For investment professionals, there are a seemingly endless array of rules and regulations to consider when reviewing a client’s existing investments and considering new investments to recommend. In this month’s Risk Management Update, we take a look at a few considerations investment professionals should be aware of when suggesting private fund offerings for a client.
Suitability vs. Eligibility
When it comes to private fund investments, a common mistake is not considering both the suitability and the eligibility or qualification of the investor. The two are not identical and both need to be reviewed in order to ensure that an investment in a private fund is appropriate for your client. As you’re probably aware, the FINRA suitability rule includes the following factors:
- Customer’s age;
- Other investments;
- Financial situation and needs;
- Tax status;
- Investment objectives;
- Investment experience;
- Investment time horizon;
- Liquidity needs; and
- Risk tolerance.
After reviewing the suitability of the fund investment for the client, the investment professional next needs to consider what type of a private fund investment is being made, and if the client satisfies the fund requirements for eligibility to invest. A few notable examples of private fund investor types are Accredited Investor (Securities Act Rule 501/Red D), Qualified Purchaser (Investment Company Act Rule 3(c)-7), Qualified Eligible Client (CFTC Rule 4.7) and Qualified Client (Adviser Act Rule 205-3). Long story short, in order to be eligible to invest in certain private fund offerings, an investor must meet one or more of these qualifications.
Some funds require more than one qualification to be met, such as a fund that requires the client to be both an Accredited Investor (“AI”) and a Qualified Purchaser (“QP”). A common misconception is the assumption that if the client is considered a Qualified Purchaser they would automatically qualify as an Accredited Investor. This is usually true, however, when investing using certain trusts, there may be issues with how the determination of the investor type is made. For example, an irrevocable trust may be considered a Qualified Purchaser with less than $5MM in investments but would not be considered an Accredited Investor because an irrevocable trust must meet the $5MM in investments standard. Although the investor may be considered appropriate for the investment under FINRA rules, they may not meet the private fund eligibility/qualification requirement, and that can lead to a number of negative outcomes. To wit, the fund could rejecti the investment, the client’s money could be returned, or it could cause the fund to lose its exemption. It is also important to note that in scenarios where a non-qualified investor manages to invest in a private fund, the investment firm may be violating the terms of the selling agreement with the fund, so it is incumbent upon all relevant parties to proceed carefully with any private fund investment.
General Solicitation Rules*
Unlike a mutual fund where you can generally solicit new investors, when selling a private fund, the investment professional needs to be aware of potentially violating general solicitation rules. The general solicitation rule for private funds essentially says you may only solicit investors with whom you have a prior substantive relationship. A substantive relationship is formed when the firm offering the securities has sufficient information to evaluate a potential investor’s status and meets the fund qualification requirements. To meet the prior or pre-existing relationship standard, many private funds either won’t allow a client to invest until a certain amount of time has passed from the distribution of offering materials to the client, or they may require that the firm have had a pre-existing relationship with the client for a certain period of time. Prior to the distribution of offering materials, the investment professional should always be sure the client meets the fund qualification requirements and documents those conversations.
*This discussion of general solicitation assumes a private fund is relying on the exemption from registering fund interests with the SEC provided by Rule 506(b) of Regulation D under the Securities Act – which limits sales primarily to accredited investors and does not allow for general solicitation. A fund may alternatively rely on the exemption provided by Rule 506(c) of Regulation D, and if so, may engage in a general solicitation of fund interests, but must affirmatively verify and document the accredited status of every investor.
Offering Memorandum/Private Placement Memorandum
Offering materials must be made available to the client prior to the time of investment. Unlike a public fund where you can point the investor to the fund website or send the prospectus in an email, the firm or the investment professional should have a way to demonstrate that the offering materials were made available to the client prior to any investment and have a reasonable basis to determine the client is qualified to invest in the fund (Accredited, Qualified Purchaser, etc.) because private fund offering documents are not made available to the general public. Firms should have a process in place to demonstrate they pre-qualified the prospect, that they have a prior relationship, and have a method for tracking delivery of the offering materials with the date they were provided. And it should go without saying that all of this activity should be documented in your books and records.
The Knowledgeable Employee Qualification
Private funds, which typically rely on the exceptions from registration provided by Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act, often offer interests to knowledgeable employees. Importantly, knowledgeable employees are: (i) excluded for purposes of determining whether a 3(c)(7) fund’s outstanding securities are owned exclusively by qualified purchasers; and (ii) not required to be counted for purposes of the 100 beneficial owner limitation for a 3(c)(1) fund. Under Rule 3c-5 of the Investment Company Act, an executive officer of the fund’s manager and certain other senior personnel of the manager and its affiliates are considered knowledgeable employees.
One should proceed cautiously when relying on the knowledgeable employee qualification. It’s simply not meant for all investment professionals of a financial firm and instead is limited only to a certain level of professional. It’s a good idea for firms to document the basis for making that determination and be prepared to explain the reasons during an SEC examination. Careful consideration must be given when determining who qualifies as a knowledgeable employee.
The foregoing are but a few of the many considerations that should be taken into account when an investment professional is considering putting private fund offerings on the table for a client. The Core Compliance team has extensive experience with, and knowledge of, the various private fund-related regulatory requirements that investment advisers and broker-dealers should take into consideration. If you have any questions about this or any other aspects of your compliance program, please reach out to our team at info@corecls.com or give us a call at 619-278-0020.
Author: Apryl Thompson, Compliance Consultant, Core Compliance & Legal Services (“Core Compliance”). Core Compliance works extensively with investment advisers, broker-dealers, investment companies, and private fund managers on regulatory compliance issues.
This article is for information purposes and does not contain or convey legal or tax advice. The information herein should not be relied upon regarding any particular facts or circumstances without first consulting with a lawyer and/or tax professional.