If you’re managing a feeder fund or fund of funds, you’ve probably spent time making sure your investors qualify under Reg D. You’ve collected investor questionnaires, reviewed accredited investor representations, and followed the subscription procedures established in your offering documents. Depending on whether you’re using Rule 506(c), you may have also completed additional investor verification.
But there’s another investor qualification standard that many fund managers overlook. Depending on the state where your management company operates, it could determine whether you qualify for an exemption from investment adviser registration.
The distinction involves accredited investors and qualified clients. Although both classifications address an investor’s financial qualifications, they serve different purposes under securities laws. An investor can be perfectly qualified to invest in your feeder fund while preventing your management company from relying on a particular state investment adviser exemption.
That’s an important distinction for managers who have already accepted investors and invested their capital into another sponsor’s syndication. Your fund may be properly structured under Regulation D and Section 3(c)(1) of the Investment Company Act, but that doesn’t automatically resolve your management company’s investment adviser obligations.
Accredited Investors and Qualified Clients Are Different
Most real estate sponsors understand the accredited investor requirements. An individual can generally qualify by having a net worth exceeding $1 million, excluding their primary residence, or by satisfying certain annual income requirements. There are also other ways for individuals and entities to qualify, including certain professional credentials.
Qualified-client status is different. Under the federal standards currently in effect, one common way to qualify is by having a net worth of at least $2.7 million, excluding the primary residence. Another involves having at least $1.4 million managed by the investment adviser, and additional qualifications are available.
This becomes important because certain state private fund adviser exemptions impose qualified client requirements on investors in particular Section 3(c)(1) funds. Those requirements are separate from the rules governing who can purchase securities in your offering, and compliance with one doesn’t establish compliance with the other.
Why Investor Qualifications Affect Your Management Company
When you establish a feeder fund or fund of funds, you’re dealing with two separate regulatory questions. The first involves the fund itself, including its securities offering and exclusion from registration under the Investment Company Act. The second involves the company managing the fund and whether its activities require investment adviser registration.
For many feeder funds, the management company identifies the underlying investment, completes due diligence, recommends the opportunity, and receives compensation for managing the investment vehicle. Those activities can constitute investment advisory services, even when the fund purchases only one limited partnership or LLC membership interest. Fortunately, federal and state laws provide exemptions for many private fund advisers. However, some exemptions impose conditions involving the financial qualifications of investors who own interests in the funds being managed.
Several states have adopted versions of a private fund adviser exemption developed by the North American Securities Administrators Association, commonly called NASAA. The model exemption includes qualified-client requirements for certain Section 3(c)(1) funds, along with additional conditions involving disclosures and annual audited financial statements.
Not every state follows the model in the same way. Some states have modified the requirements, while others provide different treatment for particular types of funds or use entirely different exemption frameworks. For an existing manager, this means the analysis can’t stop with determining that the fund has fewer than 100 beneficial owners or that every investor is accredited. The state where the management company operates, the type of fund being managed, and the qualifications of its investors may all affect whether an exemption is available.
What If You’ve Already Accepted Investors?
This issue becomes particularly difficult when a feeder fund has already completed its capital raise. The investors have signed their subscription agreements, the money has been invested, and the underlying project may not provide liquidity for several years.
Discovering that several investors don’t meet a qualified-client requirement could mean the management company doesn’t qualify for the state investment adviser exemption it expected to use. The fund’s Regulation D offering may have been entirely proper, but that doesn’t necessarily resolve the separate requirements imposed on the adviser. Unfortunately, correcting the issue may involve more than updating your subscription documents. Requiring future investors to qualify as qualified clients doesn’t automatically resolve the status of investors who have already been admitted into the fund.
The available options depend on the state’s rules and the manager’s circumstances. Another exemption may be available, registration may need to be considered, or the existing structure may require further analysis to determine an appropriate compliance approach.
This is also why simply filing Form ADV isn’t necessarily the only solution. A manager claiming an exemption must satisfy the exemption’s substantive requirements, including any applicable investor qualification conditions. Completing a regulatory filing doesn’t make an otherwise unavailable exemption available.
Not Every State Treats Fund-of-Funds Managers the Same
Texas provides an important illustration of how state exemptions can distinguish between different types of private funds.
Under Texas Rule 139.23, advisers to certain Section 3(c)(1) funds must satisfy qualified-client requirements to rely on the state’s private fund adviser exemption. However, Texas provides different treatment for qualifying real estate, private equity, and venture capital funds, which are defined under applicable regulatory standards.
