Once an entrepreneur, deal maker, or investor gain enough experience in investing, they often start to consider starting a “fund”, whereby they can aggregate capital and make investments on behalf of other investors. Unfortunately for the people with the idea to create a fund, these funds often come with a quagmire of regulations to navigate. In fact, there may be 3 or 4 different bodies of law to navigate when creating a fund (the Securities Act of 1933, the Investment Adviser Act of 1940, and the Investment Company Act of 1940).
These bodies of law can be quite complex and intertwined and make even the most experienced of lawyers’ head spin. One misstep can cause a fund or its related entities or parties to suddenly have to register as an investment adviser or register the fund as an investment company. This blog will only address some of the issues related to the Investment Adviser Act compliance. There are still many considerations to comply with the Investment Company Act that relate to the type, quality, and number of investors the fund can have and the type of compensation that that fund managers can receive (hint: taking a “carried interest” in addition to a management fee would require the fund to be comprised of either (i) all qualified purchasers or (ii) fewer than 99 qualified clients).
For first-time fund managers, we are often looking at ways to reduce the regulatory burden on them and avoid registration obligations. Assuming that the fund manager wants to have the ability to make investments (without further approval from its limited partners/investors), then we first need to determine how to comply with the Investment Advisers Act.
Essentially, the Investment Advisers Act states that, if a person or entity is paid compensation for investing in securities or advising on the investment in securities on behalf of another person, then the “adviser” must either register or have an exemption from registration.
What is an Exempt Reporting Advisor?
he most commonly used exemptions for a new fund manager would be the “private fund” exemption. Here, the SEC has stated that an investment adviser that solely acts as an adviser to “private funds” and the aggregate assets under management are less than $150,000,000, then the adviser does not need to register with the SEC. These folks are called “exempt reporting advisers” (ERAs) and they may advise funds like hedge funds and private equity funds. Although they’re exempt from the comprehensive regulations investment advisers follow, they’re still subject to unique regulatory requirements and compliance obligations. The exemptions are designed to prevent some of the regulatory burdens while still providing investor protection.
Benefits and Considerations
Operating as an ERA offers certain benefits for investment advisers. They’re subject to fewer regulatory requirements, which can result in lower administrative costs. This gives ERAs the flexibility to structure their business to suit the needs of their clients and offer more specialized advising services. Although registered investment advisers (RIAs) have rigorous regulatory oversight, making them known for their comprehensive investor protection and resources, ERAs are held equally accountable for reporting and transparency metrics. This includes all necessary disclosures to the SEC and investors.
Compliance Requirements for Exempt Reporting Advisers
ERAs must still comply with specific reporting and record-keeping obligations to ensure transparency and investor protection. Some key compliance requirements for ERAs include:
Filing Form ADV: ERAs are required to file Form ADV with the SEC and disclose relevant information about their business, employees, clients, and any potential conflicts of interest. This filing is done through the Investment Adviser Registration Depository (IARD) system. However, it’s worth noting that ERAs do not need to complete the entire ADV and are only required to produce a “short-form ADV”.
Record-Keeping: ERAs must maintain accurate and up-to-date records relating to their advisory activities, including client agreements, books and records, and other relevant documents. These records must be readily accessible for examination by the SEC upon request.
Compliance Policies and Procedures: ERAs are expected to establish and maintain compliance policies and procedures designed to prevent violations of securities laws. These policies should address areas such as conflicts of interest, trading practices, privacy, and risk management.
Becoming an ERA
An individual or firm can become an ERA if they meet the qualifications for exemptions. The reduced regulations and associated costs can be very beneficial to private fund startups that need room to grow. Even though ERAs are considered “exempt” from the same reporting as RIAs, they still have to adhere to fiduciary duties like acting in their client’s best interests, maintaining appropriate records, and keeping up with regular SEC reporting.
Prospective ERAs should consider their current business model, client needs, and long-term growth plans to determine whether the ERA status aligns with their goals. If you or your company are ready to provide investment advisory services to a private fund, the team at Doida Crow Legal is here to help. If you have questions about starting off with the right legal framework, call 720.306.1001 to schedule a free consultation.