Happy Friday, Funds Family!

This is the second in a three-part series about the holy trifecta 👼 of investment fund law:

1. The Securities Act of 1933

2. The Investment Company Act of 1940

3. The Investment Advisers 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.

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. However, the business is 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/SPVs

Real estate (buildings, land, etc.) is not a security. As a result, pure real estate funds and SPVs are typically not considered investment companies and often do not need to deal with 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 may also be an investment company.

Check with your lawyer!

💳️ Note on debt funds

Under the Securities Act (discussed last week), many 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 (discussed next week).

As a result, many debt funds are 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 (and headaches) are required for 40 Act funds. Most small and medium funds and SPVs can’t support the weight of these regulations. 😩 

Luckily…there are several exemptions. The most common for private funds and SPVs 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/SPV to 100 investors.

Simple enough.

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/SPV, 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/SPV, 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.

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 “knowledgable employees” can invest even if they aren’t qualified purchasers. See below.

💡 However, only high-level employees count. Lower-level staff who are not part of the investment decision-making process are not considered knowledgeable employees.

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.

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 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.”

To rely on 3(c)(5)(C), the fund/SPV 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 funds

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

Redeemable securities are defined as follows:

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!)

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 to withdrawal to be satisfied before redeeming).

👨‍⚖️ Note on Private Fund Adviser Rules

If you have a choice of relying on 3(c)(1) or 3(c)(5)(C), you may want to choose 3(c)(5)(C).

If the recently-killed Private Fund Rules (implemented by the SEC and struck down by the 5th Circuit ☠️ ) were revived, many of the regulations would apply to 3(c)(1) funds but not 3(c)(5)(C) funds.

Just a little food for thought.

⏩️ Next up

Next week, we’ll dive into the Investment Advisers Act.

Can’t wait. 😉 

Have a great weekend!

⚠️ Note: This newsletter is for informational purposes only and nothing should be considered legal advice. For that, hire a lawyer! I am a lawyer, but not your lawyer (unless I actually am your lawyer because you’ve signed an engagement letter and we’re working together). This newsletter may be considered attorney advertising.