Nicole M. Kuchera and Joseph M. Mannon, Vedder Price
August 23, 2016
This article provides a simple three step guide to registration considerations for managers of various types of private fund vehicles, such as for hedge funds, fund of funds, private equity funds, venture capital funds, real estate funds and commodity pools. Registration considerations under both the Commodity Exchange Act of 1936, as amended (the “CEA”), and the Investment Advisers Act of 1940, as amended (the “Advisers Act”), are outlined below. Registration considerations for non-U.S. jurisdictions are not addressed in this summary. The following discussion is provided as a source of information only and is not intended to be comprehensive or constitute legal advice. STEP 1: WHAT WILL YOU INVEST IN? Private funds can invest in a wide variety of investment products. It is therefore important to understand the scope of your firm’s investments before analyzing the potential registration considerations.[1] While traditional hedge funds may not include limits on their investment types, other fund products may have a more focused investment strategy. Your decision on the intended investment direction of the fund will determine many fundamental characteristics of your fund, such as which regulators will likely have jurisdiction over your activities. A summary of some of the most prevalent investment strategies for a private fund are listed below:- Securities Focused (including hedge funds) – A fund that invests primarily in securities will generally focus upon trading equities, fixed income or options. Common securities-based hedge fund strategies include: long/short equity, market neutral, merger arbitrage, convertible arbitrage, event driven, credit and fixed income arbitrage. We note that many private funds offer simple long only strategies.
- Fund of Funds (“FOFs”) – A fund of funds is a fund that unsurprisingly invests in other private or public funds. Examples of FOF strategies include: hedge funds, private equity funds, venture capital funds, real estate funds or commodity pools.
- Private Equity – Private equity funds generally invest primarily in mature private companies with the intent to operationally manage, grow and eventually sell these assets. Private equity firms may employ leverage when buying portfolio companies.
- Venture Capital – Venture capital funds typically invest in early (pre-revenue stage) private companies. Unlike private equity funds, venture capital funds generally make smaller individual investments across various companies (assuming that some investments may succeed and some may fail). Also unlike private equity funds that generally use a combination of equity and debt, venture capital funds generally make equity investments with a limited use of leverage.
- Real Estate Focused – Real estate funds generally focus on making investments inreal estate or real estate related assets.
- Futures/Forex/Derivatives Focused (including commodity pools) – Funds that trade in commodities and/or derivatives generally focus upon the trading of standardized contracts for future delivery, including commodities such as securities indexes, gold, silver, forex (foreign currency) or swaps.
If the fund’s manager intends to make minimal investments in commodity interests for a privately offered pool that is exempt from registration under the Securities Act of 1933 (“1933 Act”), it may be able to rely upon CFTC Regulation 4.13(a)(3) in order to avoid CPO registration with respect to the fund. In this regard, the pool cannot be marketed as a vehicle for trading commodities. In addition, for this exemption to apply, either: (1) the fund’s aggregate initial margin and premiums for commodity interests cannot exceed 5% of “liquidation value” of the fund’s portfolio (the “5% Test”) (taking into account unrealized profits and losses; provided that in the case of an option that is in-the-money at the time of purchase, the in-the-money amount may be excluded in computing such 5%) or (2) the fund’s aggregate net notional value of commodity interests cannot exceed 100% of the fund’s “liquidation value” (the “Notional Test”) (taking into account unrealized profits and losses). Liquidation value means the fund’s net asset value. Application of both de minimis tests is determined at the time the most recent position was established and applies regardless of whether such positions were entered into for bona fide purposes or otherwise. The “Notional Test” is an especially useful alternative to the “5% Test” because margin levels for broad-based stock index futures and security futures tend to exceed levels for other commodity interests, which may make it difficult to satisfy the “5% Test.” The “Notional Test” sets forth specific details regarding how to calculate the notional value by asset class and how to net contracts.
