-U.S. advisory business.\670\ Non-U.S. advisers
relying on rule 203(m)-1 will remain subject to the Advisers Act's
antifraud provisions and will become subject to the requirements
applicable to exempt reporting advisers. Moreover, the commenter
appears to suggest that an adviser that moves offshore to avoid
registering under the Advisers Act would not be subject to any
regulation as an investment adviser, but we understand that most non-
U.S. advisers to private funds locate in major financial centers in
jurisdictions that regulate investment advisers. We therefore believe
that any competitive consequences to U.S. advisers will be
diminished.\671\
---------------------------------------------------------------------------

    \669\ See supra note 392 and accompanying text.
    \670\ See supra note 393 and accompanying text.
    \671\ See also supra Section II.B.3. We also decline to accept a
separate commenter's suggestion to permit U.S. advisers to exclude
assets managed at non-U.S. offices. See supra notes 395-396 and
accompanying and following text.
---------------------------------------------------------------------------

    As we acknowledged in the Proposing Release, to avail themselves of
rule 203(m)-1, some advisers might choose to move their principal
offices and places of business outside of the United States and manage
private funds at those locations.\672\ This could result in costs to
U.S. investors in private funds that are managed by these advisers
because they would not have the investor protection and other benefits
that result from an adviser's registration under the Advisers Act. We
do not expect that many advisers would be likely to relocate for
purposes of avoiding registration, however, because, as we explained in
the Proposing Release, we understand that the primary reasons for
advisers to locate in a particular jurisdiction involve tax and other
business considerations.\673\
---------------------------------------------------------------------------

    \672\ See Proposing Release, supra note 26, discussion at
section V.B.2.
    \673\ We note that the two commenters that suggested U.S.
advisers might relocate to rely on the rule provided no data as to
the likelihood that this would occur or the number or types of
advisers who might relocate, and neither refuted our contention that
the primary reasons for advisers to locate in a particular
jurisdiction involve tax and other business considerations. See
Portfolio Manager Letter; Tuttle Implementing Release Letter.
---------------------------------------------------------------------------

    We also note that if an adviser did relocate, it would incur the
costs of regulation under the laws of most of the foreign jurisdictions
in which it may be likely to relocate, as well as the costs of
complying with the reporting requirements applicable to exempt
reporting advisers, unless it also qualified for the foreign private
adviser exemption. We do not believe, in any case, that the adviser
would relocate if relocation would result in a material decrease in the
amount of assets managed because that loss would likely not justify the
benefits of avoiding registration, and thus we do not believe our rule
is likely to have an adverse effect on capital formation.
    One commenter also proposed that we adopt an alternative approach
that would look to the source of the assets.\674\ Under this
alternative approach, a non-U.S. adviser would count the assets of
private funds attributable to U.S. investors towards the $150 million
threshold, regardless of the location where it manages private funds,
and a U.S. adviser would exclude

assets that are not attributable to U.S. investors. As a result, more
U.S. advisers might be able to rely on rule 203(m)-1 under this
alternative interpretation. To the extent that non-U.S. advisers have
U.S. investors in private funds that they manage at a non-U.S.
location, fewer non-U.S. advisers would be eligible for the exemption.
Thus, this alternative could increase costs for those non-U.S. advisers
that would have to register but reduce costs for those U.S. advisers
that would not have to register.
---------------------------------------------------------------------------

    \674\ Portfolio Manager Letter (``If you raise significant money
here you should be on the same level playing field as the fund
managers located here so that we can compete fairly.''). See also
Merkl Letter (suggested that it ``may be useful'' to look both to
assets managed from a U.S. place of business and assets contributed
by U.S. private fund investors to address both investor protection
and systemic risk concerns). Another commenter suggested that we
determine the ``assets under management in the United States'' for
U.S. advisers by reference to the amount of assets invested, or ``in
play,'' in the United States. Dougherty Letter. We decline to adopt
this approach because it would be difficult for advisers to
ascertain and monitor which assets are invested in the United
States, and this approach thus would be confusing and extremely
difficult to apply on a consistent basis. See supra note 394 and
accompanying and following text.
---------------------------------------------------------------------------

