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» FAQ - Hedge Fund & Private Equity
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Qualification of Investors in a Section 3(c)(1) Fund
Hedge fund and private equity fund can maintain their exemption from securities and mutual fund registration by qualifying under Section 3(c)(1) or Section 3(c)(7) exemption of the Investment Company Act of 1940. Under Section 3(c)(1), a fund must not publicly offer or solicit investors in the general public and is limited to 99 “accredited investors”. Unregistered funds are allowed to use securities and strategies that are either prohibited or restricted in registered funds. Funds organized as a 3(c)(1) are offered to prospective investors pursuant to an exemption from the public registration requirements for securities offerings under Rule 506 of Regulation D of the Securities Act of 1933. Securities offered under Rule 506 may be sold solely to "accredited investors" and up to 35 "sophisticated investors".
An "accredited investor" is deemed to include, in part:
- A natural person with an individual net worth, or joint net worth with his or her spouse, at the time of purchase in excess of $1,000,000;
- A natural person with an individual income in excess of $200,000, or in excess of $300,000 with his or her spouse, in each of the two most recent years and who has a reasonable expectation of an income in excess of $200,000 individually, or in excess of $300,000 with his or her spouse, in the current year;
- Any executive officer, director or general partner of the issuer of the securities offered. This is also known as “Knowledgeable Employee”;
- An employee benefit plan within the meaning of Title I of the Employee Retirement Income Security Act of 1974, as amended ("ERISA"), (a) whose investment decisions are made by a plan fiduciary, as defined in Section 3(21) of ERISA, which is either a bank, insurance company or registered investment adviser; or (b) having total assets in excess of $5,000,000; or (c) if self-directed, the investment decisions are made solely by persons that are accredited investors;
- A trust, with total assets in excess of $5,000,000 which was not formed for the specific purpose of acquiring an interest in the hedge fund, whose purchase is directed by a sophisticated investor; and
- An entity in which each of the equity owners are accredited investors.
Section 3(c)(1) fund must also pass the “look-through” provision in order to meet the qualifications of the exemptions. A “look-through” provision goes into effect if an entity/investor owns more than 10% of the fund. If an entity/investor owns more than 10%, it may cause a fund to exceed the number of permitted investors. For example, if a hedge fund holds 90 “accredited investors” and one entity/investor is a limited partnership with 30 investors, and owns 10% or more interest in the fund, those 30 investors are included in the initial 90 investors which will exceed the 99 person limitation. If a look-through is required, all participants must be qualified to invest.
There are current proposals by the Securities and Exchange Commission to revise the criteria for natural persons being considered “accredited investors” for the purpose of investing in certain privately offered investment vehicles. Please check with our professionals or your attorney regarding the criteria for accredited investors.
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Qualification of Investors in a Section 3(c)(7) Hedge Fund
Under Section 3(c)(7) of the Investment Company Act, a hedge fund is also exempt from registering as an investment company. The fund must not publicly offer or solicit investors in the general public and all its investors must qualify as “qualified purchaser” with a limit of 499 investors. Qualified purchasers are defined as high net worth individuals with certain investments in excess of $5 million and any other institutional investor that owns and invests at least $25 million in investments. The Section 3(c)(7) exemption is intended for affluent investors who understand the risks involved and do not need the full protection of the federal and state securities laws.
The amended Rule adds additional categories of investors as Qualified Clients. The Rule permits investment advisers to enter into Performance Fee Contracts with clients who are "qualified purchasers" under Section 2(a)(51)(A) of the Investment Company
Act. In general, there are five categories of qualified purchasers:
- Natural persons owning "investments" of at least $5 million;
- Family owned companies owning no less than $5 million in investments;
- Trusts whose trustees, or equivalent decision makers, and whose settlors, or other asset contributors, are all qualified purchasers described in (1) and (2) above;
- Institutional investors, acting for their own accounts or for other qualified purchasers, that own and invest on a discretionary basis "investments" of at least $25 million, including employee benefit plans that are not participant-directed; and
- Certain qualified institutional buyers ("QIBs") acting for their own accounts or for other QIBs or qualified purchasers.
The SEC has also permitted "Knowledgeable Employees" of the investment adviser for purposes of investing in a Section 3(c)(7) hedge fund without having met the requirements of “qualified purchaser”. A "Knowledgeable Employee" is defined to include the executive officers, directors, trustees, and general partners of the investment adviser, and other persons serving in similar capacities, as well as certain other employees of the adviser who participate in investment activities and have performed such functions for at least 12 months.
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Qualifications for Investment Advisors
Each state requires various qualifications and you should consult your attorney for more information. Certain states may require managers to take a general securities law exam (Series 7) and the exam on Investment Advisor Representative (Series 65).
Registering under the Investment Adviser Act
An Investment Adviser is defined as a natural person or entity who engages in the business of providing advice to others regarding securities for a paid compensation for the service provided. The SEC and each state impose different registration requirements and exemptions from registration for investment advisers. For example, California, Hawaii and Texas require hedge fund managers to register as an investment adviser if the manager maintains an office in the state.
Certain hedge fund managers or general partners may be exempt from the SEC Registered Investment Advisers requirements if they have fewer than 15 clients within the last 12 months, do not hold themselves out to the public as investment advisors, and do not provide advisory services to a registered investment company or a business development company. Any persons whose activities are already regulated, i.e. Broker-Dealers, are excluded from this registration requirement.
