The Investment Company Act of 1940
This act (the "Company Act" or "40 Act") restricts the number of and/or type of investors a private fund can have.
Summary
tl;dr: Most emerging hedge funds can only have 100 investors, but institutional funds with exclusively ultra high net worth LPs can have more.
Read on: Private funds must be exempt under the Company Act, and as a result, a private fund that trade securities of any kind (e.g. a hedge fund) must be either what is called a “3(c)(1)” or “3(c)(7)” fund. A 3(c)(1) fund is restricted to a maximum of 100 investors (or 250 if it is a "qualifying venture fund", which, well, is what it sounds like). On the other hand, a 3(c)(7) fund can have effectively unlimited investors but requires all investors to meet a very high bar of net worth and/or investment assets well in excess of being an accredited investor. As such, 3(c)(1) is more common for emerging managers, and many emerging funds are therefore capped at 100 investors, alongside other likely restrictions that result from the Investment Advisers Act and the Securities Act.
Key topics
The Investment Company Act of 1940 regulates entities (a) whose primary purpose is investing or trading in securities; and (b) that sell their interests to third parties (e.g. an investor in a hedge fund). The goal of the Company Act is to set forth certain standards and requirements around matters like disclosures, reporting, and operational practices for such entities so as to protect investors.
There are a variety of categories of companies that are considered investment companies, and these companies can be structured as corporations, partnerships, limited liability companies, etc; the form of company is largely irrelevant to the consideration as to whether it is an investment company or not. It’s primarily a question of the company’s purpose and behavior.
In any case, from the view of hedge fund managers, it’s enough to simply know that hedge funds fall directly under the Company Act.
For entities that are subject to registration under the Company Act, the requirements are extremely complex, costly, and thorough; however, the Company Act provides for a variety of ways in which a company that would otherwise be subject to the Company Act can be instead exempt, and, consequently, not subject to its strenuous requirements. As a very not-legal-advice, lay interpretation, one might think of the Company Act as the SEC saying something to the effect “if there are very few investors, and/or all the investors are extremely extremely sophisticated and rich, then you can be exempt.” Hedge funds are and literally must be in this bucket (i.e. there is no such thing as a non-exempt hedge fund). Examples of non-exempt “40 Act funds” include mutual funds, exchange-traded funds (“ETFs”), closed-end funds, and unit investment trusts; all such funds share characteristics that are not compatible with hedge funds, such generally being publicly listed, having daily priced net asset value, and restrictions on fees and asset types.
In any case, the good news, then, is that fund managers that only manage private funds need not concern themselves with the many, many complexities of the Company Act, except for ensuring that they understand how a given fund can be exempt and then following those requirements to do so. Should a fund fail to adhere to the exemption requirements of the Act, there would be serious adverse consequences. Fortunately, it’s very straightforward to claim one of the exemptions, known as “3(c)(1)” and/or “3(c)(7).”
Repool’s platform, whether for fund-in-a-box launch or standalone admin, helps to ensure you comply easily with the Company Act.
