Tag: Qualified Purchasers

Individuals as Qualified Purchasers

To pull the pieces together, private funds are exempt from the Investment Company Act under Section 3(c)(1) or Section 3(c)(7). Under (1) the fund is limited to 100 investors. Under (7), there is no limit on the number of investors, but the investors have to be “Qualified Purchasers.”

The definition of “qualified purchaser” in Section 2(51)(A) includes individuals as

(i) any natural person … who owns not less than $5,000,000 in investments, as defined by the Commission;

Which leads us to seeking out the definition of “investments” for purposes of the “qualified purchaser” definition. That was published by a SEC rule-making in 1997 and can be found in Section 270.2a51-1(b).

The first issue to tackle is marriage or spousal equivalent.

The rule provides that, in determining whether a natural person is a qualified purchaser, the person may include in the amount of his or her investments any investments held jointly with the person’s spouse (“Joint Investments”). Thus, a person who owns $3 million of investments individually and $2 million of Joint Investments would be a qualified purchaser. The spouse also would be a qualified purchaser if he or she owned, individually, an additional $3 million of investments.

A married couple investing jointly can include their joint assets. If only one spouse is investing, that spouse can use the assets in his or her own name and the joint assets to reach $5 million.

For individuals there are six items that can be considered investments.

  1. Securities, as defined in section 2(a)(1) of the Securities Act of 1933. Excluded are securities in a company controlled by the person, unless that company is (i) an investment company or one of the exclusions from the definition, (ii) a company with publicly traded securities, or (iii) showing at least $50 million in shareholders’ equity on its financial statements.
  2. Real estate held for investment purposes. That excludes your principal residence, your vacation home and the office you work in.
  3. Commodity interests held for investment purposes. That means you have to be primarily in the business of trading commodity interests.
  4. Physical commodities held for investment purposes. That means you have to be in business of trading commodities. Your Babe Ruth baseball card is not going to count unless your business is trading baseball cards.
  5. Financial contracts held for investment purposes that fall outside the definition of securities.
  6. Cash and cash equivalents held for investment purposes. That’s going to exclude your checking account, but you can probably include your savings account.

Add that stuff together if its in the person’s name or held jointly. If it adds up to $5 million. That person is a “qualified purchaser.” You just have to have a reasonable belief that the person is a qualified purchaser.

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Are you an Investment Company?

Fund managers are dealing with Dodd-Frank and the requirements under the Investment Advisers Act made by the Securities and Exchange Commission. Of course, a fund manager needs to focus on other areas of financial regulation and enforcement by the Securities and Exchange Commission. Fund managers need to keep focused on how they comply with the Investment Company Act.

Section 3 of the Investment Company Act has this definition:

1. When used in this title, “investment company” means any issuer which–

A. is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, or trading in securities;

B. is engaged or proposes to engage in the business of issuing face-amount certificates of the installment type, or has been engaged in such business and has any such certificate outstanding; or

C. is engaged or proposes to engage in the business of investing, reinvesting, owning, holding, or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40 percentum of the value of such issuer’s total assets (exclusive of Government securities and cash items) on an unconsolidated basis.

This leaves you with the tricky analysis of whether your investments are securities. To avoid that mess, most private funds look to two exemptions from the definition of “investment company”: 3(c)1 and 3(c)7.

Under 3(c)(1), the main limitations are that you have one hundred or fewer holders of beneficial interest in the fund and that you do not propose to sell them in a public offering. Under 3(c)(7) you can go beyond the 100 owners, but they need to be “qualified purchasers.” That means they need to have a big wallet.

One challenge for private funds who do not want to register under the Investment Advisers Act is that private fund is defined as an “issuer that would be an investment company as defined in Section 3 of  the Investment Company Act, but for section 3(c)(1) and section 3(c)(7) of that Act.”

There are other exemption available, but they are harder to fit under. You may have a trail of paper work stating that you fall under the section 3(c)(1) or section 3(c)(7) exemption, even though you could claim to fit under one of the other exemptions.

For example, 3(c)(5) is available for real estate funds:

Any person who is not engaged in the business of issuing redeemable securities, face-amount certificates of the installment type or periodic payment plan certificates, and who is primarily engaged in one or more of the following businesses: …  (C) purchasing or otherwise acquiring mortgages and other liens on and interest in real estate.

There are some additional limitations that come with this based on some SEC No Action letters. I’ll put some information together on that later.

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Image is Exchange hall, Copenhagen, Denmark, between ca. 1890 and ca. 1900, published by The Library of Congress

Qualified Purchasers under the Investment Company Act

In a private fund exempt under 3(c)(1) investors only generally need to be accredited investors (and “qualified clients” if the fund manager is SEC registered. If you have more than 100 investors in the fund you will need to fall under the 3(c)(7) exemption. That means all of your investors must be “qualified purchasers.” A qualified purchaser is a much greater requirement than an accredited investor and a qualified client.

To paraphrase the requirements under Section 2(a)(51) of the Investment Company Act, a “qualified purchaser” means:

  • a person not less than $5 million in investments
  • a company with not less than $5 million in investments owned by close family members
  • a trust, not formed for the investment, with not less than $5 million in investments
  • an investment manager with not less than $25 million under management
  • a company with not less than $25 million of investments

To that list you can also add:

  • A company (regardless of the amount of such company’s Investments) beneficially owned exclusively by Qualified Purchasers.
  • A “Qualified Institutional Buyer” under Rule 144A of the 33 Act (except that “dealers” under Rule 144 must meet the $25 million standard of the 1940 Act, rather than the $10 million standard of Rule 144A). Rule 144A generally defines a “Qualified Institutional Buyer” as institutions, including registered Investment Companies, that own and invest on a discretionary basis $100 million of securities that are affiliated with the institution, banks that own and invest on a discretionary basis $100 million in  securities and have an audited net worth of $25 million, and certain registered dealers.

“Investments” generally means the following:

  1. Securities, including stocks, bonds and notes, other than securities of an issuer that  is under common control with the qualified purchaser.
  2. Real estate held for investment purposes.
  3. Commodity futures contracts, options or commodity futures and options on physical commodities traded on a contract market or board of trade, held for investment purposes.
  4. Physical commodities (e.g., gold and silver), with respect to which futures contracts are traded on a contract market or board of trade, held for investment purposes.
  5. Financial contracts (e.g., swaps and similar individually negotiated financial transactions), other than securities, held for investment purposes.
  6. For an investment company or a commodity pool, any binding capital commitments.
  7. Cash and cash equivalents held for investment purposes. Neither cash used by an individual to meet everyday expenses nor working capital used by a business is considered cash held for investment purposes.

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Image of Coin Stacks is by Darren Hester under a creative commons license.