When a fund manager is determining whether or not to register as an investment advisor with the SEC or the securities agency of the state in which the advisor maintains its principal place of business, the key consideration will be determined by the amount of assets under management. A hedge fund manager must have at least $25 million of assets under management to register as an investment adviser with the SEC. If the assets under management are between $25 million - $30 million, the manager has an option to register as in investment adviser with the either the SEC or the security agency of the state which it maintains its principal place of business. If the assets under management are less than $25 million, the advisor must register with the securities agency of the state in which it maintains its principal place of business.
When determining the assets under management, the hedge fund manager may consider any account which holds at least fifty percent of the total value comprising of securities. Securities by definition do not include real estate, commodities, or collectibles.
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Applicable Securities Laws
In the past, the offer and sale of securities in the United States has been subject to federal and state regulations under the 1956 Uniform Securities Act and the state Blue Sky laws. Hedge funds and offshore funds are generally offered in private placement transactions by relying on the safe harbor provisions of Regulation D or the safe harbor provisions of Regulation S for offerings outside the United States. This provision has allowed hedge funds to avoid the registration and prospectus delivery requirements of the Securities Act of 1933.
Subsequently, a new law has been passed for a separate exemption from state registration or qualification requirements needed to be perfected under the Blue Sky law of each state where the securities are offered. This new legislation prohibits states from enforcing their Blue Sky laws relating to the registration or qualification of securities offered in a private placement transaction. At most, states still require notice filings that are similar to Form D that is filed with the SEC, and collect filing fees annually. This law disallows states from regulating the content of offering documents or terms of securities being offered. Some states do regulate general partners and their employees as brokers and require certain filings under their broker-dealer regulatory system. You should consult an attorney regarding this issue as each state’s filing requirements may vary.
The Integration Doctrine – SEC Rule
The integration doctrine was created to prevent hedge fund managers from creating identical hedge funds under the same management company in order to qualify them for the exemption as the funds approached the maximum number of investor limitations. Integration doctrine applies, for instance, when two or more hedge funds managed by the same management are distinctively similar, the SEC will combine the funds into a single fund. This means that the SEC integrates the two funds by totaling the number of investors in each fund in order to verify whether or not the investor limitations exceeded each of the exemptions.
The SEC will typically apply a “reasonable person test” as part of the process of determining whether or not to combine funds. The SEC will question the hedge funds’ portfolio trading strategy, objectives, and styles of each fund. They will also look at the type of investors each fund is attracting to conclude if the two funds’ are significantly different from each other or not. After considering all the facts, the SEC will decide if the two funds will be integrated.
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Commodity Exchange Act Registration
The Commodity Exchange Act requires a fund manager who trades any commodity futures contracts, commodity options, or invests in another commodity pool to register as a commodity pool operator, commonly known as a CPO. The manager of a commodity pool must follow various record-keeping, reporting and disclosure requirements under the regulations that have been set forth by the Commodity Futures Trading Commission.
As part of the registration process, hedge fund offering documents must be approved by the National Futures Association prior to offering the fund to investors. In general, registration may be waived if the CPO qualifies for one of the following exemptions provided in the CFTC Regulations 4.13. Examples of entity or individuals who may be exempt are as follows:
- Those who are already regulated, such as banks, insurance companies, or registered investment company;
- Those who operate one or more small pool(s) with less than $400,000 in aggregate capital contributions and with no more than 15 participants in any one pool;
- Those whose pools are only open to persons meeting certain sophistication standards and that trade futures within specified limits;
- Those whose pools are only open to persons who demonstrate a certain level of sophistication or net worth;
- Those who do not receive any compensation or other payment, directly or indirectly, for operating the pool, except reimbursement for the ordinary administrative expenses of operating the pool.
In addition, a hedge fund manager may request to be exempt from registering as a CPO if the fund’s aggregate initial margin and option premiums for commodity transactions do not exceed 10% of the fund’s net assets, or if the fund’s investors are qualified eligible participants.
A qualified eligible participant is defined as any person the hedge fund manager reasonably deems, at the time of their investment in the fund, owns securities of issuers not affiliated with participant and other investments at an aggregate market value of at a minimum of $2,000,000, and has had on deposit with the futures commission merchant, for his own account at any time during the six month period preceding the date of sale to that person of an interest in the fund, at least $200,000 in exchange-specified initial margin and option premiums for commodity interest transactions.
As always, please consult with your attorney who can best advise you on what exemptions you may be eligible for. You can also visit the CFTC website for more detail information about Commodity Pool Operator and Commodity Trading Advisor Exemptions and Exclusions by clicking on this link here.
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Employee Retirement Income Security Act of 1974 ("ERISA")
Under the ERISA Act of 1974, hedge fund managers are required to keep the investment assets of “benefit plan investors” in the aggregate at less than 25% of the aggregate equity of the fund. If the hedge fund manager exceeds the limit of 25%, they are considered to be managing plan assets and are subject to the rules and regulations under the ERISA. They become a plan fiduciary and are prohibited from entering into any transactions/trading that would create a conflict of interest with the benefit plan investors. Hedge fund managers are required to keep proper records to calculate the percentage of assets held by benefit plan investors in aggregate, not including the manager’s account value. ERISA considers benefit plan investors to include individual retirement accounts (401k), KEOGH, and employee benefit plans.
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