    This alternative approach also could adversely affect U.S.
investors to the extent that it discouraged U.S. advisers from managing
U.S. investor assets. A U.S. adviser might avoid managing assets from
U.S. investors because, under this alternative interpretation, the
assets would be included in determining whether the adviser was
eligible to rely on rule 203(m)-1. This could reduce competition for
the management of assets from U.S. investors. The likelihood of U.S.
advisers seeking to avoid registration in this way might be mitigated,
however, to the extent that the loss of managed assets of U.S.
investors would exceed the savings from avoiding registration.
    Method of Calculating Private Fund Assets. Rule 203(m)-1
incorporates the valuation methodology in the instructions to Form ADV,
which requires advisers to use the market value of private fund assets,
or the fair value of private fund assets where market value is
unavailable, when determining regulatory assets under management and to
include in the calculation certain types of assets advisers previously
were permitted to exclude. The revised instructions also clarify that
this calculation must be done on a gross basis.
    We acknowledged in the Proposing Release that some private fund
advisers may not use fair value methodologies.\675\ As we explained
there, the costs incurred by those advisers to use fair valuation
methodologies would vary based on factors such as the nature of the
asset, the number of positions that do not have a market value, and
whether the adviser has the ability to value such assets internally or
would rely on a third party for valuation services.\676\ Nevertheless,
we continue to believe that the requirement to use fair value would not
result in significant costs for these advisers, particularly in light
of our decision to require annual, rather than quarterly, valuations.
We also understand that private fund advisers, including those that may
not use fair value methodologies for reporting purposes, perform
administrative services, including valuing assets, internally as a
matter of business practice.\677\
---------------------------------------------------------------------------

    \675\ See supra note 634 and accompanying and following text. In
addition, we estimate in the Implementing Adopting Release, based on
registered advisers' responses to Items 5.D, 7.B, and 9.C of Form
ADV, that approximately 3% of registered advisers have at least one
private fund client that is not audited, and that these advisers
therefore may incur costs to fair value their private fund assets.
See Implementing Adopting Release, supra note 32, at nn.634-641 and
accompanying text. We also estimate in that release that each of
these registered advisers that potentially would incur costs as a
result of the fair value requirement would incur costs of $37,625 on
an annual basis. Id., at n.641 and accompanying text. This is the
middle of the range of the estimated fair value costs, which range
from $250 to $75,000 annually. Id. See also infra notes 680-681 and
accompanying text.
    \676\ See Proposing Release, supra note 26, at n.323 and
accompanying text.
    \677\ For example, a hedge fund adviser may value fund assets
for purposes of allowing new investments in the fund or redemptions
by existing investors, which may be permitted on a regular basis
after an initial lock-up period. An adviser to private equity funds
may obtain valuations of portfolio companies in which the fund
invests in connection with financing obtained by those companies.
Advisers to private funds also may value portfolio companies each
time the fund makes (or considers making) a follow-on investment in
the company. Private fund advisers could use these valuations as a
basis for complying with the fair valuation requirement applicable
to private fund assets.
---------------------------------------------------------------------------

    A number of commenters objected to the requirement to determine
private fund assets based on fair value, generally arguing that the
requirement would cause those advisers that did not use fair value
methods to incur additional costs, especially if the private funds'
assets that they manage are illiquid and therefore difficult to fair
value.\678\ As discussed in Section II.B.2, we are sensitive to the
costs this new requirement will impose, and we requested comment in the
Proposing Release on our estimates concerning the costs related to fair
value. Commission staff estimates that such an adviser would incur
$1,320 in internal costs to conform its internal valuations to a fair
value standard.\679\ In the event a fund does not have an internal
capability for valuing specific illiquid assets, we expect that it
could obtain pricing or valuation services from an outside
administrator or other service provider. Staff estimated that the cost
of such a service would range from $1,000 to $120,000 annually, which
could be borne by several funds that invest in similar assets or have
similar investment strategies.\680\ We did not receive any comments on
these estimates. These estimates, however, assumed that an adviser
would be required to calculate the fair value of its private funds
assets quarterly, as required by rule 203(m)-1 as proposed. We are
reducing the estimated range to $250 to $75,000 annually to reflect
that rule 203(m)-1 requires advisers to calculate their private fund
assets annually, rather than quarterly as proposed.\681\
---------------------------------------------------------------------------

