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Private equity funds ___ (basic definition)
commit capital in the securities of privately held high risk, potentially high return businesses, in divisions and subsidiaries of large conglomerates, and in securities of listed companies typically to make them private. These include venture capital and hedge funds.
structure of limited partnership (graph)
Fees and distributions
- carried interest
- - generally 20% of the gains --> GP
- - Partners will receive proceeds of investment in proportion to their relative capital contributions to such investment
33 Securities Act §4(2)
private offering exemption-
exempts from the registration and prospectus delivery requirements of Section 5 of any transactions by an issuer not involving any public offering", but most funds opt to meet the 33 Act Reg D requirements because enhanced certainty that there's a "safe harbor" for exemption
4(2) does NOT extend to anti-fraud provisions, so ensure that disclosures made to investors are not false or misleading in any material aspect.
not about purchaser, but the actions of the offeror!
self-executing- no notice or other filings or regulatory approvals required for exemption to be effective
Regulation D- overview and accredited investors
Reg D contains the current set of SEC rules governing exemptions for private offerings and defines accredited investors (see Rule 506)
- Two Tests:
- 1.) Test for sufficient net worth for individuals
- (Most financial institutions are accredited investors=> entities must have $5M )
- 2.) can't engage in general solicitation
- If individual, must have:
- -at least $1 mil net worth alone or with spouse OR
- -individual income in excess of $200,000 in each of the two most recent years or joint income above $300,000 for two years AND reasonable expectation of reaching the same income level in the current year.
Reg D- Rule 502 (c)
general solicitation and advertising
- 502(c):when a private offering is made in reliance on Reg D, neither the issuer nor any person acting on its behalf may offer or sell the securities by means of any form of "general solicitation or general advertising," including:advertisements, articles, notices or other communications published in
- magazines or
- similiar publications or
- broadcast over radio or television and
- (maybe) unrestricted notice on the internet
- good practice to avoid any comment when asked for information in media (i.e. interview requests in investment newsletters)
if chairman of PE firm does interview w/ Bloomberg talking about industries that might have buyout opportunities, admit you have plans to raise a billion dollar fund in next 6 mths and this gets published => grey area
- Can have a website but must limit info & restrict access
- Listing past performance but not upcoming offering is STILL solicitation (often these websites describe types of investments b/c aimed at joint venture partners or companies that want them to invest in them but no past performance b/c that info speaks to investors)
Reg D- 502 (b)
no specific info required to be furnished when LP interests in PE fund are sold only to accredited investors --> disclosure requirements triggered if the offering extended to persons that are not accredited investors
>additional reqs if have any non-accredited b/c assumption of having less $, the additional reqs are cumbersome or impossible for a private investment fund to provide so funds normally don't let non-accredited invest.
Reminder: doesn't extend to anti-fraud provisions!, only registration and prospectus delivery requirements; so disclosures may not be false or misleading in any material respect
502(d)-issuer of securities to exercise reasonable care to ensure that the purchasers are not underwriters
Reg D- Rule 506 (b)
Safe harbor exemption
506(b)(2)(i)- no more than 35 purchasers, excluding "accredited investors"--> in effect, permits sales to an indefinite # of accredited investors; but in practice too many would be cause for concern
- rule re no more than 35 non-accredited focuses on number of purchasers not number of those offered securities
Rule 506 (d)
506d limitation on b: GP, affliates, and any owner of 20% or greater interest in fund can be "bad actor" (based on voting rights). Foreign investors may not like having to make all the add'l reps to show not bad actor which is why will see Reg S & Reg D within same fund for different investors.
Rule 506 (c)
an issuer may use general solicitation to offer and sell securities, provided that:
- -the issuer takes reasonable steps to verify that the purchasers of the securities are ALL accredited investors:
- - all purchasers of securities are sold; and
- - the sales otherwise satisfy the definitional, integration and resale provisions of the Regulation D safe harbor
- Problem w/ using gen solicitation:
- -sponsors don't want to have to do a heightened level of due diligence b/c doing gen solicitation (get verification all are accredited)
- -if do a gen solicitation in a public paper like WSJ with int'l subscription base and the foreign country has law against gen sol. then now the fund is restricted from those investors
Reg S v. Reg D Hypo: 1
Do you need to use Reg D/US Sec Law exemption if the Fund is incorporated in Caymen Islands, all the investors are french insurance companies, and the GP firm is based in NYC?
No. This fund is a non-US issuer and investors are foreign, so long as no sales directed at US doesn't matter where GP/mgmt team is located just matters if investors are in the US or the Fund is in US.
Reg S v. Reg D Hypo: 2
Do you have to comply with US Sec Law if Fund is incorporated in Caymen Islands and have US investors?
Yes. If have any US investors you are subject to the same regime no matter where Fund is.
