Private Investment Funds.txt

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Private Investment Funds.txt
2014-05-09 13:13:31

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  1. 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.
  2. structure of limited partnership (graph)
  3. Fees and distributions
    • carried interest
    • - generally 20% of the gains --> GP

    • waterfall
    • - Partners will receive proceeds of investment in proportion to their relative capital contributions to such investment
  4. 33 Securities Act §4(a)(2)
    private offering exemption-

    exempts from the registration and prospectus delivery requirements of Section 5 any offering not involving a "public offering".  Most most funds opt to meet the  Reg D "safe harbor" requirements for exemption.

    4(a)(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
  5. Regulation D - overview and accredited investors

    [506(b) Offering]
    Reg D contains the current set of SEC rules governing exemptions for private offerings  (see Rule 506)

    • Reqs: (1) No general solicitation and (2) need accredited investors (can have up to 35 non-accredited) 

    • 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.

    If entity: pretty much need $5mil + in assets

    If you have any Non-accredited investors, you're still required to make greater disclosure and need to have a purchaser representative.-->This heightened disclosure makes them not worth it, so PE funds generally don't take advantage of this.
  6. Reg D- No Gen Sol under 506(b) Offering
    general solicitation and advertising

    • When a private offering is made in reliance on Reg D 506(b), 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
    • newspapers, magazines or similar publications or broadcast over radio or television.  

    Website usually restrict access and usually don't have past performance (but some tensions for public funds that have disclosure reqs.) Original goal was to get JVs.  

    • ------
    • good practice to avoid any comment when asked for information in media (i.e. interview requests in investment newsletters)

    •  --------------
    • Doesn't matter if gen sol was successful, just strict liability
  7. Reg D 506(c) General Solicitation Offering
    Offerings are allowed under this new Jobs Acts provision, which can use general solicitation, but must be sold to accredited investors only, in which the market will let investors dictate the type of information that they need in order to make informed investment decisions.
  8. Reg D 502 (b)-- Information Requirements
    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

    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
  9. Reg D 502(d)
    502(d)-issuer of securities to exercise reasonable care to ensure that the purchasers are not underwriters
  10. Reg D- Rule 506 (b) Offering
    No general solicitation (info provided to investors using a PPM)

    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

    - focuses on number of purchasers not number of those offered securities
  11. Bad Actor Rule 506(d)
    No one involved in offering of the interest or anyone who is gonna own 20% of fund (per voting power) can be a bad actor.  If they are, they cant rely on Reg D
  12. Reg D - Rule 506 (c) General Offering
    -Jobs Act new addition

    -an issuer may use general solicitation to offer and sell securities, provided that:

    • -the issuer takes reasonable steps to verify that all the purchasers of the securities are accredited investors (at least at the time the securities are sold):
    • Regulation D safe harbor
    • -----
    • If you do a gen. solicitation in the US and it leaks abroad and those other countries have restrictions on gen. sol. you would be barred from those.
  13. Regulation S
    avoid violating '40 Act Section 7(d) which requires registration of offshore funds and avoid registration under '33 act 4(a)(2): offerings made outside the US by a foreign or domestic issuer.

    • 1) the offer and sale is made in an offshore transaction; and
    • 2) there are no "directed selling efforts" in the United States

    • ----
    • -US citizen residing and purchasing abroad would not ruin this.
    • -Location of GP (even if they're US based) doesn't matter for Reg S
  14. Regulation S/ Regulation D Examples
    -US fund with all 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.

    -No intergration with Reg D offering 4(a)(2) exemption
  15. Curing--In case you have accidental Gen Sol
    Under Reg D, a 6 mos period would essentially guarantee a reset.  

    In real life, they usually go abroad and rely on Reg S, or they rely on a shorter cooling off period
  16. ICA ('40 Act)--What makes you fall under?
    Companies are subject to the the '40 act if more than 40% of their assets are in investment securities (funds have 100% in investment securities) or if they hold themselves out to be an investment company.

    Why is Berkshire not one?  Because they don't hold themselves out to be an investment company (ie. they don't take fees and etc); basically a smell test.

    Why is bad? Subject to a bevy of regulation and (1) can't charge performance fees; (2) severe restrictions on related party transactions; and (3) burdensome limitations on borrowing (leverage ratio requirements).
  17. ICA Section 3(a)(1) Subsidiary Exemption
    Majority owned subsidiaries (50%+) are carved out from the 40% calculation
  18. ICA ('40 Act) Section 3(c)(1) Fund Registration Exemption
    • 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 requirements) and
    • 2) issuer is not making and does not presently intend to make a public offering of its securities (Meeting the Reg D means that you meet this prong; Reg S doesn't help)
    • ----------
    • Concern 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 usually. arise as to the 100 person limit.

    -Short term paper are securities that mature in 9 mos or less
  19. ICA ('40 Act) Section 3(c)(1)(A) Look-through
    • 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 or would be 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.

    (This is tested at the time the securities are purchased.  If an investor drops out and redeems, increasing your percentage, then this would not kick in)
  20. "Formed for the purpose of" Look-through
    Applies to both 3(c)(1) and 3(c)(7)

    If an entity is created solely for the purpose of investing in the fund, then we disregard the entity and look-through.  

