Happy Friday, Funds Family!

This is the third 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

But first…a quick announcement about a free webinar.

We’re excited to announce our first official Fundamentals webinar, where we’ll learn about the typical timeline of investment fund formation and operations.

In this session, we will cover:

• Timeline of how the funds work

• Steps to take before launching a fund

• Duration of the fundraising period

• Lifespan of the fund

• Detailed timeline of a Closed-End Investment Fund

Please submit any questions here.

Event Details:

• Date: July 30, 2024

• Time: To be defined according to poll votes – Please register and vote here

• Location: Online – Link to be provided upon registration

Alright…on to the Investment Advisers Act.

⚖️ Who does the Investment Advisers Act apply to?

The Investment Adviser Act applies to investment advisers. The definition of an investment adviser is:

✅ In short, an investment adviser is a person engaged in the business of advising others as to the value of securities for compensation.

Let’s parse the definition a bit.

1. “Engaged in the business”

The SEC interprets this broadly. You're likely considered “engaged in the business” if you:

• Hold yourself out as an investment adviser, financial planner, or similar.

• Charge a fee for investment advice.

• Provide advice regularly.

2. “Advising others…as to the value of securities”

Examples of “advice” include recommendations regarding:

• Stocks, bonds, mutual funds, and limited partnerships.

• Market trends and asset allocation.

• Investment manager selection

• Market valuations and security lists.

🗺️ Side Quest: What is a “Security”?

If you’re not advising clients on “securities” then you may not be an investment adviser.

In the context of investment fund managers, the following asset classes are generally considered to be subject to the Investment Advisers Act:

• Private Equity

• Venture Capital

• Hedge Funds

• Funds of Funds

• Debt Funds

🏠️ What about real estate?

Real estate isn’t a security, so if you’re investing in pure real estate (dirt and buildings), you typically would not be subject to the Investment Advisers Act.

For further discussion, please see last week’s notes on real estate funds and debt funds.

3. “For compensation”

Compensation includes any economic benefit from giving advice, such as:

• Advisory fees.

• Commissions.

• Fees for total services rendered.

Statutory Exclusions

Please note there are several statutory exceptions to the definition of investment adviser, including:

1. Banks: Regulated banks

2. Professionals: Any lawyer, accountant, engineer, or teacher whose advice regarding securities is merely incidental to the practice of his/her professional services

3. Brokers: Any broker or dealer whose advice regarding securities is merely incidental to the practice of his/her professional services and who receives no special compensation for the advice

4. Publications: News publications with a general and regular circulation

5. Treasuries: Advice regarding securities of the US government

6. Credit Rating Agencies: Moody’s, Fitch, S&P, etc.

7. Family offices: Family offices (as defined by the SEC)

⚖️ Three key exemptions for investment fund managers

To avoid registering as a Registered Investment Adviser (discussed below), investment fund managers typically seek an exemption from registration.

Here, we’ll hit on the three main exemptions available to fund managers:

1. Private Fund Exemption (Rule 203(m)-1)

2. Venture Capital Exemption (Rule 203(l)-1)

3. Foreign Private Adviser Exemption (Rule 202(a)(30)-1)

1️⃣ Private Fund Exemption

The private fund exemption exempts investment fund managers with less than $150 million of regulatory assets under management.

🧮 Calculating “Regulatory Assets Under Management”

Regulatory assets under management is calculated on a gross, fair market value basis across all of your securities portfolios, including:

1. Investment portfolios where at least 50% of the portfolio consists of securities

2. All private funds (funds exempt under 3(c)(1) or 3(c)(7))

3. Family and proprietary accounts

4. Accounts for which you receive no compensation for your services

Form ADV has a helpful section on calculating regulatory assets under management, beginning on page 7.

💡 Note that regulatory assets under management is your total AUM across all of these portfolios, not the AUM of any particular fund.

2️⃣ Venture Capital Exemption

 I suppose the VC lobby was doing its duty, because there’s a specific exemption for venture capital funds.

To be an exempt venture capital fund, the fund must (among other requirements) comply with the following requirements:

Let’s dive in 🏊️ 

(1) Venture capital strategy

To satisfy this requirement, VC funds typically include a sentence saying they are pursuing a venture capital strategy in the PPM, LPA, and other governing documents.

(2) No more than 20% non-qualifying investments

No more than 20% of the fund’s assets can be invested in assets that are not “qualifying assets.”

“Qualifying Investments” means an equity security acquired directly from a qualifying portfolio company, which is a company that:

1. No public companies: At the time of the fund’s investment, is a private company;

2. No leveraged buyouts: Does not borrow or issue debt in connection with the fund’s investment and distribute the borrowing proceeds to the fund; and

3. No fund investments: Is not an investment company, private fund, or commodity pool.

✅ In short, “qualifying investments” are directly acquired equity securities of operating businesses.

🤔 What about secondaries?

Secondaries are not “acquired directly” from a qualifying portfolio company, and therefore are not qualifying investments.

Therefore, for a fund to fall under the VC exemption, secondaries can sometimes be a risky business. The fund can invest in secondaries, but must ensure at least 80% of the fund’s assets are non-secondary qualifying investments.

(3) 15% leverage limitation

The fund cannot have debt in excess of 15% of the total fund size.

In addition, the debt cannot have a term of more than 120 days (subject to some exceptions).

In practice, the only debt VC funds take on are “subscription lines” that enable the fund to borrow short-term funding needs without calling capital from investors.

The fund may want to use a subscription line to (i) make an investment quickly, (ii) avoid annoying LPs with too many capital calls or, (iii) less virtuously, juice IRR.

