If you’re managing a private investment fund, you’ve probably spent considerable time making sure your offering complies with federal securities laws. You’ve worked with attorneys to prepare your Private Placement Memorandum, Subscription Agreement, and operating documents. You’ve selected a Regulation D exemption, filed your Form D, and established procedures for accepting investors.
You may have also structured your fund to qualify under Section 3(c)(1) of the Investment Company Act of 1940, which generally allows qualifying private funds with no more than 100 beneficial owners or Section 3(c)(5) for real estate funds to avoid registration as investment companies. For many sponsors, particularly those operating feeder funds or funds that invest in other syndications, this is an important part of the legal structure.
But there’s another federal securities law that doesn’t always get the same attention during fund formation: the Investment Advisers Act of 1940. And depending on how your fund operates, it may be just as important as the exemptions you relied upon when raising capital.
The distinction is that your investment fund and the company managing that fund have separate legal obligations. Your fund may be properly exempt from registration under the Investment Company Act, but that doesn’t necessarily mean your management company is exempt from registration or reporting under federal and state investment adviser laws.
Your Fund and Your Fund Manager Are Two Different Things
Let’s use a fairly common real estate investment structure as an example. Suppose you establish an LLC to raise $2 million from investors for the purpose of investing in another sponsor’s $20 million multifamily syndication. Your investors contribute capital to your LLC, and your fund purchases a limited partnership or LLC membership interest in the larger investment.
You’ve essentially created a feeder fund or commonly called a fund of funds. Assuming you’ve properly structured the offering, your fund may qualify under Section 3(c)(1) of the Investment Company Act, and the securities you’re selling to your investors may be offered under Regulation D.
Now consider what happens after you’ve raised the money. Someone needs to manage the feeder fund, make the investment decisions, monitor the underlying syndication, communicate with investors, and determine what happens when the investment is eventually sold. In many cases, the sponsor has established a separate management company that receives fees, a carried interest, or some other form of compensation for those activities.
That management company is generally acting as an investment adviser under federal or state securities laws. The fund’s Investment Company Act exemption doesn’t resolve whether the GP is acting as an investment adviser.
This is where some fund sponsors make an understandable mistake. They assume that because they’ve completed the offering documents, filed the appropriate securities notices, and established their fund under Section 3(c)(1), their securities compliance obligations have been addressed. Unfortunately, that analysis is incomplete.
What Makes Someone an Investment Adviser?
The Investment Advisers Act generally defines an investment adviser as a person or business that, for compensation, is engaged in the business of advising others about securities. There are exclusions and qualifications to that definition, but those three elements provide a useful starting point for understanding how the law applies.
Most real estate sponsors don’t think of themselves as investment advisers. They’re fund managers, syndicators, capital raisers, or real estate operators. Their business involves identifying investment opportunities, negotiating transactions, gathering investors, and managing the investments.
The problem is that the law generally focuses on what you’re actually doing rather than the title you’ve given yourself. If your company is receiving compensation to select, recommend, or manage investments involving buying into other entities, you are generally operating an investment advisory business even though your investment strategy involves real estate.
Consider the difference between a company that directly purchases an apartment building and a company that raises money to purchase limited partnership interests in unrelated apartment syndications. Both businesses are involved in real estate, but they’re not necessarily engaged in the same activities from a securities law perspective.
The first company is primarily acquiring and operating real property. The second is selecting and managing investments in securities issued by other companies, which can create investment adviser issues that may not exist in the same way for a direct real estate operator.
Of course, not every LLC or partnership interest is automatically a security, and there are circumstances where the structure and management rights affect that determination. Nevertheless, when your fund is purchasing passive ownership interests in other sponsors’ investment offerings, investment adviser regulation needs to be part of your legal analysis.
Why Feeder Funds and Funds of Funds Deserve Particular Attention
Feeder funds have become an increasingly popular way for sponsors to participate in larger real estate transactions. Rather than serving on the general partner team of a syndication, a sponsor might organize a separate fund, raise $1 million or $2 million from their investor relationships, and invest that capital into the larger offering.
Sometimes the sponsor receives an allocation of profits from the underlying transaction. Other times, the feeder fund charges its own management fees or establishes a different preferred return and profit-sharing arrangement with its investors. The economics can vary considerably, but the sponsor is generally responsible for managing an investment vehicle that owns securities in another entity.