    Something is formed "solely for the purpose of" if 40% or more of their assets are invested in the fund.

    • For 3(c)(1) you count them towards for the 100 person limit.
    • For 3(c)(7) you look to see if they are Qualified Purchasers
  21. ICA ('40 Act) Section 3(c)(7) Funds Registration Exemption
    A company is exempted from requirements of an investment company under 1940 Act if all of the investors are "qualified purchasers":

    -natural person or family owned company exempted if owns at least $5 mil in investments

    -trust (with $25mil) not formed for specific purpose of acquiring securities and each settlor or other contributer is a QP or

    - any entity who in aggregate owns and invests at least $25 mil

    If an entity has less than $25mil, then you look-through

    If you work for the PE fund, you are a "knowledgeable employee", so you are deemed to be a "qualified purchaser"--this would make you not count for the 3(c)(1) 100 person limit.
  22. Reg D Rule 502 Fund Intergration
    Reg D Funds will be integrated unless they were created over six month apart or they cater to different universe of investors (different risk/reward profile). 

    Ex: one fund has tax-exempt and one has regular tax paying, so the one with the tax exempt has blocker corps.  

    -3(c)(1) and 3(c)(7) funds will never be integrated.
  23. '34 Act Section 12(g)
    Automatically subject to SEC reporting requirements if you have more than 500 unaccredited investors and/or more than 2000 investors total

    This acts like a ultimate backstop limiting 3(c)(7) Funds--they can go up to 2000
  24. Investment Adviser's Registration Act of 2010 (When to register w/ SEC or State)
    If U.S. based manager

    $150+ mil assets under management (AUM) --> SEC Reg

    $100 mil AUM but $1 or more non fund client(s) --> SEC Reg

    $25-$100 mil AUM--> state registration, unless state stated doesn't register advisers, then SEC reg

    < $25 mil --> state registration
  25. IAA Foreign Private Advisor
    Non-US advisors

    • - < $25 mil AUM from the US investors
    • - no office in U.S.
    • - no more than 15 US clients (aka investors)then no obligation to register with SEC

    but 25 mil easily reached, so they need Exempt Reporting Adviser
  26. IAA "Exempt Reporting Avisor"
    • Can have :
    • -Up to $150mil AUM from US persons (in funds)
    • -An unlimited number of clients from the US (so long as they are only in private funds)
    • -An office in the US

    If you meet these, you get "registration light" under the SEC.  This gets you out of State Reg.
  27. Volcker Rule (3%3% Rule)
    Restriction on Banks engaging in proprietary trading and  limiting their ability to sponsor/invest in funds

    -Banks are prohibited from sponsoring or investing "Covered Funds" [3(c)(1) and 3(c)(7)] unless they limit their participation to 3% of commitments to the fund and no more than 3% of their capital can be invested in "covered funds".

    -If they sponsor, it has to be for their clients...not for external LPs (as part of their asset management services to those clients)
  28. General Fund Taxation
    Primary issue/motivation is avoiding double taxation.

    Corporate entities can be treated as partnerships for tax purposes by "checking the box."

    Partnerships don't file tax returns; income gets allocated to the partners (1065 information return prepared for each partner w/re to their partnership income)--capital account

    In dealing with taxes, there are two systems, one for cash and one for income...they don't always match. (Tax rules require a fake liquidation to figure out the position of each party at the end of the year, and taxes them w/ re to that)

    "Management fee waiver" technique is a way that PE funds have tried to convert management fees into Carry in order to get preferential tax treatment.  They waive management fee, ask the LP to contribute that fee to the fund, and are entitled to 100% of returns on the fee, and the LP gets the fee amount back.  [high risk/high reward strategy]
  29. Effectively Connected Income (ECI)
    Applies to foreigners (non-US investors)

    ECI is income connected with a trade or business in the US.  One must file a US tax return if one has ECI.

    Funds use "blocker corps" to make sure that foreigners don't have ECI.
  30. Unrelated Business Taxable Income (UBTI)
    Applies to Tax-exempt US investors

    If the tax exempt entity gets this income, they would have to file a tax return, which would make them subject to an Audit.  To avoid this, they use "blocker corps".

    Business income unrelated to their primary income generating activities
  31. Unrelated Debt-Finance Income (UDFI)
    Applies to Tax-exempt US investors

    If the tax exempt entity gets this income, they would have to file a tax return, which would make them subject to an Audit.  To avoid this, they use "blocker corps".

    Income earned by using debt to finance something
  32. Sun Capital Case
    The taxation of PE funds is built on the premise that the funds are merely investors in portfolio companies and are not engaged in a “trade or business” for tax purposes – in other words, they are not actively involved in the business. But the court found that a private equity fund was engaged in a trade or business for purposes of the ERISA.

    ERISA case, but could have tax implications w/re to LTCG treatment of earnings upon disposition
  33. Blocker Corps
    Regular corporations used to convert a passthrough structure to a corporate structure (the corp pays taxes).  Goal is to block "operating income" from PCs.  

    When the fund sells, the sale gets corp gains treatment.  Tax exempt people don't worry about that.