Reg S v. Reg D Hypo: 3
What if the Fund is domiciled in Caymen and all investors are non-US investors?
Still have nexus to US so have to rely on 4(a)(2) private placement exemption, but can use Reg S as long as no "directed" selling efforts to US.
What if there is only 1 US investor and rest are non-US or vice versa? Do you use Reg S or Reg D?
Can do offering for US investor using Reg D and non-US investors using Reg S and these offerings will not be integrated.
Don't have to use Reg S, would try to just use one safe harbor: Reg D for all investors, but might end up doing both b/c foreign investors might not like having to make all the additional representations re certifying not "bad actors" in 506d, so that is why you would do both types of offerings in 1 fund.
- avoid relying on 4(a)(2) alone.
- avoid violating 1940 Act Section 7(d) which requires registration of offshore funds: offers by a foreign issuer (including an offshore fund) where there no substantial US market interest need to satisfy the following conditions:
- 1) the offer and sale is made in an offshore transaction; and
- 2) there are no "directed selling efforts" in the United States
Regulation S/ Regulation D relationship
US fund w/ foreign investors: a nexus with U.S. laws, so need exemption from 33 Act registration requirement. But no reliance on Reg D, use Reg S
- -U.S. fund, one U.S. investors, 9 non U.S. investors
- can offer with Reg S for foreign and Reg D for U.s.; non integerated, not *required* to offer via Reg S for foreign investor could do all under Reg D.
What if there is a mistake (reporter gets ahold of offering doc and prints it and it includes past performance, specific info, etc.) = general solicitation. Can the fund add a certification that any investor did not see the article?
No. Doesn't matter if the gen solicitation is successful or if even 1 investor who comes into the fund came based on it. Only matters that it was made.
=> cooling off period of 6 months.
Practically speaking not good for biz to shut down for 6 mths so instead fund would pack up and go to europe and solicit non-US investors only and file under Reg S
Investment Company Act
"The 40 Act"
Why are PE Funds subject to 40 Act?
- Subject to the act if company:
- -has 40% or more of its balance sheet as investments
- -Section 3a: if Fund holds itself out as an investment company
- WHY is BH not subject to '40 Act?
- -b/c says it is in business of its holdings, they hold and operate for a long time and not charging fees for their involvement with company
If you are acquiring investments w/ stated intent of selling off those investments w/in a given period and taking fees for those investments you are holding yourself as in that business. (if PE Fund could get out of this wouldn't have to worry about meeting 3c1 or 3c7 exemption).
Why is it bad to be subject to the 40 Act?
It imposes limitations on leverage that is used by HF and some PE Funds
Restrictions on related transactions, can't use affiliates for their services
Can't charge a performance fee (the carry)
Investment Company Act- 3(c)(1)
- not an investment company if:
- 1) the issuer's outstanding securities (other than short term paper) are beneficially owned by fewer than 100 persons (NO SUITABILITY REQS FOR THESE INVESTORS), and
- 2) issuer is not making and does not presently intend to make a public offering of its securities (means must satisfy Reg D)
- issue is whether company is privately held
- 100 person limit applies to the holders of all securities except for short-term paper--whether securities are debt or equity or voting or non-voting makes no difference for this purpose. questions usu. arise as to the 100 person limit
When are multiple 3c1 funds integrated or not?
- Requirement: to not be integrated, funds must have a different risk/reward profile
- -create multiple identical funds all with 99 investors. These would be integrated.
- -if make same investments but put in a blocker b/c one fund has non-US investors and one has US investors or if have different structure based on TE status.
Investment Act- 3(c)(1)(A)
Statutory Look Through Provision
- i) if a company owns ten percent or more of the outstanding voting securities of a private investment company and
- ii) the ten percent owner is an investment company but for the 3(c)(1) and (7) exceptions then
- owners of the outstanding securities of the ten percent owner are deemed to hold outstanding securities of the private investment company.
- if you have 98 LPs that all join together to form one LP entity, will look through the entity and count the 98 if the entity own 10% or more interest in the Fund.
If the entity owns LESS than 10% of the fund then they will be fine.
- * ex uses 99 and not 100 b/c counting GP (GP is technically not a security b/c not relying on efforts of others but it is not definitive that they aren't securities so count them just in case)
- *This is tested at point in time securities are acquired so if originally buy 9% and then another LP redeems so now have 15%, will not be subject to 40 Act.
3c1 Formed for the Purpose Lookthrough
If an entity is formed for the purpose of avoiding 40 Act regulation it will be looked through.
Formed for the purpose = 40% of its assets are invested in 1 Fund.
Then would count each LP in the entity.