In order to claim the exemption, the manager must reasonably believe that each investor in the commodity pool is an “accredited investor,” a trust that is not an “accredited investor” but that was formed by an “accredited investor” for the benefit of a family member, a “knowledgeable employee” of the manager, or a qualified eligible person as defined under CFTC Regulation 4.7. The 4.13(a)(3) exemption is not self-executing and a request for relief must be filed with respect to the fund with NFA. An annual affirmation to maintain this exemption must be filed within 60 days of the calendar year-end with the NFA. Each person who files for such relief must still keep books and records of its activities as a pool operator for 5 years, and such records must be readily accessible for 2 years. See CFTC Regulation 4.13(c)(1). Such person is not required to keep full books and records, however, as detailed in CFTC Regulation 4.23.
2. FOF Exemption – 12-38 Letter If the fund’s manager acts in whole or in part as a CPO of one or more fund of funds, the manager may be able to rely on CFTC No-Action Letter 12-38 (the “Letter 12-38”) to avoid registration as a CPO. In order for Letter 12-38 to apply, the amount of commodity interest positions to which the fund is directly exposed cannot exceed the levels specified in the “5% Test” or “Notional Test” (as described above with respect to 4.13(a)(3) funds) and the manager must not know and could not have reasonably known that the fund’s indirect exposure to commodity interests derived from contributions to the various third-party funds exceed such levels, either calculated directly, or through the use of Prior Appendix A under Rule 4.13(a)(3) relating to such relief. In addition, the fund for which the manager seeks relief must be compliant with the provisions of Regulation 4.13(a)(3)(i), (iii) and (iv) (namely that, all interests in the pool are part of a private offering, the manager must have a reasonable belief that each pool participant is an accredited investor, qualified eligible person, knowledgeable employee or other enumerated type of sophisticated investor, and the pool is not marketed as a vehicle for trading in futures or commodities options markets). This Letter 12-38 relief is not self-executing, and the manager must file a claim to perfect the relief with the NFA with respect to the fund. No annual affirmation is required to maintain this exemption. Once final fund of fund guidance is issued by the CFTC, affected CPOs must reevaluate whether they can continue to rely on Letter 12-38. Letter 12-38 is only intended to be effective through the later of June 30, 2013 or six months after the effective date of the revised guidance (or the compliance date, if later) regarding the application of de minimis thresholds to fund of funds in the context of CFTC Regulations 4.13(a)(3) and 4.5. Although the time period for claiming the original relief has expired, the exemption can still be claimed based on discussions with CFTC staff. 3. CFTC Registration Lite – 4.7 If a fund’s manager is unable to claim an exemption from CPO registration, a manager can register as a CPO and then claim relief under CFTC Regulation 4.7 – oftentimes referred to as “registration lite.” In order to claim the exemption, the fund must limit its sales activity to qualified eligible persons (“QEPs”), as defined under CFTC Regulation 4.7. Although CFTC Regulation 4.7 necessitates registration of the fund’s manager as a CPO, reduced disclosure (such as in regards to disclosing past performance of exempt funds), reporting, recordkeeping and other regulatory requirements apply with respect to the fund. Briefly stated, “QEPs” include persons such as certain investment professionals, knowledgeable employees, qualified purchasers as defined under the Investment Company Act of 1940, as amended (“1940 Act”), non-U.S. persons and accredited investors that meet the portfolio requirement. If an offering memorandum is distributed in connection with soliciting prospective participants in a 4.7 fund, such offering memorandum must include a 4.7 disclosure on its cover page, or, if none is provided, immediately above the signature line on the subscription agreement or other document that the prospective participant must execute to become a participant in the fund. The manager must also note on the cover page of each annual report that the 4.7 exemption is being claimed for the fund. The 4.7 exemption is not self-executing, and a request for relief must be filed with respect to the fund with NFA. No annual affirmation is required to maintain this exemption. 4. Non-U.S. Managers An exemption from CPO registration under CFTC Regulation 3.10(c)(3) is available if a manager is advising a non-U.S. fund of which: (1) all investors are located outside of the U.S.; (2) no solicitations are directed into the U.S. and (3) all commodity interest transactions are submitted for clearing through a registered futures commission merchant (except with respect to swaps not subject to clearing). A manager acting in accordance with this exemption remains subject to Section 4(o) of the CEA (which relates to fraud and misrepresentations). No filing is required for this exemption to be effective. It should be noted that on July 27, 2016 the CFTC announced proposed rules to remove the clearing requirement of this exemption, but a final rule has yet to be adopted as of the date of this article. 