    \678\ See, e.g., Gunderson Dettmer Letter; Merkl Letter;
O'Melveny Letter; Seward Letter; Wellington Letter.
    \679\ We estimated in the Proposing Release that such an adviser
would incur $1,224 in internal costs to conform its internal
valuations to a fair value standard. See Proposing Release, supra
note 26, at n.325. We received no comments on this estimate. We are,
however, increasing this estimate slightly, to $1,320, to account
for more recent salary data. This revised estimate is based upon the
following calculation: 8 hours x $165/hour = $1,320. The hourly wage
is based on data for a fund senior accountant from SIFMA's
Management & Professional Earnings in the Securities Industry 2010,
modified by Commission staff to account for an 1800-hour work-year
and multiplied by 5.35 to account for bonuses, firm size, employee
benefits and overhead.
    \680\ These estimates are based on conversations with valuation
service providers. We understand that the cost of valuation for
illiquid fixed income securities generally ranges from $1.00 to
$5.00 per security, depending on the difficulty of valuation, and is
performed for clients on a weekly or monthly basis. We understand
that appraisals of privately placed equity securities may cost from
$3,000 to $5,000 with updates to such values at much lower prices.
For purposes of this cost benefit analysis, we are estimating the
range of costs for (i) a private fund that holds 50 fixed income
securities at a cost of $5.00 to price and (ii) a private fund that
holds privately placed securities of 15 issuers that each cost
$5,000 to value initially and $1,000 thereafter. We believe that
costs for funds that hold both fixed-income and privately placed
equity securities would fall within the maximum of our estimated
range. We note that funds that have significant positions in
illiquid securities are likely to have the in-house capacity to
value those securities or already subscribe to a third-party service
to value them. We note that many private funds are likely to have
many fewer fixed income illiquid securities in their portfolios,
some or all of which may cost less than $5.00 per security to value.
Finally, we note that obtaining valuation services for a small
number of fixed income positions on an annual basis may result in a
higher cost for each security or require a subscription to the
valuation service for those that do not already purchase such
services. The staff's estimate is based on the following
calculations: (50 x $5.00 x 4 = $1,000); (15 x $5,000) + (15 x
$1,000 x 3) = $120,000).
    \681\ The staff's revised estimate is based on the following
calculations: (50 x $5.00 = $250; 15 x $5,000 = $75,000). See also
supra note 680.
---------------------------------------------------------------------------

    In addition, as discussed above, we have taken several steps to
mitigate these costs.\682\ While many advisers will calculate fair
value in accordance with GAAP or another international accounting
standard,\683\ other advisers acting consistently and in good faith may
utilize another fair valuation standard.\684\ While these other
standards may not provide the quality of information in financial
reporting (for

example, of private fund returns), we expect these calculations will
provide sufficient consistency for the purposes that regulatory assets
under management serve in our rules, including rule 203(m)-1.\685\
---------------------------------------------------------------------------

    \682\ See supra notes 363-366 and accompanying text.
    \683\ See supra note 364 and accompanying text.
    \684\ See supra note 365 and accompanying text.
    \685\ See supra note 366 and accompanying text.
---------------------------------------------------------------------------