*employees will not count toward #
1940 Investment Company Act- 3(c)(7)
A company is exempted from requirements of an investment company under 1940 Act if:
- 1.) Not engaged in a public offering
- 2.) investors are qualified purchasers
- -natural person or family owned company exempted if owns at least $5 mil in investments
- - any entity who in aggregate owns and invests at least $25 mil
Exception: employees that invest do not have to be qualified purchasers
3c7 look formed for the purpose look through
If an entity is formed for the purpose of avoiding 40 Act regulation it will be looked through.Formed for the purpose = 40% of its assets are invested in 1 Fund.
So will look through to see if each member of entity is qualified.
What if 3 people each of who have $4M put 3.3M each into this LP vehicle and invest 10M dollars into a fund through the vehicle?
They cannot do this.
The LP vehicle is not qualified as an entity b/c it doesn't have $25M
Would still have worked if each individual was qualified, but here they are not b/c are not investing $5M.
Ex 2: If have 50 LPs in a partnership, that partnership has $100M and it puts in 100% to the fund, would this satisfy 3c7?
Would look through b/c formed for the purpose even tho meets statutory look through test. Would have to check if each individual LP in the partnership is a qualified purchaser.
Cannot have even 1 non-qualified purchaser in 3c7 fund unless a knowledgeable employee.
'34 Act Section 12g
imposes reporting requirements on any issuer that issues securities to 500 or more holders of record.
Ppl who created 3c7 did not intend for it to be limited to certain # of investors but b/c of 12g they cannot have more than 500 qualified purchasers. => JOBS Act set it at 2000 now.
Investment Adviser's Registration Act of 2010
If U.S. based manager
$150 mil or more assets under management (AUM) --> SEC
- $100-150 AUM in Funds: State Registration
- $100 mil -150 AUM but $1 or more non fund client(s) --> SEC
$25-$100 mil --> state registration, unless state stated doesn't register advisers, then SEC
< $25 mil --> state registration (won't go to SEC at all/ever)
- If no US investor, Foreign Private Adviser's Exemption:
- Need all 3 reqs:
- - < $25 mil from US investors
- - no office in U.S.
- - no more than 15 clients (aka investors)
then no obligation to register with SEC
but 25 mil easily reached, so see Exempt Reporting Adviser
Exempt Reporting Advisor
APPLIES TO US BASED AND FOREIGN BASED ADVISORS
- -can manage from a place of business in US
- -can have up to $150M from US persons IN FUNDS (IF NOT IN FUNDS THEN ONCE HAVE 100M SUBJECT TO FULL REGISTRATION)
- -can have unlimited # of clients in the US so long as they are in private funds
- -not free from registration but subject to "registration light"
-a fund of one person is considered to be a non-fund
Prohibits banks from sponsoring covered funds = 3c1 and 3c7 funds unless they limit their participation to 3% commitments and no more than 3% in aggregate of firm's net capital is invested in covered funds across the board. Called 3%/3%
Fund Taxation Motivations
Fund structure is intended to avoid double taxation.
Means = LP or LLC
Partnership is transparent, flows through to partners but does not report gain, loss, reduction, credit, etc.
Two Tax Systems: Treatment of Cash & Treatment of Income
Tax rules require the partners to look at the end of the year and capital accounts have to match what they would get if everything was liquidated
This is why you have to allocate enough $ to the GP for tax purposes
for practice problem: assumed 20% tax rate. Test income at the partnership level.
Management Fee Conversion for Lower Tax Rate
PE firm sets up structure where waive mgmt fee and instead have LPs put up the ant that would be equal to mgmt fee as capital input on a pre-tax interest & gets preferential treatment
-heavily scrutinized b/c question is if it is a legitimate loan or really is carried interest
Classes of Investors
- 1. ECI: Effectively Connected Income. if fund is treated as engaging n a business then income from that fund will be taxable to foreign investors.
- -foreigners hate this b/c capital gains in general are not taxable but if non-US person you have to file a US tax return if engaged in a business
2. Tax exempt investors: don't want to be subject to an audit b/c if goes straight to them will have to pay income tax on it. They call this: Unrelated Business Taxable Income (UBTI).
3. Unrelated Debt Finance Income. UDFI. If a tax exempt entity borrows $, leverages
Sun Capital Case: argued that PE firm is an active investor, engaged in a business. Counter argument is that it is more like inventory: buying company just to sell it, sounds like inventory. Another argument is that fund isn't an investor it's a dealer (Nissan says this goes to far).
Before Sun Capital, Funds were never considered "engaged in a business" but the ERISA argument that they were is similar to that which IRS would use to attack fund so now set up blockers and have blockers for UBTI, ECI & UDFI
*important to note do not have blocker sitting right between the Fund and the LLC b/c would block ALL the funds
Types of Structures
- HF use:
- -Master Feeder Fund
Conflict of Interest between TE & Regular Investors