5. Non-U.S. Pools – Advisory 18-96 Registered U.S. CPOs are provided relief from certain reporting, recordkeeping and disclosure requirements for their funds that are organized offshore and only have non-U.S. participants. For this exemption to apply, the fund must also: (1) not hold meetings or conduct administrative activities in the U.S.; (2) not receive, hold or invest any capital directly or indirectly contributed from sources within the U.S.; and (3) conduct no marketing that could reasonably be expected to have the effect of soliciting U.S. investors. A hard copy of the exemption under CFTC Advisory 18-96 must be filed with NFA’s Compliance Department to be effective. No annual affirmation is required to maintain this exemption. 6. Incidental Commodities Trading Pursuant to CFTC Regulation 4.12(b), registered CPOs are afforded relief from certain reporting and disclosure requirements with respect to their private funds operating pursuant to the 1933 Act or a related private offering exemption where the fund routinely engages in securities business. For the relief to apply, the aggregate initial margin and premiums for the fund cannot exceed 10% of the fair market value of the fund’s assets. Further, commodities trading must be only incidental to the fund’s securities trading activities. This relief is not self-executing, and a request for relief must be filed with respect to the fund. No annual affirmation is required to maintain this relief. C. CTA Exemptions In addition to the CPO exemptions described above, the fund’s manager will also need to consider whether it needs to register as a CTA with the CFTC. Like CPOs, registered CTAs must also generally become members of the NFA. 1. Exempt CPO Advising Own FundAn exemption from CTA registration under CFTC Regulation 4.14(a)(5) is available for an exempt CPO that is acting as a trading advisor to its own fund. For this relief to apply: (1) the CPO must be exempt from registration as a CPO; and (2) the person’s commodity trading advice must be directed solely to, and for the use of, the fund(s) for which it is so exempt. No filing is required for this exemption to be effective.
2. Registered CPO Advising Own FundAn exemption from CTA registration under CFTC Regulation 4.14(a)(4) is available for a registered CPO that is acting as a trading advisor to its own fund. For this relief to apply: (1) the CPO must be registered under the CEA as a CPO; and (2) the person’s commodity trading advice must be directed solely to, and for the use of, the fund(s) for which it is so exempt. No filing is required for this exemption to be effective.
3. Less than 15 Persons A manager who, in the preceding 12 months, has not furnished commodity trading advice to more than 15 persons and who does not hold itself out generally to the public as a CTA is exempt from CTA registration. See CEA § 4(m)(1) and CFTC Rule 4.14(a)(10). CFTC Rule 4.14(a)(10) provides additional guidance regarding how a manager relying on this exemption should count clients toward the 15-client limit. In particular, non-U.S. firms need only count U.S.-resident clients towards the 15-client limit. In addition, the exemption provides that a manager shall not be deemed to hold itself out generally to the public for purposes of Section 4m(1) solely because the manager participates in a non-public offering of interests in a collective vehicle (e.g., a private offering of securities exempt from registration under the 1933 Act). “Holding oneself out” briefly means that a person is not advertising to obtain clients or actively trying to get new accounts. No filing is required for this exemption to be effective. 4. Investment Advisers – Not Primarily Engaged An exemption from CTA registration under CEA § 4(m)(3) is available for a manager who is: (1) registered with the U.S. Securities and Exchange Commission (the “SEC”) as an investment adviser; (2) whose business does not consist primarily of acting as a CTA; and (3) who does not act as a CTA to any investment trust, syndicate or similar form of enterprise that is engaged primarily in trading in any commodity for future delivery on or subject to the rules of any contract market or registered derivatives transaction execution facility. In this regard, the exemption provides that a CTA or a commodity pool shall be considered to be “engaged primarily” in the business of being a CTA or commodity pool if it is or holds itself out to the public as being engaged primarily, or proposes to engage primarily, in the business of advising on commodity interests or investing, reinvesting, owning, holding or trading in commodity interests, respectively. No filing is required for this exemption to be effective. 5. Investment Advisers – Solely IncidentalAn exemption from CTA registration under CFTC Regulation 4.14(a)(8) is available for an investment adviser that is acting as a trading advisor. For this exemption to apply: (1) the CTA must only provide advice to pools operating under a 4.13(a)(3) exemption, non-U.S. pools or CFTC Regulation 4.5 exempt pools; (2) such trading advice must be solely incidental to its securities advice; and (3) the manager cannot otherwise hold itself out as a CTA. This exemption is not self-executing. For the relief to apply, the manager must make the exemption filing with the NFA. An annual affirmation to maintain this exemption must be filed within 60 days of the calendar year-end with the NFA.
