The Securities Act of 1933
This act (the "Securities Act") sets forth requirements for the private sale of securities, which is what is occuring when private funds bring on investors.
Summary
tl;dr: Most hedge funds must sell their interests (bring on investors) via either 506(b) or 506(c), which place restrictions on allowable investor types, solicitation, and verification.
Read on: Whenever a pooled capital vehicle (or even a private company) brings on investors, what it's actually doing is selling securities to them. Naturally, the SEC has something to say about selling securities. In the case of private funds, the offering isn't done via an IPO or some other public offering, and is instead known as a "private placement." In order to conduct a private placement without the costs, disclosures, and process of a public offering of securities, a seller of private interests must generally conduct its sale under a "safe harbor" - basically, an exemption relating to what is called Regulation D (commonly, "Reg D") of the Securities Act. The two safe harbor types are called 506(b) and 506(c). 506(b) is more common, but 506(c) has some interesting tradeoffs. This guide discusses both - learn more below!
Key topics
It is most common to see funds elect to conduct a 506(b) offering. In a 506(b) offering, a fund can raise an unlimited amount of capital (but is usually capped at 100 investors because of the Investment Company Act) so long as:
- There is no general solicitation. That means no public website, advertising, or generally any sort of publicly available information about the fund. Some compliance sensitive asset managers won’t even publicly mention the name of a fund or acknowledge that it exists!
- Investors are all accredited. All investors or LPs brought into the fund must meet the threshold to be considered accredited investors (but they may also need to be qualified clients because of the Investment Advisers Act). This is a self-attestation, and all fund offering documents will ask prospective investors to declare if and how they are accredited.
There is a common misconception that hedge funds can take on up to 35 non-accredited investors, and that misconception relates to this act. The reason is that, well, the act does technically state that up to 35 non-accredited investors may participate in a 506(b) offering. However, there are two huge issues that make this essentially unfeasible:
- The second part of the rule requires that any non-accredited investors are furnished with a Reg A-like prospectus, which in practical terms means paying a law firm a couple dozen thousand dollars to prepare a 100+ page disclosure in addition to the “regular” fund offering documents, the cost of which isn’t justified by the relatively small amount of capital non-accredited investors can contribute;
- Other acts that also apply, such as the Advisers Act, will almost always prohibit fund managers from having non-accredited investors in a fund anyways. Remember that you must consider all applicable acts, not just each act in vacuum. There are non-fund situations in which 506(b) applies and this 35 non-accredited investor possibility is more relevant.
In our experience, no credible counsel will ever advice their clients to attempt to take on non-accredited investors, and most fund admins, Repool included, will strictly forbid it in any case. Lastly, even if everything is done “by the book,”, the SEC has demonstrated that it generally severely dislikes when non-accredited investors are harmed, and fund managers should have the honest self-assessment that if they believe their fund’s success is contingent on non-accredited investors, frankly, they are thinking about a fund that is probably unviable economically to begin with.
