Fully Invested: Exchange Act Registered Private Funds (’34 Act)

On this episode of Fully Invested, Ropes & Gray asset management partner Jessica Marlin and capital markets counsel Marc Rotter discuss ’34 Act Registered Private Funds. These funds register under the Securities Exchange Act of 1934 and disclose information publicly, while remaining exempt from the Investment Company Act of 1940. Jessica and Marc explore the funds’ features and differences in comparison to traditional private funds.

Transcript:

Jessica Marlin: Hello, and thank you for joining us today on this Ropes & Gray Fully Invested podcast, the latest in our series of podcasts and webinars focused on topics of interest for asset managers and their investors. I’m Jessica Marlin, a partner in our New York office, and today I’m joined by my colleague Marc Rotter, a counsel in our New York office. I am part of Ropes & Gray’s global asset management practice, and Marc is part of our capital markets practice. On this episode, we’ll be discussing private investment funds that register under the Securities Exchange Act of 1934 and disclose information publicly, but are otherwise exempt from registration under the Investment Company Act of 1940 because they are limited to “qualified purchasers.” Throughout this episode, we’ll refer to these funds as “Exchange Act Registered Private Funds” although I note that in the market, sometimes they are also referred to as “34 Act funds.” We’ll be discussing the features of Exchange Act Registered Private Funds and their similarities and differences with traditional private funds.

Exchange Act Registered Private Funds are typically structured as evergreen, permanent capital vehicles that provide investors with liquidity through periodic repurchases. To date, the Exchange Act Registered Private Funds in the market have offered private equity or infrastructure strategies, including fund of funds strategies, but these Funds could also be utilized for other alternative strategies including credit. Exchange Act Registered Private Funds only offer securities to investors that are “qualified purchasers” and “accredited investors”—allowing them to take advantage of exemptions from registration under the Investment Company Act and the Securities Act of 1933. Throughout this podcast, we’ll dive deeper into the regulatory requirements, economic structures, liquidity features, and governance terms of Exchange Act Registered Private Funds. Marc, do you want to kick us off by discussing the impetus for registering a private fund under the Exchange Act?

Marc Rotter: Sure, thanks, Jess. The Exchange Act requires that any issuer with more than $10 million in assets and a class of equity securities with more than 2,000 holders of record register under the Exchange Act.  Because most traditional private funds want to avoid registration under the Exchange Act and the associated public disclosure obligations, that “slot count” limit impacts how and how many LPs can come into a fund. As the name suggests, Exchange Act Registered Private Funds take a different approach than traditional private funds—they register under the Exchange Act. That allows them to take in an unlimited number of LPs.

Like traditional private funds, Exchange Act Registered Private Funds are structured to take advantage of exemptions from registration under the Investment Company Act of 1940 by relying on Section 3(c)(7) of the ’40 Act. That means that while there’s no limit on the number of investors that can come in, all of those investors need to be “qualified purchasers”—which generally requires that individuals have more than $5 million in investments and that entities have more than $25 million in investments. As such, while Exchange Act Registered Private Funds are required to file with the SEC and produce detailed public disclosure, they’re still not a product that can be accessed by every Main Street investor.

Relatedly, like traditional private funds, offerings by Exchange Act Registered Private Funds are structured to comply with Rule 506 of Regulation D in order to be exempt from registration under the Securities Act.   

Unlike traditional private funds, Exchange Act Registered Private Funds are subject to reporting obligations under the Exchange Act. I’ll briefly touch on some of those requirements. In order to register under the Exchange Act, a fund files a Form 10. A Form 10 is a registration statement, an extensive disclosure document with requirements similar to those for annual reports or IPO registration statements filed with the SEC—it requires detailed disclosure about the fund, its strategy and structure, management and risks, as well as U.S. GAAP financial statements that are audited by an independent auditor. A Form 10 is subject to SEC review and comment, but it goes automatically effective after 60 days.

After the Form 10 becomes effective, Exchange Act Registered Private Funds are required to file annual reports on Form 10-K. Annual reports are required to include detailed information, similar to what’s included in a Form 10. 

In addition to the annual Form 10-K requirement, Exchange Act Registered Private Funds must file quarterly reports with the SEC on Form 10-Q. That includes interim financial statements, prepared in accordance with U.S. GAAP. These interim financial statements are unaudited but are reviewed by the independent auditor. Disclosure in a Form 10-Q also includes material updates reflecting developments during the quarter, including an updated MD&A and any updates to risk factors.