But investment adviser regulation may require looking at the entire management operation. If the same management company is directing the investment activities, the relevant analysis may include the manager’s combined assets under management, the nature of its advisory services, and the relationship among the entities.
Establishing a new LLC for each investment doesn’t necessarily mean the management company gets a new exemption for each LLC. The fact that each feeder fund is relatively small also doesn’t automatically take the manager outside investment adviser regulation.
The issue becomes even more relevant with traditional funds of funds, where a single investment vehicle raises capital to invest across syndications, private funds, or other investment opportunities. A manager selecting those investments and receiving compensation for managing the portfolio has activities that should be carefully evaluated under the Investment Advisers Act.
The Federal Exemption Doesn’t Resolve Every State Requirement
Fortunately, there are exemptions available to many private fund managers. Federal law recognizes that certain advisers operating private funds shouldn’t necessarily be subject to the same registration framework as larger investment advisory firms serving individual retail clients.
One important federal provision is Section 203(m) of the Investment Advisers Act. Under the applicable SEC rule, qualifying U.S. advisers that advise solely private funds and manage less than $150 million in private fund assets may be exempt from SEC investment adviser registration. That is the easy analysis.
Advisers relying on this exemption are generally required to report certain information to the SEC through Form ADV as exempt reporting advisers, rather than completing the full registration process.
This distinction is particularly important for smaller fund managers, because the federal and state registration frameworks don’t operate in exactly the same way. An adviser managing $10 million in feeder fund investments may have a very different filing obligation than an adviser managing $125 million, even though both amounts are below the federal private fund adviser exemption threshold.
All smaller advisers are subject to state investment adviser regulation. Those advisers may qualify for a private fund adviser exemption in their home state, but the requirements for using that exemption can differ substantially from those applicable to an SEC exempt reporting adviser.
A manager therefore needs to determine which regulatory framework applies before deciding whether to register, claim an exemption, or submit an exempt reporting adviser filing.
Why Your State Matters
Investment adviser compliance becomes more complicated when we look at how individual states regulate private fund managers. Some states have adopted exemptions modeled on rules developed by the North American Securities Administrators Association, commonly known as NASAA. Other states have adopted different requirements or modified the conditions for qualifying as an exempt private fund adviser.
Depending on the state, an exemption may require the manager to satisfy investor qualification standards, provide particular disclosures, obtain audited financial statements, or make filings through the Investment Adviser Registration Depository, commonly called IARD. Other states may have exemptions that operate differently, including circumstances where a particular exemption doesn’t require a filing.
This means a feeder fund manager operating in Texas may have different legal obligations from a manager conducting similar activities in California, Florida, or Arizona. Even where the states recognize similar types of exemptions, the conditions for claiming them may not be identical.
The analysis also needs to consider more than the state where the management company was formed. A manager might have a Delaware LLC, maintain its principal office in Texas, and raise capital from investors living throughout the country.
Forming an LLC in Delaware doesn’t necessarily make Delaware the primary jurisdiction for regulating the advisory business. The actual locations where the manager operates, its places of business, and the applicable investor and jurisdictional rules can be more significant.
Investor locations deserve attention as well, but there is an important distinction here. For many investment adviser registration purposes, a private fund is generally treated as the adviser’s client rather than treating every individual investor in that fund as a separate advisory client. This means having investors in ten different states doesn’t automatically require an adviser to register in all ten states.
Nevertheless, other state requirements and the manager’s actual activities may create obligations outside its home state. That is one reason investment adviser compliance requires a separate analysis rather than simply relying on the states identified in the fund’s Form D filings.
Accredited Investors May Not Be Enough
One of the more surprising issues for private fund managers involves the difference between accredited investors and qualified clients. Most sponsors understand the accredited investor standards used in Regulation D offerings, including the familiar income and net worth qualifications.
But certain state private fund adviser exemptions impose additional conditions involving a different investor qualification standard. Under NASAA’s model private fund adviser exemption, advisers to certain Section 3(c)(1) funds generally must limit beneficial ownership to individuals satisfying the applicable qualified client standard, among other requirements.
A person may qualify as an accredited investor under Regulation D without qualifying as a qualified client. Those standards serve different purposes, and satisfying one doesn’t automatically establish eligibility under the other. A qualified client has a net worth of at least $2.7 million, not including the value of the investor’s primary residence.