    Use of the alternative approaches recommended by commenters (e.g.,
cost basis or any method required by the private fund's governing
documents other than fair value) would not meet our objective of having
more meaningful and comparable valuation of private fund assets, and
could result in a significant understatement of appreciated assets.
Moreover, these alternative approaches could permit advisers to
circumvent the Advisers Act's registration requirements. Permitting the
use of any valuation standard set forth in the governing documents of
the private fund other than fair value could effectively yield to the
adviser the choice of the most favorable standard for determining its
registration obligation as well as the application of other regulatory
requirements. For these reasons and those discussed in the Implementing
Adopting Release, commenters did not persuade us that the extent of the
additional burdens the fair value requirement would impose on some
advisers to private funds would be inappropriate in light of the value
of a more meaningful and consistent calculation by all advisers to
private funds.
    We also do not expect that advisers' principals (or other
employees) generally will cease to invest alongside the advisers'
clients as a result of the inclusion of proprietary assets, as some
commenters suggested.\686\ If private fund investors value their
advisers' co-investments as suggested by these commenters, we expect
that the investors will demand them and their advisers will structure
their businesses accordingly.\687\
---------------------------------------------------------------------------

    \686\ See, e.g., ABA Letter; Katten Foreign Advisers Letter;
Seward Letter.
    \687\ See supra note 347 and accompanying text.
---------------------------------------------------------------------------

    One commenter also argued that including proprietary assets would
deter non-U.S. advisers that manage large sums of proprietary assets
from establishing U.S. operations and employing U.S. residents.\688\
Such an adviser, however, would not be ineligible for the private fund
adviser exemption merely because it established U.S. operations. As
discussed in Section II.B, a non-U.S. adviser may rely on the private
fund adviser exemption while also having one or more U.S. places of
business, provided it complies with the exemption's conditions.
---------------------------------------------------------------------------

    \688\ Katten Foreign Advisers Letter.
---------------------------------------------------------------------------

    Some commenters objected to calculating regulatory assets under
management on the basis of gross, rather than net, assets. They argued,
among other things, that gross asset measurements would be
confusing,\689\ complex,\690\ and inconsistent with industry
practice.\691\ However, nothing in the current instructions suggests
that liabilities should be deducted from the calculation of an
adviser's assets under management. Indeed, since 1997, the instructions
have stated that an adviser should not deduct securities purchased on
margin when calculating its assets under management.\692\ Whether a
client has borrowed to purchase a portion of the assets managed does
not seem to us a relevant consideration in determining the amount an
adviser has to manage, the scope of the adviser's business, or the
availability of the exemptions.\693\
---------------------------------------------------------------------------

