506(b) is a "safe harbor" private placement type for funds and other investment companies who offer their securities to investors. It is arguably the most common private placement utilized by hedge funds.
What is Rule 506(b)?
When investment companies (or funds) bring on investors, they are generally considered to be offering the sale of a security to investors: a stake in the fund. As such, funds are subject to the Securities Act of 1933 (the “Securities Act“), which governs the sale and issuance of securities in the United States. In contrast to offering public securities, such as via an initial public offering (“IPO“), hedge funds generally seek to offer their securities privately. In order to do so, the private offering – better known as a private placement – must be considered acceptable by the SEC. Rule 506(b) provides for one way to conduct an acceptable private placement, alongside its less common sibling rule, Rule 506(c).
How does 506(b) work?
506(b) is what’s called a “safe harbor”, which is to say that any private offering conducted in accordance with the restrictions of 506(b) is acceptable as a matter of course. In other words, investment companies must do – or not do – certain things in the course of their offering to qualify for safe harbor. For 506(b), generally, the key considerations are as follows:
- Investor accreditation. Generally, investors must be accredited investors at minimum. It is theoretically possible to allow up to a maximum of 35 non-accredited investors in a 506(b) offering, but practically, this is quite rare, for two reasons. The first reason is that 506(b) specifies that in order to sell securities to such non-accredited investors, those investors must (a) meet the legal standard of having sufficient investing sophistication, and (b) be supplied disclosures substantially similar in nature to those required of a “Regulation A offering”, which is to say, relatively extensive additional legal documents specific to the fund directionally similar in nature to that of a public offering. Assuming that the aforementioned is not an issue, the second reason is that regardless of what is allowed in the Securities Act, other applicable acts to hedge funds may introduce restrictions on who may be charged fees or brought on into the fund anyways, rendering the 35 non-accredited investor possiblity as potentially moot regardless.
- No general solicitation. Information about the fund cannot be broadly or publicly accessed, i.e. via a website, advertisements, mailing lists, social media platforms, television, or generally any sort of group or public format where general members of the public could inadvertently come across material information about the fund or any solicititation to invest. Solictation must be done on a more one-to-one relationship and referral basis, or with the help of a regulated broker-dealer that specializes in investor-to-fund pairing (also known as an “introducing broker”).
- Investor self-attestation. The accreditation status and other related financial status(es) of investors can be self-attested to by the investor, which reduces the administrative and liability burden associated with 506(b) offerings greatly. This stands in contrast to certain other offering types, where the fund manager has a higher duty towards validation of fund investor financial status. Fund administrators, such as Repool, typically handle this self-attestation on behalf of the fund.
What steps need to be taken to conduct a 506(b) offering?
Beyond following the boundaries of 506(b) offering, there is no approval or application process to make such an offering; it is self-executing. An apt analogy might be driving under the speed limit on a highway; you don’t need to seek permission to do so, but if you go over the limit, you could be pulled over. Similarly, the SEC and state securities regulators bear the right to validate the legitimacy of any fund’s offering, and have been known to conduct industry-wide compliance sweeps from time to time. As such, funds must be careful to both understand what type of offering they are making and what they must do or not do to stay compliant.
Due to the relatively minimal requirements of 506(b), it is an extremely common offering type, all the more so for emerging managers. This is in contrast to its sibling safe harbor offering type, 506(c), which has certain advantages around broader solicitation, but certain disadvantages around validating investor financial status.
Any entity whose principle purpose is to invest and which brings on third-party capital is inherently conducting a securities offering, and as such, the consideration of 506(b) or other private placements is one of the key considerations for any aspiring or existing fund manager.