The model exemption also includes requirements involving written disclosures and annual audited financial statements for certain 3(c)(1) funds. Not every state has adopted those conditions, and some states provide different exemptions or special treatment for particular types of funds.
Imagine you’ve been managing a feeder fund for three years with 25 accredited investors. You structured the offering correctly under Regulation D, but later discover that the state exemption you believed applied to your management company requires a different investor qualification standard.
Depending on the state’s rules and your specific circumstances, that could create a compliance issue that isn’t easily resolved by filing another form. Investor eligibility, audit requirements, and the manager’s exemption should ideally be evaluated before investors are admitted, but they’re also important considerations when reviewing an existing fund.
What Is Form ADV, and When Is It Required?
Form ADV is the principal registration and reporting document used by investment advisers. Registered advisers use it to provide information about their businesses, while certain advisers that qualify for exemptions from registration must still report specified information through the same system.
Those advisers are commonly called exempt reporting advisers, or ERAs. Although they’re exempt from registration under an applicable provision, they may still be required to identify themselves and disclose information about their advisory activities.
The information typically includes the manager’s ownership, business structure, advisory activities, assets under management, private funds, and certain disciplinary matters. Depending on the applicable exemption, the report may be filed with the SEC, one or more state securities regulators, or both, through IARD.
For example, Texas provides a private fund adviser exemption under its state rules that includes Form ADV reporting for qualifying managers. Its filing requirements distinguish between advisers eligible to report to the SEC as ERAs and smaller advisers that may report at the state level without making an SEC ERA filing.
The important point is that Form ADV isn’t simply paperwork you submit because you operate a private fund. You first need to establish whether your management company is acting as an investment adviser, which laws apply, whether an exemption is available, and what reporting requirements accompany that exemption.
For managers who are required to report, there are also continuing obligations involving amendments and periodic updates. An initial filing isn’t necessarily the end of the compliance process, particularly when the manager launches additional funds, changes its operations, or experiences significant growth.
What If You’ve Been Managing a Fund for Years?
If you’ve been operating a feeder fund or fund of funds for several years without evaluating investment adviser registration requirements, that doesn’t necessarily mean you’ve done anything wrong. Your management company may qualify for an exemption, and in some circumstances, the exemption may not require a registration or reporting filing.
But the fact that you’ve operated successfully for several years without hearing from a regulator doesn’t establish that your company has met its obligations.
At a minimum, an existing fund manager should understand whether its activities fall within the definition of investment adviser, which federal or state regulatory framework applies, and whether the manager qualifies for an available exemption. If a filing was required but never completed, the appropriate response will depend on the circumstances and the applicable law.
In some cases, that evaluation may result in preparing an initial Form ADV filing or addressing an overdue reporting requirement. In other cases, the analysis may identify more substantial concerns involving investor qualifications, fund structure, registration, or the conditions of a state exemption.
These are issues worth identifying before launching another feeder fund, accepting additional investors, or expanding into a new investment strategy.
Let Crowdfunding Lawyers Evaluate Your Fund Management Operation
At Crowdfunding Lawyers, we regularly work with sponsors establishing and operating private investment funds, including feeder funds and funds of funds. We understand that most of these managers aren’t trying to establish traditional investment advisory firms. They’re raising capital from investors, identifying investment opportunities, and managing investments in other real estate syndications and private funds.
Nevertheless, those activities can create investment adviser obligations that are entirely separate from the Regulation D and Investment Company Act exemptions used to structure the investment offering.
Our firm assists existing fund managers with evaluating their operations under applicable federal and state investment adviser laws, identifying available registration exemptions, and determining whether Form ADV reporting or registration is necessary. We also assist with preparing and submitting applicable SEC exempt reporting adviser and state Form ADV filings.
If you’re managing a feeder fund, fund of funds, or another private investment vehicle that purchases securities issued by other companies, it’s worth making sure your management company has addressed these requirements. An investment adviser exemption evaluation can help identify what obligations apply to your business and what additional filings, if any, should be completed.
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Attorney Advertisement. This article is intended for general educational purposes and does not constitute legal advice. Investment adviser registration and exemption requirements depend on the manager’s activities, fund structure, relevant jurisdictions, and applicable law.