    \689\ Dechert General Letter. See also Implementing Adopting
Release, supra note 32, at n.80 and accompanying text.
    \690\ MFA Letter.
    \691\ See, e.g., Merkl Letter; Shearman Letter. See also supra
note 351.
    \692\ See Form ADV: Instructions for Part 1A, instr. 5.b.(2), as
in effect before it was amended by the Implementing Adopting Release
(``Do not deduct securities purchased on margin.''). Instruction
5.b.(2), as amended in the Implementing Adopting Release, provides
``Do not deduct any outstanding indebtedness or other accrued but
unpaid liabilities.'' See Implementing Adopting Release, supra note
32, discussion at section II.A.3.
    \693\ See id.
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    Moreover, we are concerned that the use of net assets could permit
advisers to highly leveraged funds to avoid registration under the
Advisers Act even though the activities of such advisers may be
significant and the funds they advise may be appropriate for systemic
risk reporting.\694\ One commenter argued, in contrast, that it would
be ``extremely unlikely that a net asset limit of $150,000,000 in
private funds could be leveraged into total investments that would pose
any systemic risk.'' \695\ But a comprehensive view of systemic risk
requires information about certain funds that may not present systemic
risk concerns when viewed in isolation, but nonetheless are relevant to
an assessment of systemic risk across the economy. Moreover, because
private funds are not subject to the leverage restrictions in section
18 of the Investment Company Act, a private fund with less than $150
million in net assets could hold assets far in excess of that amount as
a result of its extensive use of leverage. In addition, under a net
assets test such a fund would be treated similarly for regulatory
purposes as a fundamentally different fund, such as one that did not
make extensive use of leverage and had $140 million in net assets.
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    \694\ See id., at n.82 and preceding and accompanying text.
    \695\ ABA Letter.
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    The use of gross assets also need not cause any investor confusion,
as some commenters suggested.\696\ Although an adviser will be required
to use gross (rather than net) assets for purposes of determining
whether it is eligible for the private fund adviser or the foreign
private adviser exemptions (among other purposes), we would not
preclude an adviser from holding itself out to its clients as managing
a net amount of assets as may be its custom.\697\
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    \696\ See, e.g., Dechert General Letter. See also Implementing
Adopting Release, supra note 32, at n.80 and accompanying text.
    \697\ See supra note 357.
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    Definition of a Qualifying Private Fund. As discussed above, we
modified the definition of a ``qualifying private fund'' to include an
issuer that qualifies for an exclusion from the definition of
``investment company,'' as defined in section 3 of the Investment
Company Act, in addition to those provided by section 3(c)(1) or
3(c)(7) of that Act. To the extent advisers are able to rely on the
exemption as a result of this modification, investors and the
Commission will lose the benefits registration would provide. This
modification does, however, benefit advisers, as discussed above, and
investors (and the Commission) will still have access to the
information these advisers will be required to file as exempt reporting
advisers.
    Solely Advises Private Funds. Some commenters asserted, in effect,
that advisers should be permitted to combine other exemptions with rule
203(m)-1 so that, for example, an adviser could advise venture capital
funds with assets under management in excess of $150 million in
addition to other, non-venture capital private funds with less than
$150 million in assets under management.\698\ One commenter argued
that, by declining to adopt this view, we are imposing unnecessary
burdens, particularly on advisers who advise both small private funds
and small business investment companies.\699\ But as we discuss in
Section II.B.1, the approach the commenter suggests runs contrary to
the language of section 203(m), which directs us to provide an
exemption ``to any investment adviser of private funds, if each of such
investment adviser acts solely as an adviser to private funds and

has assets under management in the United States of less than
$150,000,000.'' Thus, we believe that the costs to advisers that may
have to register because they do not advise solely private funds with
assets under management in the United States of less than $150 million
flow directly from the Dodd-Frank Act.
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    \698\ NASBIC/SBIA Letter; Seward Letter.
    \699\ NASBIC/SBIA Letter.
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    Assessing Whether the Exemption Is Available and Costs of
Registration and Compliance. We estimate each adviser may incur between
$800 to $4,800 in legal advice to learn whether it may rely on the
exemption.\700\ We did not receive any comments concerning these
estimates. We also estimate that each adviser that registers would
incur registration costs, which we estimate would be $15,077,\701\
initial compliance costs ranging from $10,000 to $45,000, and ongoing
annual compliance costs ranging from $10,000 to $50,000.\702\ Some
commenters suggested that these estimates are too low, and estimated
that they would incur one-time registration and compliance costs
ranging from $50,000 to $600,000, followed by ongoing annual compliance
costs ranging from $50,000 to $500,000.\703\ Although some advisers may
incur these costs, we do not believe they are representative, as
discussed above.\704\ Moreover, as discussed above, commenters
identifying themselves as ``middle market private equity fund''
advisers provided the highest estimated costs, but these commenters
generally would not qualify for the private fund adviser exemption we
are required to provide under section 203(m).\705\ We also note that
the costs of registration for advisers that do not qualify for the
private fund adviser exemption flow from the Dodd-Frank Act, which
removed the private adviser exemption on which they currently rely.
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    \700\ We estimate that a private fund adviser would obtain
between 2 and 12 hours of external legal advice (at a cost of $400
per hour) to determine whether it would be eligible for the private
fund adviser exemption.
    \701\ See supra note 597 and accompanying text.
    \702\ See supra note 601 and accompanying text.
    \703\ See supra notes 602-603 and accompanying text.
    \704\ See supra Section V.A.2.
    \705\ We note that the advisers that gave us these estimates for
registration costs have assets under management in excess of the
$150 million threshold and they are not representative of advisers
that would qualify for the private fund adviser exemption. See supra
notes 602-603 and accompanying text. We also note that approximately
570 smaller advisers currently are registered with us. See supra
note 613 and accompanying text. These advisers have absorbed the
compliance costs associated with registration, notwithstanding the
fact that their revenues are likely to be smaller than those of a
typical adviser that will be required to register as a result of
Congress's repeal of the private adviser exemption (e.g., an adviser
to private funds with $150 million or more of assets under
management in the United States, or a ``middle market'' private
equity adviser). See, e.g., Atlas Letter (middle market private
equity adviser with $365 million of assets under management); Cortec
Letter (middle market private equity adviser with less than $750
million of assets under management). See also supra note 614 and
accompanying text.
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C. Foreign Private Adviser Exemption

