Private Equity, Hedge Funds Are Ready For Their Close-Up

The answer is a series of affirmative decisions taken by the proposed fund’s sponsors, and explicitly agreed to by prospective investors, to operate within designated exemptions to securities laws and financial regulations.

Simply put, private equity and hedge funds must be operated in such a way as to remain in compliance with detailed financial regulations that govern who is allowed to invest in them. Marketing restrictions determine who is, and who is not, permitted to participate in an alternative investment fund. The principal effect of these restrictions, in both the United States and the United Kingdom, is to exclude retail investors. Uncle Edgar’s and Aunt Edna’s money should not be going into these vehicles. As a result of limiting these funds to non-retail investors and deciding as an explicit policy choice not to subject it to product-level regulation like public investment funds, the government explicitly places primary responsibility for the investment decision on the prospective investor.

Marketing restrictions operate in conjunction with tax rules to determine the structure and operation of alternative investment funds, but to countervailing effect. On the one hand, the financial regulatory regime attempts to exclude retail investors who may not have the knowledge or experience required to negotiate adequate protections from participating in private investments. On the other hand, in order to prevent these vehicles from being instruments of tax avoidance, the taxing authorities – such as the US Internal Revenue Service or the UK HM Revenue and Customs – often impose ownership restrictions or require management and control of these vehicles to be conducted in such a way as to limit the influence that these investors can exert on a day-to-day basis.

In the United States, exemptions must be secured under a number of federal statutes that govern the securities industry. These include both the Investment Company Act, for the fund vehicle itself, and the Securities Act, for the marketing of the fund’s interests. Absent an exemption, most private equity and hedge funds would be required to register with the SEC as a retail mutual fund under the Investment Company Act and become subject to a number of constraints incompatible with many investment strategies pursued by alternative investment funds. Private equity and hedge funds typically make use of the exemptions provided by Section 3(c)(1) and Section 3(c)(7) of the Investment Company Act and forgo registration, and the substantive restrictions that this entails.

Section 3(c)(1) is the older of the two exclusions from the definition of ‘investment company.’ The requirements are twofold: the interests in the fund must be privately placed to investors; and the fund must not have in excess of 100 investors. Section 3(c)(7) instead focuses on the status of investors in the fund, rather than their number. The requirements are also twofold: as with Section 3(c)(1), the interests in the fund must be privately placed to investors; and the fund may only have as investors who are either ‘qualified purchasers’; or ‘knowledgeable employees’ of the fund manager.

When marketing an alternative investment fund to US investors, it is also necessary to ensure that each offer and sale of interests in the fund is exempt from registration under the Securities Act. Whether constituted as a limited partnership or a company, the interests of a fund will fall within the definition of a ‘security.’ Absent a suitable exemption, the offer and sale of such interest will require registration with the SEC. Alternative investment funds generally avoid the registration requirements by relying on the exemption provided by Section 4(2) of the Securities Act, which covers transactions by an issuer not involving any public offer, and the safe harbour rules adopted by the SEC as part of Regulation D.

Traditionally, there was a prohibition in the United States that meant that no general solicitation or general advertising could occur. This lead to the exemption being lost if, for example, advertisements or articles were published in a newspaper or magazine, or interviews or notices were broadcast on television or radio. However, in April 2012, President Obama caught many by surprise by signing into law the controversial JOBS Act, undoing with a flourish of the pen decades of law and practice that limited the publicity that could surround a private placement of securities. Private equity and hedge funds are among the beneficiaries of this liberation.

Regardless of the marketing free-for-all that is now possible, other restrictions on private placements remain intact for now. Importantly, a fundamental concept within Regulation D is the ‘accredited investor,’ which includes an individual earning more than $200,000 per year (or $300,000 jointly with their spouse) or has net assets of $1,000,000, excluding their principal residence. Underlying the “accredited investor” definition is the belief that sophisticated investors have the resources and financial expertise required to obtain and evaluate the information necessary to make their investment decisions. In short, they can “fend for themselves.” A similar belief serves as the rationale behind the categories of exceptions that operate in the United Kingdom and across Europe.

There are a number of different exemptions under the US securities laws for wealthy individuals, of which “accredited investor” is the most familiar. As Vijay Sekhon, a Senior Counsel with the SEC’s Office of General Counsel, has observed, “The federal securities laws are littered with exemptions for wealthy investors. The rationale underlying these exemptions is that wealthy investors can fend for themselves because they either possess sufficient financial sophistication to make informed decisions or can acquire the services of advisers who possess such sophistication.”

Some critics have argued that the fact that so many sophisticated investors fell victim to Bernard Madoff’s infamous Ponzi scheme is compelling evidence that, in fact, such investors are either unable or unwilling to protect themselves. Among Madoff’s victims were celebrities and hedge fund managers, as well as sizeable pension funds and charities. If this is correct, continuing to provide a private placement exception to enable marketing of investments to these people would ultimately be a mistake.

Based on the misery that resulted from the Madoff fraud, will legislators and regulators be willing to reexamine the premises underlying the current approach that sophisticated investors should be left to fend for themselves?
Given the significant increase in income and wealth since the original adoption of the accredited investor standard, the SEC has begun to slowly question the uniform ability of every member of this group to have the means to “fend for themselves.” Ultimately, as part of Dodd-Frank, the net worth test for individuals to qualify as accredited investors was amended to exclude a natural person’s primary resource from such calculations. The SEC is further mandated to periodically review the numeric threshold set for accredited investors every few years.

However, the “accredited investors” standard in the United States is for all intents and purposes sacrosanct in federal securities law. The adoption of the Dodd-Frank amendments to the existing US financial regulatory regime represent an attempt by Congress to address some, but not all, of the concerns identified by critics of the policies that led to the recent global financial crisis.

Curiously, within less than two years of adopting the Dodd-Frank reforms, a bipartisan consensus, led by President Obama, substantially liberalized government oversight by passing the JOBS Act. The net effect of this legislative schizophrenia remains to be seen, but private equity and hedge funds are gearing up to take advantage of the increased marketing opportunities in a few weeks time.

The above is an excerpt from the forthcoming book, “ONE STEP AHEAD – Private Equity and Hedge Funds After the Global Financial Crisis,” which will be published by Oneworld in the fall. Click here for more information.