10/07/2009

Registration Rush Squeezes Placement Firms

Small placement agents may become a thing of the past, as increasing pressure to register their operations forces them to grow or die.

At the core of the matter is the New York Common Fund scandal, which has created a growing wariness of placement agents that don't have both a broker-dealer license from the SEC and a registration with the Financial Industry Regulatory Authority. While unlicensed fund-marketing shops have scurried to obtain stronger credentials in response, many are finding the costs to be prohibitive.

"Legal fees for a basic [broker-dealer] license application are in the $50,000 range," said Eric Wright, co-head of the private-funds group at law firm Ropes & Gray. "This assumes a typical level of Finra review and doesn't include ongoing costs for compliance and other legal work needed to remain registered."

That kind of money won't break the bank for a large placement agent. But it's simply unaffordable for many smaller players or startups, especially those with just a couple of staffers. Market players are forecasting a thinning of the herd as a result, or at least a decline in new players.

According to a survey by Private Equity Insider, there are 69 placement agents serving U.S. private equity clients. Only 22 of them have double-digit headcounts.

Technically, the Securities Exchange Act of 1934 requires that anyone offering securities transactions must have an SEC broker-dealer license and a Finra registration. But many small placement agents - and individuals working in the business on their own - were able to sidestep those costs in the past by operating as "finders" who introduced fund managers to potential backers without playing a role in structuring any resulting investments. Others went the "rent-a-broker" route, in which a placement agent's staffers would obtain basic Finra qualifications while paying a fee to a broker-dealer for the use of its registration.

The problem is that both approaches have come to be looked down upon by investors and the SEC following the April revelations that two state-connected individuals took millions of dollars of kickbacks from fund managers to arrange commitments from New York Common Fund.

One of them, former Democratic political advisor Hank Morris, passed Finra's Series 7 exam, which qualified him as a general securities representative, along with the state-required Series 63 exam. While he has often been referred to as a finder, he was operating under the wing of licensed broker-dealer Searle & Co.

"We could have hung our shingle out with an established broker-dealer, but several [limited partners] we spoke to balked at the concept," said the head of a startup placement agent that is in the final stages of securing its own SEC license. "They didn't like the idea of yet another party being involved, and some questioned whether the host shop would know or care enough to properly monitor us."

Finra registration does helps alleviate some concerns. To join the independent regulator, all staffers within a placement agent must meet a basic set of qualifications and at least two principals must pass more than 25 hours of tests to certify that they are suited to supervise the operation. The firm must also have a legal-compliance officer and a financial-and-operations principal, both of which are also subject to extensive testing.

Finra's exams focus mainly on selling of publicly traded securities to individuals, however, and there's some concern about whether broker-dealers that aren't familiar with private-company investments would offer adequate oversight via rent-a-broker arrangements. Some startup placement agents don't want to be seen as working for potential competitors either.

Another possible alternative for smaller firms that can't afford more extensive registration: One company that performs compliance and advisory services for mutual funds is thinking about establishing a business that would cater to placement agents working for private equity funds and hedge funds. That's not a sure thing though, and in the meantime, "we're all bending over backwards to comply with everyone else's rules and desires," said the startup chief.