6. CFTC Registration Lite – 4.7 Similar to the related CPO exemption, CFTC Regulation 4.7 makes available an exemption from certain CEA Part 4 requirements for a CTA when the manager’s investments are only made by qualified eligible persons (i.e., QEPs) – oftentimes referred to as “registration lite.” In order to claim the exemption, the manager must limit its sales activity to QEPs, as defined under CFTC Regulation 4.7. Briefly stated, “QEPs” include persons such as certain investment professionals, knowledgeable employees, qualified purchasers as defined under the 1940 Act, non-U.S. persons and accredited investors that meet the portfolio requirement. Although CFTC Regulation 4.7 necessitates registration of the manager as a CTA, reduced disclosure (such as in regards to disclosing past performance of exempt accounts), reporting, recordkeeping and other regulatory requirements still apply with respect to the manager’s activities. If a brochure or other disclosure statement is distributed in connection with soliciting prospective clients, such brochure or other disclosure statement must include a 4.7 disclosure on its cover page, or, if none is provided, immediately above the signature line on the agreement or document that the prospective client must execute before it opens an account with the CTA. The 4.7 exemption is not self-executing, and a request for relief must be filed with respect to the manager with NFA. No annual affirmation is required to maintain this exemption. STEP 3: IS SEC REGISTRATION REQUIRED? A. Investment Adviser Registration Considerations If your fund’s trading strategy involves investments in securities, FOFs, private equity, venture capital or real estate, you will need to consider whether investment adviser registration is required for your firm. In determining whether registration is warranted, some relevant considerations are provided below. 1. Calculating RAUM Following the enactment of Title IV of the Dodd-Frank Act, the SEC developed a new registration regime for investment advisers that focused on the amount of regulatory assets under management (“RAUM”) managed by the manager under Section 203A of the Advisers Act. RAUM measures a manager’s gross assets under management. When calculating RAUM, a manager must take into account the value of all “securities portfolios” over which it provides continuous and regular supervisory or management services. This will generally include separate accounts, pooled vehicles, family or proprietary accounts, accounts managed without receiving compensation and assets of foreign clients. An account or entity is a “securities portfolio” if at least 50% of its value is attributable to “securities,” in which case the entire value of that account or entity (including the portion attributable to assets which are not securities) is included in determining the value of all “securities portfolios” managed by the manager. If less than 50% of the account or entity’s value is attributable to securities, the account/entity is not considered by the Advisers Act to be a “securities portfolio,” regardless of the size of its securities holdings, and none of its assets are counted when determining the amount of RAUM of the manager. For private funds that rely on the exemptions under Section 3(c)(1) or Section 3(c)(7) of the 1940 Act, the entire value of the fund is considered for purposes of determining RAUM without regard to the nature of its investments. A private fund’s RAUM equals its gross assets, which is measured by the asset side of the fund’s balance sheet. In other words, RAUM will combine a fund’s long and short exposure which will result in a gross exposure that will exceed a fund’s net assets. RAUM is not reduced by hedging techniques even if such techniques reduce overall risk to the portfolio. In addition, to the extent a fund has uncalled capital, the uncalled capital will be included in the RAUM. This is of particular importance for private equity and venture capital funds. More information on RAUM can be found on the SEC’s website at:https://www.sec.gov/divisions/investment/iard/ iardfaq.shtml. Below is a summary of various RAUM levels that determine whether investment adviser registration may be required:- Less than $25 million in RAUM. A manager with less than $25 million in RAUM will need to consider whether it needs to register with a state regulatory authority. While certain states provide exemptions from registration, other states provide limited or no exemptions.
