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⚖️3 Key Fund/SPV Laws You Must Know, Part 2 (2025 Update)

The Investment Company Act of 1940

Author

Michael Huseby
May 23, 2025

🎉 Happy Friday, Funds Family!

Laws change! As a result, we’re going to update each of the four core regulatory articles.

  1. ⚖️The Securities Act of 1933 (2025 update)

  2. ⚖️ The Investment Company Act of 1940 (2024 version)

  3. ⚖️The Investment Advisers Act of 1940 (2024 version - to be updated shortly)

  4. ⚖️ State Investment Adviser laws (2024 version - to be updated shortly)

This one (as the subtitle suggests) is an updated version of the Investment Company Act of 1940.

⚖️ Who does the Investment Company Act apply to?

The Investment Company Act applies to investment companies. The 🔗 definition of “Investment Company” is shown below.

(a) Definitions

(1) When used in this subchapter, “investment company” means any issuer which—

(A) is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, or trading in securities;

(B) is engaged or proposes to engage in the business of issuing face-amount certificates of the installment type, or has been engaged in such business and has any such certificate outstanding; or

(C) is engaged or proposes to engage in the business of investing, reinvesting, owning, holding, or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40 per centum of the value of such issuer’s total assets (exclusive of Government securities and cash items) on an unconsolidated basis.

(2) As used in this section, “investment securities” includes all securities except (A) Government securities, (B) securities issued by employees’ securities companies, and (C) securities issued by majority-owned subsidiaries of the owner which (i) are not investment companies, and (ii) are not relying on the exception from the definition of investment company in paragraph (1) or (7) of subsection (c).

In short, the two main ways to be an investment company are:

  1. Primarily investing in securities. The business is primarily engaged in investing in securities (or holds itself out as being primarily engaged in investing in securities).

  2. 40% test. Even if the business isn’t “primarily” investing in securities, it’s partially engaged in security investment, with at least 40% of the business’s assets being securities (excluding government securities).

Private equity funds, venture capital funds, and hedge funds are typical examples of investment companies.

🏠️ Note on real estate funds/syndications

Real estate (buildings, land, etc.) is not a security. As a result, pure real estate funds and syndications are typically not considered investment companies and often do not need to find a specific exemption from the Investment Company Act.

However, a real estate fund of funds does invest in securities (i.e., the securities of the underlying fund) and would typically be an investment company. A fund formed to invest in passive JV interests or preferred equity may also be an investment company.

Check with your lawyer!

💳️ Note on debt funds

Under the ⚖️Securities Act (discussed last week), some debt instruments are not securities. However, it’s generally understood that many debt instruments are securities for the purposes of the Investment Company Act and the ⚖️ Investment Advisers Act (link is to last year’s).

As a result, debt funds are typically considered investment companies.

Check with your lawyer!

🏦 What happens if you’re an investment company?

Investment companies are subject to significant SEC regulation (similar to mutual funds and ETFs). These are called “40 Act” funds.

Lots of lawyer time and legal bills are required for 40 Act funds. Small and medium investment funds and syndications can’t support the weight of these regulations. 😩 

Luckily…there are several exemptions. The most common for private funds and syndications are:

  1. 3(c)(1) - The “100 Investor” exemption

  2. 3(c)(7) - The “Qualified Purchaser” exemption

  3. 3(c)(5)(C) - The “Real Estate” exemption

Let’s dive in 🏊‍♂️ 

1️⃣ 3(c)(1) - The “100 Investor” exemption

One way to be exempt from the onerous 40 Act requirements is to limit your fund to 100 investors.

Simple enough, right?

But wait…there’s more. Counting is harder than you thought! Some investors count as more than one investor. 🧮 

The rules are complicated enough that we don’t need to get into them all here, but here are some examples:

  • If people form an LLC just to invest in your fund, you may need to count all of the owners of that LLC.

  • If a fund of funds is more than 10% of your fund’s equity, you may need to count all the fund of fund’s investors.

  • If more than 40% of an entity’s assets are invested in your fund, you may need to count all of the entity’s investors.

Questions regarding 3(c)(1) “investor counting” should be in your investment fund’s subscription documents. Your lawyer will help you review the investors’ answers to ensure you have a good exemption from the Investment Company Act. This is one of the few times you want your lawyer doing math for you. 😉 

2️⃣ 3(c)(7) - The “Qualified Purchaser” exemption

An investment company can also be exempt if 100% of its investors (other than members of the GP team) are Qualified Purchasers.

The bar to be a Qualified Purchaser is much higher than the accredited investor threshold. Generally:

  • Individuals must have investment assets of at least $5 million.

  • Entities must have investment assets of at least $25 million.

I would post the 🔗 definition of “Qualified Purchaser” here, but it’s too ugly. Click the link if you dare. 👻 

🗺️ Side Quest: Knowledgeable Employees

You may have noticed that “other than members of the GP team” language up there. What is that?

Well, the GP and its core team (called “knowledgeable employees” can invest even if they aren’t qualified purchasers. 🔗 See below.

