Private Fund Formation
Starting a new private fund can be an exciting and profitable opportunity for new fund managers, but it also comes with significant legal considerations. These legal issues can have a significant impact on the success of a new private fund. In this post, we will discuss some of the most important legal issues that new private fund managers should consider.
Structuring the Fund
Private funds are pools of money that invest in companies or other assets not traded on public stock exchanges. The goal of private funds is to make investments, help them grow, and then sell the investments for a profit. Private funds typically have a limited life span (8-12 years) and are managed by a private equity firm.
One of the first legal considerations that new fund managers must address is how to structure the fund. There are several different structures available, but the most common are limited liability companies (LLCs) and limited partnerships (LPs). The choice of structure will depend on a variety of factors, including the fund’s investment strategy, the investors’ preferences, and the tax implications of each structure.
The structure of a private fund generally involves the following:
- The fund (LLC or LP)
- General Partner (GP)
- Limited Partners (LPs) (i.e., the investors)
- Investment Advisor
- Portfolio companies acquired
A fund is usually a limited partnership or a limited liability company. The fund manager (or one of its affiliates) acts as the general partner of the fund and the investors are the limited partners of the fund. A separate entity typically serves as the investment advisor company to provide investment advisory services to the fund, which entity may be an affiliate of the general partner.
Private funds are subject to a myriad of US federal legislation, including the Securities Act of 1933 (Securities Act), the Investment Company Act of 1940 (ICA), and the Investment Advisers Act of 1940 (IAA).
This federal law regulates the offering and sale of securities, including those offered by private funds.
Registration Requirements and Exemptions
The Securities Act requires companies that offer or sell securities to register with the Securities and Exchange Commission (SEC) unless they qualify for an exemption. Private funds rely on exemptions from registration. Two commonly used safe harbor exemptions are the Rule 506(b) and 506(c) exemptions under Regulation D. Rule 506(b) offerings allow private funds that do not engage in general solicitation to offer and sell their securities without registration to an unlimited number of accredited investors and up to 35 non-accredited investors who meet certain requirements, although typical practice is to limit the offering to accredited investors only. Rule 506(c) offerings allow private funds to engage in general solicitation, but this exemption requires that all investors are accredited.
Private funds that rely on the Rule 506 exemption must file a Form D with the SEC and typically provide certain information to investors through the distribution of a private placement memorandum (PPM), which includes information about the company offering the securities and the terms of the offering.
The Securities Act also includes antifraud provisions that prohibit companies from making false or misleading statements or omitting material information in connection with the offer or sale of securities. Private fund managers must ensure that all information provided to investors is accurate and complete, and they must disclose any material information that could affect an investor’s decision to invest in the fund.
Investment Company Act (ICA)
The ICA is a federal law that regulates investment companies, including private funds. New private fund managers must consider whether their fund is required to register with the SEC under the ICA.
Exemptions from the Investment Company Act
Private funds typically structure the fund to comply with an exemption from the ICA. Commonly used exemptions include (1) the “3(c)(1) exemption,” which allows private funds to avoid registration as an investment company if they have no more than 100 investors and do not make public offerings of their securities; and (2) the “3(c)(7) exemption,” which allows private funds to avoid registration if they are owned by qualified purchasers, which generally includes individuals with at least $5 million in investments or entities with at least $25 million in investments.
Investment Advisers Act (IAA)
The IAA is a federal law that regulates investment advisers, including those who provide advice to private funds. Similar to the ICA, new private fund managers must consider whether they are required to register as an investment adviser with the SEC or with state securities regulators under the IAA. Generally, investment advisers with more than $100 million in assets under management are required to register with the SEC, while advisers with less than $100 million must register with state securities regulators, unless a state exemption applies.
The IAA imposes a fiduciary duty on investment advisers, which requires them to act in the best interests of their clients. This duty includes a duty of loyalty and a duty of care, which require advisers to avoid conflicts of interest and to provide advice that is suitable for their clients’ needs. Fund managers must ensure that they are acting in accordance with their fiduciary duty and are not engaging in any activities that could be seen as a conflict of interest.
Disclosures to Clients
The IAA also requires investment advisers to provide certain disclosures to their clients, including information about the adviser’s fees, conflicts of interest, and investment strategies. These disclosures must be provided in a Form ADV, which is filed with the SEC or state securities regulators. Fund managers must ensure that these disclosures are accurate, complete, and not misleading.
Starting a new private fund can be a complex and challenging process, and navigating the legal issues can be daunting for new fund managers. However, by taking the time to address these legal considerations early on, managers can ensure that their fund is set up for success. By consulting with legal professionals and staying up-to-date on regulatory requirements, new fund managers can navigate the legal landscape and focus on growing and managing their fund. We offer private fund expertise in the following areas:
- Advice regarding compliance with regulatory requirements when structuring new funds
- Drafting Fund formation and offering documents
- Representing you when you buy and sell portfolio investments
- Negotiating contracts
- Conducting due diligence
Laws and regulations are constantly changing, so you need to stay updated on the legal aspects of operating a fund.
Starting a Fund? Get the Legal Advice You Need.
At Doida Crow Legal, we are here to assist you with your fund formation and operation needs. Using our business law experience and unique industry insights, we can help you get your new fund started on the right foot. To schedule a no-obligation consultation, call us now at 720.306.1001.
This article provides a broad overview and is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.