Those classifications deserve attention when dealing with feeder funds. A fund that purchases a membership interest in another sponsor’s apartment syndication shouldn’t assume it qualifies as a real estate fund merely because the underlying investment involves an apartment building. The nature of the securities owned by the feeder fund and the applicable regulatory definitions matter.
California provides a different approach under Rule 260.204.9. Its private fund adviser exemption generally allows accredited investors in certain qualifying funds, subject to additional conditions involving disclosures and audited financial statements. It also restricts certain performance-based compensation arrangements involving investors who aren’t qualified clients.
The practical result is that an investor’s status may affect one manager’s ability to claim an exemption while creating a different type of compliance issue for another manager. The laws aren’t uniform, and the relevant fund classifications need to be reviewed before assuming an exemption applies.
Carried Interests Create Another Qualified-Client Issue
Most feeder fund managers don’t establish their investment vehicles simply to collect an annual management fee. They frequently negotiate a carried interest or other profit-sharing arrangement that compensates them when the underlying investment performs well.
Those arrangements raise a separate qualified client question. Under federal investment adviser rules, performance based compensation involving certain Section 3(c)(1) funds can require looking through the fund to determine whether the investors subject to those fees qualify as qualified clients. This issue shouldn’t be confused with the investor qualification conditions imposed by a state registration exemption. A manager may satisfy the requirements for an exemption from registration while still needing to evaluate whether its compensation arrangement is permitted.
The distinction becomes particularly important when the carried interest is described in the operating agreement as a sponsor promote or special allocation of profits. The terminology doesn’t necessarily determine how the arrangement is treated under investment adviser laws. Not every carried interest is automatically subject to the same restrictions, and applicable exceptions may affect the analysis. Nevertheless, reviewing the compensation provisions is an important part of evaluating an existing feeder fund manager’s compliance obligations.
Multiple LLCs Don’t Necessarily Solve the Problem
Feeder funds often use multiple entities for legitimate business and investment purposes. A manager might organize separate LLCs for different syndications or establish a holding entity through which investors participate in an underlying offering.
Those structures don’t necessarily eliminate qualified-client requirements. Certain investment adviser rules require looking through entities to the beneficial owners when determining whether the applicable investor qualifications have been satisfied. The manager also needs to consider the broader advisory operation rather than assuming each LLC creates an entirely separate investment adviser business. Common ownership, management authority, and the relationship among the funds can all be relevant.
For sponsors operating several feeder funds, this makes the exemption analysis more involved than simply reviewing the investor questionnaire for one LLC. The management company’s operations and the requirements applicable to each advised fund need to be considered together.
Reviewing Your Existing Fund Management Operation
If you’re already operating a feeder fund, the starting point is determining which investment adviser exemption your management company is relying upon. That involves reviewing the manager’s actual activities, state of operation, fund investments, and compensation arrangements.
Investor qualifications should be part of that review, particularly when the applicable exemption includes qualified-client requirements. An accredited investor questionnaire may not establish qualified-client status, although investors can sometimes qualify through other financial or regulatory criteria.
The evaluation should also consider whether the exemption requires annual audited financial statements, specific disclosures, or reporting through Form ADV. Those obligations can apply even when the management company qualifies for an exemption from full investment adviser registration.
For managers who have already been operating for several years, the review may reveal that additional filings should have been completed. It may also establish that the manager qualifies for an exemption and identify the requirements necessary to maintain that status.
Investment Adviser Compliance Evaluations and Form ADV Preparation
At Crowdfunding Lawyers, we assist existing feeder fund and fund-of-funds managers with evaluating their operations under federal and state investment adviser laws. Our services include reviewing the management company’s activities, fund structures, investor qualifications, compensation arrangements, and the requirements of available registration exemptions.
We also provide Form ADV preparation and filing services, including state reporting requirements. For managers who have already established their funds, we can evaluate whether previous filings were required and identify appropriate next steps to address outstanding compliance obligations.
If you’re managing a feeder fund that invests in another sponsor’s syndication or private fund, it’s worth confirming that your management company qualifies for the exemption you’re relying upon. Your investors may have properly qualified under Regulation D, but that doesn’t necessarily mean they satisfy the separate requirements applicable to your investment advisory business.
Schedule an Investment Adviser Compliance Consultation with Crowdfunding Lawyers
Attorney Advertisement. This article is provided for general educational purposes and does not constitute legal advice. Investment adviser exemptions, qualified-client requirements, compensation restrictions, and reporting obligations depend on applicable federal and state laws and the circumstances of each fund.