    Section 403 of the Dodd-Frank Act replaces the current private
adviser exemption from registration under the Advisers Act with a new
exemption for any ``foreign private adviser,'' as defined in new
section 202(a)(30) of the Advisers Act.\706\ We are adopting,
substantially as proposed, new rule 202(a)(30)-1, which defines certain
terms in section 202(a)(30) for use by advisers seeking to avail
themselves of the foreign private adviser exemption, including: (i)
``Investor;'' (ii) ''in the United States;'' (iii) ``place of
business;'' and (iv) ``assets under management.'' \707\ We are also
including in rule 202(a)(30)-1 the safe harbor and many of the client
counting rules that appeared in rule 203(b)(3)-1.\708\
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    \706\ See supra notes 415-418 and accompanying text. The new
exemption is codified as amended section 203(b)(3). See supra
Section II.C.
    \707\ Rule 202(a)(30)-1(c).
    \708\ See supra Section II.C. Rule 203(b)(3)-1, which we are
rescinding with the Implementing Adopting Release, provides a safe
harbor for determining who may be deemed a single client for
purposes of the private adviser exemption. We are not, however,
carrying over rules 203(b)(3)-1(b)(4), (5), or (7). See supra notes
316, 420 and 425 and accompanying text.
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    Rule 202(a)(30)-1 clarifies several provisions used in the
statutory definition of ``foreign private adviser.'' First, the rule
includes a safe harbor for counting clients, which previously appeared
in rule 203(b)(3)-1, and which we have modified to account for its use
in the foreign private adviser context. Under the safe harbor, an
adviser would count certain natural persons as a single client under
certain circumstances.\709\ Rule 202(a)(30)-1 also includes another
provision of rule 203(b)(3)-1 that permits an adviser to treat as a
single ``client'' an entity that receives investment advice based on
the entity's investment objectives and two or more entities that have
identical owners.\710\ As proposed, we are omitting the ``special
rule'' that allowed advisers not to count as a client any person for
whom the adviser provides investment advisory services without
compensation.\711\ Finally, the rule includes two provisions that
clarify that advisers need not double-count private funds and their
investors under certain circumstances.\712\
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    \709\ Rule 202(a)(30)-1(a)(1).
    \710\ Rule 202(a)(30)-1(a)(2)(i)-(ii). In addition, rule
202(a)(30)-1(b)(1) through (3) contain the following related
``special rules:'' (1) An adviser must count a shareholder, partner,
limited partner, member, or beneficiary (each, an ``owner'') of a
corporation, general partnership, limited partnership, limited
liability company, trust, or other legal organization, as a client
if the adviser provides investment advisory services to the owner
separate and apart from the investment advisory services provided to
the legal organization; (2) an adviser is not required to count an
owner as a client solely because the adviser, on behalf of the legal
organization, offers, promotes, or sells interests in the legal
organization to the owner, or reports periodically to the owners as
a group solely with respect to the performance of or plans for the
legal organization's assets or similar matters; and (3) any general
partner, managing member or other person acting as an investment
adviser to a limited partnership or limited liability company must
treat the partnership or limited liability company as a client.
    \711\ See rule 203(b)(3)-1(b)(4); supra notes 425-427 and
accompanying text.
    \712\ See rule 202(a)(30)-1(b)(4) (an adviser is not required to
count a private fund as a client if it counts any investor, as
defined in the rule, in that private fund as an investor in the
United States in that private fund); rule 202(a)(30)-1(b)(5) (an
adviser is not required to count a person as an investor if the
adviser counts such person as a client in the United States). See
also supra note 429.
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    Second, section 202(a)(30) provides that a ``foreign private
adviser'' eligible for the new registration exemption cannot have more
than 14 clients ``or investors in the United States.'' We are defining
``investor'' in a private fund in rule 202(a)(30)-1 as any person who
would be included in determining the number of beneficial owners of the
outstanding securities of a private fund under section 3(c)(1) of the
Investment Company Act, or whether the outstanding securities of a
private fund are owned exclusively by qualified purchasers under
section 3(c)(7) of that Act.\713\ We are also treating as investors
beneficial owners of ``short-term paper'' issued by the private fund,
who must be qualified purchasers under section 3(c)(7) but are not
counted as beneficial owners for purposes of section 3(c)(1).\714\
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    \713\ See rule 202(a)(30)-1(c)(2); supra Section II.C.2. In
order to avoid double-counting, the rule allows an adviser to treat
as a single investor any person who is an investor in two or more
private funds advised by the adviser. See rule 202(a)(30)-1, at note
to paragraph (c)(2).
    \714\ See rule 202(a)(30)-1(c)(2)(ii); supra notes 453-462 and
accompanying text. Consistently with section 3(c)(1) and section
(3)(c)(7) of the Investment Company Act, the final rule, unlike the
proposed rule, does not treat knowledgeable employees as
``investors.'' Cf. proposed rule 202(a)(30)-1(c)(1)(i).
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    Third, rule 202(a)(30)-1 defines ``in the United States'' generally
by incorporating the definition of a ``U.S. person'' and ``United
States'' under Regulation S.\715\ In particular, we define ``in the
United States'' in rule 202(a)(30)-1 to mean: (i) With respect to any
place of business, any such place

