Learn the implications of operational integration and the risks for fund managers avoiding registration by forming separate entities.
The Securities and Exchange Commission (SEC) recently brought to light a significant enforcement action that raises concerns for fund managers aiming to set up separate entities in hopes of avoiding registration requirements.
The move has become a focal point for fund managers considering a spinout from an existing investment adviser or forming new entities that share management teams or operational functions with another adviser.
The SEC has reiterated its long-standing view: if two or more affiliated advisers, even though legally separate entities, are deemed operationally integrated, they may be considered a single adviser under the Investment Advisers Act of 1940 (Advisers Act).
It could compel one or more of these advisers to register, with substantial implications for the fund's operations and compliance.
The Advisers Act prohibits advisers from indirectly engaging in actions that would be unlawful if performed directly. This principle means that investment advisers and their affiliates cannot bypass registration requirements by forming separate entities if they are ultimately “operationally integrated.” Operational integration is a term used by the SEC to describe scenarios where separate legal entities are, in effect, functioning as one integrated operation.
For example, a fund manager relying on the venture capital adviser exemption (VC exemption) may wonder if forming a separate legal entity to manage funds outside the VC scope — such as secondary funds, continuation vehicles, or crypto funds — can avoid violating the Advisers Act. Unfortunately, the SEC views this strategy as a potential workaround that undermines the intent of the law.
Similarly, a fund manager applying the private fund adviser exemption (PF exemption) might be tempted to set up a new adviser entity each time regulatory assets under management approach $150 million to avoid registration.
This too would be scrutinized as an improper attempt to circumvent the requirements.
The SEC's determination of whether advisers are operationally integrated depends on a five-factor test, originally established in a no-action letter to Richard Ellis, a financial services firm. The test evaluates whether an adviser has a distinct, independent existence from its affiliated adviser.