- Mid-Sized Advisers ($25 million to $100 million in RAUM).[2] Mid-sized advisers include managers with between $25 million and $100 million in RAUM. If a mid-sized adviser has less than $100 million in RAUM, it must register with the states and is prohibited from registering with the SEC unless the manager is not “required to be registered” in the state of its principal place of business or is not subject to examination authority in the state of its principal place of business (i.e., Wyoming and New York). Rule 203A-1 of the Advisers Act also includes a registration buffer such that SEC registration is not required for a mid-sized adviser until the manager exceeds $110 million in RAUM. For a manager with between $100 million and $110 million in RAUM, registration with the SEC is voluntary. Conversely, a manager need not withdraw its SEC registration until its assets are less than $90 million.
- Over $100 million. A manager with RAUM over $100 million will likely need to register with the SEC as an investment adviser unless an exemption described below applies. Of particular note, above $150 million in RAUM, the Private Fund Adviser Exemption (as described below) will no longer be available.
- qualify as a “private fund” (i.e., a fund that would be an investment company under the 1940 Act but for the exemptions under Sections 3(c)(1) or 3(c)(7));
- pursue a venture capital strategy;
- not exceed the 20% basket for “non-qualifying investments,” calculated as a percentage of the fund’s total commitments;[4] [5]
- not borrow, issue debt obligations, provide guarantees or otherwise incur leverage in excess of 15% of its capital commitments (which borrowing, indebtedness, guarantee or leverage is on a short-term basis only – non-renewable and not longer than 120 days);
- not offer investors redemption or other similar rights, except in extraordinary circumstances (such as withdrawal or excuse rights for legal or regulatory requirements); and
- not be registered as a U.S. registered investment company and not elect to be treated as a business development company.
The 20% basket for non-qualifying investments, such as investments in bridge loans, publicly offered securities, leveraged buyouts or investments in other venture capital funds, is calculated immediately after the fund’s purchase of such investment.
If a manager chooses to rely on the Venture Capital Fund Exemption, it will need to file as an ERA with the SEC. Section B below contains a comparison of the significantly reduced compliance obligations of an ERA, as compared to an RIA.
4. Foreign Advisers Exemption As an alternative to the “Private Fund Exemption” described above, which is typically relied upon by foreign managers that operate private funds, a foreign manager can otherwise seek to rely upon the narrower “Foreign Private Adviser Exemption,” which applies if the manager meets all of the following conditions:- has no place of business in the U.S.;
- has fewer than 15 clients and investors in the U.S. in private funds advised by the manager;
- has aggregate assets under management of less than $25 million attributable to clients in the U.S., including U.S. domiciled private funds and U.S. investors in private funds advised by the manager;
- does not hold itself out generally to the public in the U.S. as an investment adviser; and
- does not advise registered investment companies or business development companies.
[1] Depending on your structure, your fund’s investment management services may be provided by a general partner or a separate investment manager.
[2] The Dodd-Frank Act created a “mid-sized” adviser category under Section 203A(a)(2) of the Advisers Act.
[3] See Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers with Less Than $150 Million in Assets Under Management, and Foreign Private Advisers, Advisers Act Rel. No. 3222 (June 22, 2011).
[4] “Qualifying investments” generally include any equity security that is issued by a “qualifying portfolio company” that is: (i) directly acquired by the fund from the company; (ii) in exchange for directly acquired equity issued by the same qualifying portfolio company; or (iii) a majority-owned subsidiary or predecessor and that is acquired by the fund in exchange for directly acquired equity described above.
[5] “Qualifying portfolio company” is any company that: (i) is not a reporting or foreign traded company and does not control, is not controlled by or under common control with, a reporting or foreign traded company; (ii) does not borrow or issue debt obligations in connection with the fund’s investment in the company and then distribute to the fund the proceeds of such borrowing or issuance in exchange for the fund’s investment; and (iii) is not itself a private fund or other pooled investment vehicle (i.e., is an operating company).