located in the ``United States,'' as defined in Regulation S; \716\
(ii) with respect to any client or private fund investor in the United
States, any person who is a ``U.S. person'' as defined in Regulation
S,\717\ except that under the rule, any discretionary account or
similar account that is held for the benefit of a person ``in the
United States'' by a non-U.S. dealer or other professional fiduciary is
a person ``in the United States'' if the dealer or professional
fiduciary is a related person of the investment adviser relying on the
exemption; and (iii) with respect to the public, in the ``United
States,'' as defined in Regulation S.\718\
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    \715\ Rule 202(a)(30)-1(c)(3). See supra Section II.C.3.
    \716\ See 17 CFR 230.902(l).
    \717\ See 17 CFR 230.902(k). We are allowing foreign advisers to
determine whether a client or investor is ``in the United States''
by reference to the time the person became a client or acquires
securities issued by the private fund. See rule 202(a)(30)-1, at
note to paragraph (c)(3)(i).
    \718\ See 17 CFR 230.902(l).
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    Fourth, rule 202(a)(30)-1 defines ``place of business'' to have the
same meaning as in Advisers Act rule 222-1(a).\719\ Finally, for
purposes of rule 202(a)(30)-1, we are defining ``assets under
management'' by reference to ``regulatory assets under management'' as
determined under Item 5 of Form ADV.\720\
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    \719\ See rule 202(a)(30)-1(c)(4); rule 222-1(a) (defining
``place of business'' of an investment adviser as: ``(1) An office
at which the investment adviser regularly provides investment
advisory services, solicits, meets with, or otherwise communicates
with clients; and (2) Any other location that is held out to the
general public as a location at which the investment adviser
provides investment advisory services, solicits, meets with, or
otherwise communicates with clients.''). See supra Section II.C.4.
    \720\ Rule 202(a)(30)-1(c)(1); Form ADV: Instructions to Part