(b) For purposes of determining the number of beneficial owners of a Section 3(c)(1) Company, and whether the outstanding securities of a Section 3(c)(7) Company are owned exclusively by qualified purchasers, there shall be excluded securities beneficially owned by:

(1) A person who at the time such securities were acquired was a Knowledgeable Employee of such Company;

(2) A company owned exclusively by Knowledgeable Employees;

(3) Any person who acquires securities originally acquired by a Knowledgeable Employee in accordance with this section, provided that such securities were acquired by such person in accordance with § 270.3c-6

However, only high-level personnel count. Staff not involved in the investment decision-making process are not considered knowledgeable employees. Note that, if relying on (ii) below, the employee must have at least 12 months of experience before they count as a knowledgeable employee.

(4) The term Knowledgeable Employee with respect to any Covered Company means any natural person who is:

(i) An Executive Officer, director, trustee, general partner, advisory board member, or person serving in a similar capacity, of the Covered Company or an Affiliated Management Person of the Covered Company; or

(ii) An employee of the Covered Company or an Affiliated Management Person of the Covered Company (other than an employee performing solely clerical, secretarial or administrative functions with regard to such company or its investments) who, in connection with his or her regular functions or duties, participates in the investment activities of such Covered Company, other Covered Companies, or investment companies the investment activities of which are managed by such Affiliated Management Person of the Covered Company, provided that such employee has been performing such functions and duties for or on behalf of the Covered Company or the Affiliated Management Person of the Covered Company, or substantially similar functions or duties for or on behalf of another company for at least 12 months.

By the way, knowledgeable employees are also excluded from the 100-investor limit in 3(c)(1). ✅ 

🪞Parallel Funds🪞 

Does a cap of 100 investors seem too restrictive? Upset that you have some investors who are not qualified purchasers? There’s gotta be a better way! 🤷 

Well, there’s a solution: Parallel Funds.

Parallel funds are side-by-side 3(c)(1) and 3(c)(7) funds. You fill one fund with no more than 100 investors 🫲 and fill the other fund with only qualified purchasers 🫱. Then, when you invest in underlying assets, each fund contributes a portion of the capital required.

In some cases, you may form an “aggregator” entity, jointly owned by the 3(c)(1) fund and the 3(c)(7) fund. The aggregator is a single investor on the investment’s cap table. In addition, ownership between the two parallel funds can be adjusted at the aggregator level (in the event you admit more investors into one or both parallel funds) without bothering the investment.

If you do use an aggregator structure, consider limiting each aggregator to no more than 40% of the funds’ investments. Otherwise, you might run the risk of the SEC “integrating” the two parallel funds, blowing the 3(c)(1) and 3(c)(7) exemptions you worked so hard to preserve. 💣️ 

It goes without saying that you should work with a lawyer if you want parallel funds (but I said it anyway).

3️⃣ 3(c)(5)(C) - The “Real Estate” exemption

One last exemption to discuss!

We learned above that pure real estate funds are often outside the Investment Company Act’s reach.

But…

  • What if you’re a real estate debt fund?

  • What if some of your assets are real estate equity and some are real estate debt?

  • What if your fund invests in preferred equity?

  • What if some of your assets are passive interests in other funds, syndications, or JVs?

Then, you need 🔗 3(c)(5)(C), which exempts funds “purchasing or otherwise acquiring mortgages and other liens on and interest in real estate.”

(5) Any person who is not engaged in the business of issuing redeemable securities, face-amount certificates of the installment type or periodic payment plan certificates, and who is primarily engaged in one or more of the following businesses: (A) Purchasing or otherwise acquiring notes, drafts, acceptances, open accounts receivable, and other obligations representing part or all of the sales price of merchandise, insurance, and services; (B) making loans to manufacturers, wholesalers, and retailers of, and to prospective purchasers of, specified merchandise, insurance, and services; and (C) purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.

To rely on 3(c)(5)(C), the fund/syndication must meet the following test (legal nerds can see this 🔗 SEC no-action letter):

  1. At least 55% of the fund’s assets must consist of “qualifying investments.” A qualifying investment is an actual interest in real estate or a loan or lien fully secured by real estate.

  2. At least 80% of the fund’s assets must consist of qualifying assets and “real estate-type interests.”

  3. No more than 20% of its total assets consist of assets that have no relationship to real estate.

♻️ Note on open-ended real estate funds

3(c)(5)(C) is not available to funds “in the business of issuing redeemable securities.”

🔗 Redeemable securities are defined as follows:

“Redeemable security” means any security, other than short-term paper, under the terms of which the holder, upon its presentation to the issuer or to a person designated by the issuer, is entitled (whether absolutely or only out of surplus) to receive approximately his proportionate share of the issuer’s current net assets, or the cash equivalent thereof.

Financial products like mutual funds and ETFs are typically redeemable securities—it’s very easy to sell shares in an ETF. Interests in typical hedge funds are also likely redeemable securities.

However, there’s some gray area around whether open-ended real estate-related funds issue redeemable securities. (In fact, two of the biglaw firms I’ve worked at have disagreed on this question.)

In general, the more restrictions on withdrawals/redemptions, the less likely the fund will be deemed to have redeemable securities. If you need to rely on 3(c)(5)(C), you may want to make LP redemptions at the GP’s discretion (or require several conditions for withdrawal to be satisfied before redeeming).

Thanks for reading, everyone.

Have a great weekend! 🙌 

/ JURY TRIAL

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