Private funds, such as hedge funds, private equity funds, and venture capital funds, are governed by a host of intersecting federal laws that impact who can invest in these fund, including the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Advisers Act of 1940, and the Investment Company Act of 1940. This post provides prospective and existing private fund managers with a basic understanding of the primary categories of investors and why understanding these categories is essential in structuring and marketing a fund.
The three most common types of investors referenced in these laws and the regulations adopted by the Securities and Exchange Commission (SEC) are 1) accredited investors, 2) qualified clients, and 3) qualified purchasers. While the terms may sound familiar, there are crucial distinctions between each category that have a significant impact on issues like whether a fund qualifies for the private placement exemption, whether a fund’s manager will be entitled to receive performance-based compensation, and whether the fund will be required to register as an investment company.
Whether the investor is purchasing an interest in a private fund organized as a limited partnership or limited liability company, an investment in the fund is considered a “security” under federal securities laws. Therefore, under the Securities Act of 1933, the fund must register its securities offering with the SEC or find an exemption from SEC registration. The vast majority of unregistered securities offerings utilize the exemption under Rule 506(b) of Regulation D, which for all practical purposes, limits the offering to accredited investors.
Under Rule 501 of the Securities Act, an individual is an accredited investor if he or she:
(i) has a net worth (along with his or her spouse) that exceeds $1,000,000 (excluding the value of his or her primary residence); or
(ii) income in excess of $200,000 (or joint income in excess of $300,000 with spouse) in each of the two most recent years with a reasonable expectation of reaching the same income level in the current year.
An entity is an accredited investor if it:
(i) is owned exclusively by accredited investors; or
(ii) is not formed for the specific purpose of acquiring the interest in the fund and has total assets in excess of $5,000,000.
Generally, investors are allowed to self-certify as accredited investors, and a private fund manager will be permitted to rely on an investor’s representation that he or she meets the requirements without any further documentation. However, if the fund is using the relatively new securities law exemption under Rule 506(c), which allows for general solicitation in connection with the marketing of the fund, the manager will incur additional obligations related to verifying the accredited investor status of each prospective investor.
Private fund managers typically are compensated with a management fee based on a percentage of the assets under management (often 2%) and a performance fee based on the capital appreciation of the value of the fund’s holdings (often 20% of the appreciation). However, private fund managers that are registered with the SEC or are located in certain states are prohibited from charging the performance-based fee under the Investment Advisers Act to investors who are not “qualified clients” as defined in Rule 205-3 of the Investment Advisers Act. Currently, an individual or entity is a qualified client if he, she, or it:
(i) has $1,000,000 or more of assets under management with the investment adviser after the investment in the fund;
(ii) has a net worth of $2,100,000 prior to the investment in the fund (excluding the value of his or her primary residence);
(iii) is a “qualified purchaser” (see the next section); or
(iv) is an officer or director of the fund manager or is an employee who participates in the investment activities of the investment adviser and has been doing so for 12 months.
Although many private funds meet the definition of an “investment company” under the Investment Company Act of 1940 due to their securities investment and trading activities, most private funds are exempt from registering as an investment company under the statute’s exemptions under Sections 3(c)(1) or 3(c)(7). Under Section 3(c)(1) of the Investment Company Act, private funds that are owned by not more than 100 persons and not making a public offering of its securities are not required to register as an investment company. Section 3(c)(7), although less frequently relied upon, also exempts funds from registering if they are owned exclusively by “qualified purchasers” and are not making a public offering of its securities.
Generally, a qualified purchaser is an investor that meets any of the following criteria:
(i) an individual or family-owned business not formed for the specific purpose of acquiring the interest in the fund that owns $5,000,000 or more in investments;
(ii) a trust not formed for the specific purpose of acquiring the interest in the fund which is sponsored by and managed by qualified purchasers;
(iii) an individual or entity not formed for the specific purpose of acquiring the interest in the fund which owns and invests at least $25,000,000 in investments (or someone who is acting on account of such a person); or
(iv) an entity, of which each beneficial owner is a qualified purchaser.
Section 3(c)(7) does not contain a limitation on the number of investors in the fund, but the Securities Exchange Act of 1934 effectively limits 3(c)(7) funds to no more than 1,999 investors.
Why Investor Qualification Distinctions Matter
A typical private fund will make a private offering of its securities under Regulation D, charge performance-based fees, and qualify as exempt under the Investment Company Act. For this reason, investments in the fund should be limited to investors that are both accredited investors and qualified clients (unless that fund manager is neither registered with the SEC nor located in a state that regulates performance fees, in which case, they must simply be accredited investors). Offering only to accredited investors is critical to qualifying as a private offering of securities under Regulation D, and, in many situations, limiting investment to qualified clients is required for the fund manager to share in the success of the investments through performance-based compensation.
To qualify as exempt under the Investment Company Act, the private fund manager will have to decide between a fund structure that limits the fund to less than 100 investors (a 3(c)(1) fund) or a structure that limits the fund to investors that are qualified purchasers (a 3(c)(7) fund). 3(c)(7) funds are less common and generally cater more to institutional investors. Therefore, the majority of private funds will not have to worry about limiting investments to qualified purchasers.
Whether you are launching your fund or operating an established fund, it’s essential to know who is eligible for an investment in your fund. Keeping these investor categories in mind will help your private fund adhere to the investor qualification standards and avoid the significant adverse consequences of taking money from the wrong investor.
© 2017 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.