You’ve identified a real estate syndication that you believe is a strong investment opportunity. You’ve reviewed the underwriting, evaluated the sponsor’s experience, examined the financing, and spent time understanding the business plan. After completing your due diligence, you’ve decided it’s a project worth bringing to your investor network to buy into the syndication.
Rather than referring investors directly to the sponsor, you establish a feeder fund (also known as fund of funds) to raise $2 million and invest into the syndication. Your fund will make one investment, hold that investment until the property is sold or refinanced, and distribute the proceeds to your investors.
You’re not managing a stock portfolio, trading securities, or making investment decisions every week. You’ve already identified the investment before accepting the first dollar from your investors. So why would the Investment Advisers Act of 1940 apply to your business?
You’ve Already Selected the Investment. Does That Matter?
Your presentation includes the property’s historical operations, projected cash flow, financing arrangements, and anticipated returns. You’re explaining why you’ve decided to invest and why you believe the opportunity makes sense.
By the time investors subscribe to the feeder fund, you’ve already made the primary investment decision. There’s very little discretion remaining because the fund was established to acquire an interest in a specific syndication.
That doesn’t remove your management company from the definition of an investment adviser. Selecting and managing a single investment can involve investment advisory activities, even when your fund has no intention of purchasing additional securities.
The Investment Advisers Act generally defines an investment adviser as someone who, for compensation, is engaged in the business of providing advice about securities. There are exclusions and exceptions, but these elements provide a starting point for evaluating feeder fund management activities.
Consider what happens during your due diligence. You review the sponsor’s projections, evaluate the property’s financial performance, assess the proposed debt structure, and determine whether the anticipated returns justify the risks.
You might negotiate the investment terms or decide not to participate because the transaction doesn’t meet your expectations. You’re using your knowledge and judgment to determine whether your feeder fund should purchase an ownership interest in another company.
When that ownership interest is a security, your activities constitute investment analysis and advice. This differs from researching an investment for your personal account because you’re making decisions on behalf of a separate investment vehicle funded by other investors.
Of course, not everyone who evaluates an investment becomes an investment adviser. The manager’s authority, compensation, and actual business activities all matter. However, completing due diligence before forming the feeder fund doesn’t automatically eliminate investment adviser considerations.
Who Is Actually Receiving the Investment Advice?
There’s an important distinction between recommending an opportunity to prospective investors and advising the feeder fund itself.
When investors subscribe to your feeder fund, they generally purchase securities issued by your LLC or limited partnership. The feeder fund then uses that capital to purchase an ownership interest in the underlying syndication.
For investment adviser purposes, the fund itself is generally treated as the advisory client. Your investors aren’t always automatically treated as individual advisory clients simply because they’ve invested in your feeder fund.
Your management company may nevertheless be providing investment advisory services to the fund and its investors. It evaluates the underlying transaction, determines whether the fund should invest, and manages the fund’s ownership interest.
The fact that investors know which syndication the feeder fund intends to acquire doesn’t necessarily change that relationship. A predetermined investment strategy may limit your discretion, but it doesn’t automatically eliminate investment adviser status.
Does It Matter How You’re Compensated?
Many feeder fund managers don’t charge a fee specifically identified as an investment advisory fee. Instead, they receive an annual management fee, a share of profits through a carried interest, or other economic benefits associated with organizing and managing the fund.
Depending on the circumstances, these arrangements satisfy the compensation element of the investment adviser definition. Securities regulators generally consider the substance of the arrangement rather than simply the terminology used in your operating agreement.
Suppose your feeder fund invests $1 million into an apartment syndication. Your investors receive distributions from the underlying investment, but your management company also receives a percentage of the profits defined as asset management fees after investors achieve a specified return.
You may view that compensation as payment for finding the opportunity, completing due diligence, and managing investor relationships. However, those activities and the associated compensation need to be evaluated under investment adviser laws.
Separate rules concerning performance-based compensation and qualified clients may also apply. This is another reason to review the management company’s compensation arrangements as part of an investment adviser exemption evaluation.
What If You Don’t Make Any More Investment Decisions?
Some feeder fund managers believe their responsibilities are primarily administrative after the investment closes. The underlying sponsor operates the apartment building, makes renovation decisions, and eventually determines when to sell or refinance.
Meanwhile, the feeder fund manager receives reports, communicates with investors, and distributes funds when payments arrive. There may be very little additional investment activity.
But managing an investment doesn’t necessarily require making new investment decisions every month. The original selection of the securities investment can be relevant, and your management company may retain authority to approve amendments, respond to capital calls, exercise voting rights, or evaluate a restructuring.
The important question isn’t how frequently you trade or select investments. It’s whether your management activities, considered together, bring your company within the applicable investment adviser definition.
Does Your Feeder Fund Manager Qualify for an Exemption?
Even when a feeder fund manager is acting as an investment adviser, that doesn’t necessarily mean full investment adviser registration is required.
Federal law provides an exemption under Section 203(m) for qualifying advisers that advise solely private funds and manage less than $150 million in private fund assets in the United States. Advisers eligible to rely on this exemption within the SEC framework generally report through Form ADV as exempt reporting advisers.
However, smaller fund managers frequently fall primarily under state investment adviser regulation. Some states provide exemptions for private fund advisers, while others impose conditions involving investor qualifications, audited financial statements, disclosures, or regulatory filings.
A manager operating in Texas may therefore face different requirements from one operating in California, Florida, or Arizona. The manager’s principal place of business, additional business locations, and applicable jurisdictional rules can all be relevant.
Having fund investors in several states doesn’t automatically require investment adviser registration in every investor’s state. Nevertheless, investor locations and related activities should be considered when evaluating applicable requirements.
Should You Have Filed Form ADV?
Form ADV is used by investment advisers for registration and certain exemption-related reporting requirements. Some managers must register, while others qualify for exemptions that still require them to submit information as exempt reporting advisers.
Depending on the circumstances, filings may be required with the SEC, state securities regulators, or both through the Investment Adviser Registration Depository, commonly called IARD.
For example, Texas has a private fund adviser exemption that includes Form ADV reporting requirements for certain qualifying managers. Smaller advisers may report at the state level without being eligible to file as SEC exempt reporting advisers.
If you’ve been managing a feeder fund without making a filing, that doesn’t automatically mean you’ve violated the law. You may qualify for an exemption that doesn’t require reporting, but determining that requires reviewing your management activities and applicable state requirements.
Let Crowdfunding Lawyers Evaluate Your Fund Management Operation
At Crowdfunding Lawyers, we regularly work with sponsors who establish feeder funds to invest in other real estate syndications and private investment funds. Many have already identified the investment, completed extensive due diligence, and decided to recommend the opportunity before forming their feeder fund.
Those activities don’t automatically require investment adviser registration, but they can create obligations separate from the Regulation D and Investment Company Act exemptions used to structure the fund.
Our firm assists existing fund managers with evaluating investment adviser exemptions under federal and state laws, determining applicable reporting requirements, and preparing Form ADV filings for qualifying SEC exempt reporting advisers and applicable state filings.
If you’re currently managing a feeder fund or fund of funds, it’s worth making sure your management company has addressed these issues. An investment adviser exemption evaluation can help determine which obligations apply and whether additional filings or compliance measures are necessary.
Schedule a Consultation with Crowdfunding Lawyers
Attorney Advertisement. This article is provided for general educational purposes and does not constitute legal advice. Investment adviser status, exemptions, and filing obligations depend on the manager’s actual activities, fund structure, and applicable federal and state laws.