Launching a private fund is hard, and first impressions matter. Sophisticated investors do their homework, and a single legal or regulatory misstep can be enough to make them walk away. The good news? Most of these issues are entirely manageable when you spot them early. Here are the legal issues most likely to shape an investor’s decision, and what sponsors should do about each one.
Confirm Your Investment Company Act Exclusion
Private funds often rely on Section 3(c)(1) or Section 3(c)(7) under the Investment Company Act of 1940 to avoid having to register as investment companies under federal securities laws. A traditional Section 3(c)(1) fund is generally limited to 100 beneficial owners. A Section 3(c)(7) fund may generally admit a larger number of investors, but its investors must be “qualified purchasers,” a higher eligibility standard than accredited-investor status. It is essential that the sponsor carefully identify investors and ensure their eligibility. A failure to maintain the conditions of the exclusion could jeopardize the fund’s exempt status.
Choose the Right Securities Act Exemption
To comply with the Securities Act of 1933, many private funds follow Regulation D, particularly Rule 506(b) or Rule 506(c). A Rule 506(b) offering may generally accept unlimited accredited investors and up to 35 non-accredited investors, while a Rule 506(c) offering is limited to accredited investors and requires the issuer to take reasonable steps to verify the investors’ status. The selection between these exemptions should occur before the fundraising process to ensure a smooth start.
Don’t Overlook State Blue Sky Requirements
A private equity fund raising capital from investors in multiple states must also address “blue sky” requirements that are state-specific regulations governing offerings and sales of fund interests. Even if the fund is exempt from federal registration, the fund may need to follow state notice filings, fees, timing, and documentation requirements. Missing these obligations can expose the fund to enforcement risk and avoidable costs, while diminishing investor confidence in the fund’s compliance practices.
Address Investment Adviser Registration
The fund sponsor must also evaluate whether the investment adviser is required to register under the Investment Advisers Act of 1940. Certain advisers may qualify as exempt reporting advisers, including advising private funds with less than $150 million in U.S. assets under management or venture capital funds. Although exempt reporting advisers do not complete the same registration process as registered advisers, they still have reporting and compliance obligations. It is important to ensure that the adviser complies with the applicable registration or reporting requirements, as noncompliance may result in additional costs and delays.
Get Your Governing Documents in Order
Governing documents establish the formal connection between the sponsor and investors. These documents provide investors with a detailed understanding of their financial rights and remedies, as well as the terms of their investment. By looking at the drafted operating agreement, subscription agreement, private placement memorandum, and side letters, investors can see how organized, or not, the sponsor is. Unresolved or ambiguous provisions signal potential risk that requires further diligence or negotiation and could deter investors from committing capital.
Account for Foreign Investors and CFIUS
It is not uncommon for U.S. funds to engage foreign investors in our global market. However, funds with foreign investors might trigger additional regulatory scrutiny. The Foreign Investment Risk Review Modernization Act expanded the Committee on Foreign Investment in the United States’ authority to review certain foreign investments in U.S. businesses and can also extend to noncontrolling investments involving U.S. businesses that deal with critical technologies, critical infrastructure, or sensitive personal data. Under FIRRMA, funds with foreign limited partners will not be considered foreign if certain conditions are met. Ensuring the fund’s structure satisfies these requirements will ensure CFIUS does not gain jurisdiction over the fund.
Weigh Conflicts and Business Risks
Beyond regulatory concerns, investors might also reconsider their investment decisions if they identify potential conflicts of interest and business, financial, operational, and reputational risks associated with the sponsor or the fund. These may include concerns about pending litigation or disputes involving the sponsor or portfolio companies, inadequate disclosure or management of conflicts, or a lack of transparency regarding fees and expenses.
The good news is that each of these issues is manageable when addressed early. Spotting and resolving them before you approach investors signals discipline and builds the confidence that leads to a commitment of capital. RR&A has years of experience guiding sponsors through fund formation, securities compliance, and investor negotiations. If you would like help laying this groundwork, we are here to guide you through every step.
Disclaimer: The information and material on this website is general information about our practice and firm. This information does not offer specific legal advice and the use of this information does not create an attorney-client relationship with RR&A or any of its attorneys. The information on this website should not be used for legal advice, and persons should not act upon the information on this website without engaging professional legal counsel.
Miranda is a Managing Associate at R. Reese & Associates and Team Lead of the Corporate practice. To learn more about Miranda, visit her attorney page.