Investment Company Act of 1940 - Exemptions

Overview:

The Investment Company Act of 1940 (commonly, the “40 Act,” “Investment Company Act” or the “Act“) is an American act and regulatory regime that governs over entities of any kind that primarily engage in investing in securities. As such, hedge funds that have any amount of securities holdings fall under the Act.  Official information about the Act can be found on the SEC’s website.

The Act provides for registration, organizational and disclosure, and other compliance requirements for entities that fall under it. Generally, such entites that offer their securities (i.e. bringing on investors) to the public must become registered, or seek to qualify for an exemption under the Act which excludes the entity from the requirements of the Act. The very act of bringing on investors into an entity that is considered to primarily invest in securities is the sale of a security.

Examples of investment companies that offer their securities publicly include mutual funds or exchange traded funds (“ETFs“). On the other hand, hedge funds generally seek to avoid offering their securities publicly, and as such, look to be exempt from the act. The most common exemption frameworks utliized by hedge funds are called Section 3(c)(1) and Section 3(c)(7). In particular, emerging managers most commonly structure their funds to be 3(c)(1) exempt.

Common exemptions:

Under Section 3(c)(1), there are only two requirements for a hedge fund: (a) it may not publicly offer its securities, and (2) it can have a maximum of 100 investors in the fund at a given time. For funds which are considered qualifying venture capital funds, it is possible to have up to 250 investors under the Act, so long as the total invested and uninvested capital contributions for such a qualifying venture capital fund is less than $10 million.

Under Section 3(c)(7), a hedge fund can have as many as 2000 investors. However, in order to qualify under 3(c)(7) of the Act, such a fund (alongside not offering its securities publicly, just as in 3(c)(1) above) can only sell its securities/bring on investors who meet the threshold of being considered a “Qualified Purchaser” (“QP“). A QP, for a natural person, at least, is a person who has $5 million in investable assets, not including their primary residence, if any. In other words, if even a single investor fails to meet the QP threshold, the 3(c)(7) exemption cannot be claimed.

For more detailed explanations of both 3(c)(1) or 3(c)(7), visit the dedicated pages for either linked herein.

Wrap up:

Any hedge fund that deals in securities should make sure that they understand the Investment Company Act and how their planned or existing fund fits in with its requirements or exemptions.  When using Repool’s services, ultimately, we cannot make a recommendation as to which is suitable or advisable for your facts and circumstances, and you must represent to us which route you intend to take.  If you have any confusion, seek the advice of legal counsel with specialization in investment management and fund compliance practices.

In our experience, most emerging funds tend to rely on 3(c)(1), but 3(c)(7) starts to become more common with larger funds who have access to a wide network of high net worth individuals or institutional investors such as family offices.