💡Note on VC fund managers who manage funds in other asset classes

Per the applicable SEC release, “an adviser is eligible to rely on the venture capital exemption only if it solely advises venture capital funds.”

In other words, you can’t use the VC exemption if you manage VC funds alongside private equity funds, hedge funds, or secondaries funds.

More than once, I’ve seen a manager who thought they were exempt, but they actually had some secondaries funds, which blows their entire VC exemption. 💣️ 

3️⃣ Foreign Private Adviser Exemption

A non-US adviser may be exempt if they satisfy the following criteria:

1. Limited US Nexus: No place of business in the United States and does not hold itself out to the US public as an investment adviser;

2. Limited US Clients: Has fewer than 15 clients and private fund investors in the United States; and

3. Limited US AUM: Has less than $25 million of regulatory assets under management attributable to such U.S. clients and investors (see “Calculating Regulatory Assets Under Management” above).

For #2 above, “counting” US private fund investors is similar to counting under 3(c)(1) under the Investment Company Act (here’s a link to last week’s article where we discuss counting).

📚️Selecting Exemptions

As long as you fit within one of the exemptions above, you’re generally good.

Emerging managers can often rely on the private fund exception (less than $150 million in AUM) for quite a while.

However, managers should always look to the future to determine what exemptions (if any) they might be able to use once they cross the $150 million threshold.

In some cases, managers might alter their investment strategy to avoid registration.

Here are a couple of examples:

• A venture capital fund could decline to purchase secondaries so it can stay within the VC exemption

• A real estate fund might avoid investing in other real estate funds or syndications to avoid subjecting itself to the Investment Advisers Act altogether.

🏦 Becoming a Registered Investment Adviser

If you cross the $150 million AUM threshold and you can’t find another exemption, you must register with the SEC as a Registered Investment Adviser (RIA).

📄 Form ADV

To register as an RIA, you’ll need to file Form ADV electronically via the Investment Adviser Registration Depository (IARD).

Form ADV, Part 1 contains basic information about the investment adviser, such as:

• Identifying information

• Number of employees

• Information about clients

• Regulatory assets under management

• Information on managed funds

• Information on key personnel (including criminal/disciplinary history)

Form ADV, Part 2 contains more specific disclosure about the investment adviser’s business, such as:

• Information on key personnel

• Fees and compensation arrangements

• Methods of analysis, strategy, and risks

• Code of ethics

• Financial industry affiliations

• Brokerage/custody arrangements

• Financial information

✍️ How do you prepare Form ADV?

You will want help from a lawyer or a compliance consultant to file your Form ADV. Compliance consultants are firms that specialize in RIA compliance matters. They will often prepare your Form ADV at a lower cost than a lawyer.

In any case, you’ll need a lot of input from your team to prepare the Form ADV. It’s a relatively large undertaking.

📆 Annual Form ADV Updates

Registered investment advisers must file an updated Form ADV within 90 days of the end of their fiscal year.

There’s often a mad dash in early Spring to get ADVs filed. I would suggest preparing early. Your lawyer or compliance consultant will be grateful. 🙏 

💼 Additional requirements applicable to RIAs

In addition to filing and maintaining Form ADV, RIAs are subject to various additional compliance measures, including:

• Custody Rule: RIAs must maintain client funds with a qualified custodian, provide various statements to clients, and submit to unannounced audits.

• Marketing Rule: RIAs are subject to stricter rules regarding advertising and marketing, including disclosing performance results, testimonials, and endorsements.

• Chief Compliance Officer: RIAs must appoint a Chief Compliance Officer who is responsible for the RIA’s compliance with regulations, including an annual review, training, education, monitoring, testing, and reporting.

Do investment managers want to become RIAs?

Due to the increased regulatory burden, most investment fund managers try to avoid registration as long as possible.

However, a minority of managers submit to registration voluntarily. Their goal is to increase credibility with sophisticated investors and are willing to put up with the increased compliance requirements. Investment managers are permitted to register as an RIA once they have $100 million in regulatory assets under management (or once they would be required to register with 15 or more states).

⚠️ Exempt Reporting Adviser (ERA) Filing

Investment fund managers with at least $25 million in assets under management, but who are exempt from registering as RIAs, are called Exempt Reporting Advisers (ERAs).

While ERAs aren’t subject to nearly the same regulatory burden as RIAs, ERAs still must file Part 1A of Form ADV with the SEC within 60 days of crossing the $25 million threshold. Like RIAs, ERAs must update their Form ADV each year.

☠️ Note on the Private Fund Rules

Last year, the SEC adopted a huge package of new rules applicable to private investment funds, including:

• Audit requirements

• Side letter restrictions

• Quarterly statement rules

• Prohibited activities

It was a whole big thing we investment fund nerds spent a lot of time learning about.

Then, out of nowhere, the 5th Circuit torpedoed the whole slate of rules in National Association of Private Fund Managers v. Securities and Exchange Commission.

It’s possible the SEC will appeal, but as of now, the rules are…not happening.

While some lawyers are likely weeping in their office singing “How Could This Happen to Me?” 😭, it’s a big win for investment managers. 🥳 

🚨 State regulation of investment advisers

This whole article has been about federal regulation of investment advisers.

However, many managers (especially emerging managers) are also subject to state investment advisory laws.

We’ll hit those next week in Part 3.5 of this three-part series (this post was already long enough).

Have a great weekend!

Special thanks to Bo Stratton for working on this article with me!

⚠️ 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.