Private Fund Exemptions under the Investment Company Act

Private investment funds primarily use two exemptions to avoid being defined as an “investment company” under the Investment Company Act of 1940: Section 3(c)(1) or Section 3(c)(7).

Less than 100 Investors

Section 3(c)(1) of the Investment Company Act excludes from being an investment company any issuer whose outstanding securities are beneficially owned by not more than 100 persons and that is not making and does not presently propose to make a public offering of its securities. The benefit of Section 3(c)(1) is that there is no additional status requirement for the investor, such as net worth, total assets, or total investments owned beyond the “accredited investor” standard.

There are some catches in trying to count the number of investors. There are several types of investors that result in a look through their ownership.

More than 100 Investors

If your private fund will have more than 100 investors, either directly or because of a look-through, then the fund will need to fit under the Section 3(c)(7) exemption. As with Section 3(c)(1) you cannot anticipate making a public offering. Investors in 3(c)(1) fund need only be accredited investors, but investors in a 3(c)(7) fund must be “qualified purchasers.”

The higher standard of qualified purchaser limits potential investors to institutional investors, investment managers and high net worth individuals. (More on the “qualified purchaser” definition in my next post.)

Contacting lots of investors may be viewed as general solicitation so you need to pay attention to the prohibition on general solicitation or advertisement under Regulation D.

You will also need to be careful in limiting future transfers of interest in the private investment funds. With more than 100 investors, you will no longer be in the safe harbor exemption from being a publicly traded partnership.

500 or more Investors

Once you have 500 or more investors and more than $10 million in assets you are subject to the reporting requirements of the Exchange Act. Effectively you are no longer a private fund.

I believe something analogous happened to Google. They had gotten so big and their shares ended up in the hands of more than 500 people. Since they would have to begin complying with the reporting requirements, they may as well let the shares trade publicly.

So if you are going to end up with more than 500 investors in a private fund, you are better off having several smaller funds to avoid the public reporting requirements under the Exchange Act.

Sources:

• Section 3 of the Investment Company Act – Definition of Investment Company
• Section 12(g) of the Exchange Act of 1934
• Fund Raising Publicity – prior post
• Advertising or Solicitation to Offer or Sell Securities Under Rule 502(c) – prior post
• Classification of Private Funds as Publicly Traded Partnerships – prior post

Image of the Twenty Dollar Bill is by Darren Hester under a Creative Commons License.