As part of its SEC filings, Exchange Act Registered Private Funds are required to publicly file certain documents as exhibits, including, for example, organizational documents, material agreements, like the investment management agreement, material credit agreements, material agreements with dealer-managers or placement agents, and warehousing agreements as well as certain compensatory plans or arrangements.

In addition to periodic reports, the Exchange Act requires registrants to file current reports on Form 8-K that are triggered by the occurrence of certain specified events, such as changes in officers and directors, the creation of material financial obligations and material impairments. Among the events that trigger filings on Form 8-K are issuances of securities that are not registered under the Securities Act. As a result, subject to some de minimis thresholds, Exchange Act Registered Private Funds are required to file Form 8-Ks when investors subscribe to or increase their stake in the fund. That disclosure includes the number of shares subscribed for and the subscription price, which will generally be the Fund’s net asset value. For example, a fund that allows for monthly subscriptions would typically have monthly 8-K filings reporting those subscriptions. Jess, would you like to discuss subscriptions, liquidity, and the economics of these funds?

Jessica Marlin: Sure. So, as Marc mentioned, there is no limit on the number of investors in these Funds due to the Exchange Act registration. Investments in Exchange Act Registered Private Funds are typically fully funded at monthly closings (or on subscription dates) where shareholders purchase shares of the Fund at the Fund’s net asset value. This means the cash needs to be deployed right away to avoid cash drag, and therefore the strategies that these funds deploy need to generally work with that sort of taking monthly subscriptions. Because of the accredited investor and qualified purchaser requirements, the target investors for Exchange Act Registered Private Funds are high-net worth retail or institutional investors typically seeking to access private equity, infrastructure, or other alternative strategies. Shares of Exchange Act Registered Private Funds are generally offered through wirehouses, registered investment advisers, broker-dealers, or other platforms typically used to offer private fund shares to retail investors. Investors must complete subscription documents as part of the subscription process, and investors typically pay fees to those intermediaries, including load fees and ongoing fees, in addition to management fees and incentive fees paid to the sponsor. Note that Exchange Act Registered Private Funds may offer multiple classes of units without applying for or obtaining exemptive relief from the SEC.

The Exchange Act also does not require that these Funds offer investors liquidity, though similar to other open-end style private fund products, the standard practice is to offer investors liquidity through periodic offers for the fund to repurchase its interests at the Fund’s net asset value. Those offers are subject to limitations—for example, that the Fund won’t buy back more than a certain percentage of its outstanding shares at the time of any offer. Those thresholds are usually 3-5% of the Fund’s net asset value. When they receive repurchase requests in excess of that threshold, redeemers are cut back pro rata. Exchange Act Registered Private Funds are required to publicly report repurchases in their 10-Qs and 10-Ks.

The economics of Exchange Act Registered Private Funds are similar to those of traditional private equity funds. Differential management fees are permitted for different classes of units, and a Fund may charge performance or incentive fees. The management fees charged by these Funds vary by class of units and typically range from 0.875% to 1.25% per annum of the Fund’s net asset value. All or a portion of the management fee for certain classes of units, including founder’s units, may be waived for a special period following the initial closing date. Some Exchange Act Registered Private Funds on the market also have management fees that increase for certain classes of units after a specified period of time, typically 36 or 48 months following the initial subscription, and certain classes of units may have no management fee at all.

Exchange Act Registered Private Funds are permitted to charge performance or incentive fees based on income and capital gains. Generally, in the market, the performance fee is equal to 12.5% of a fund’s total return, subject to a 5% annual hurdle amount and a high-water mark with 100% GP catch-up. In other words, the sponsor is getting the incentive fee on all profit so long as they exceed the hurdle, and only to the extent they’ve recovered previous losses to that investor.

As mentioned, certain classes of units of Exchange Act Registered Private Funds may pay an initial subscription fee and an ongoing servicing fee to broker-dealers and other financial intermediaries. Subscription fees are charged at the time of the initial investment for certain classes of units. The subscription fees charged to investors vary by class of units and are typically 1.5% to 3.5% of the applicable subscription amount. Servicing fees also vary by class of units and are typically 25 basis points to 85 basis points of the applicable class’s net asset value, payable monthly. Not all classes of units of a Fund charge subscription fees or servicing fees but many of them do. Those fees are often paid to the intermediaries selling the funds. The documents for these funds, in addition to the documents Marc discussed, include a traditional limited partnership agreement, a private placement memorandum, and a subscription agreement. And those documents generally look like traditional private fund documents.

Marc, do you want to discuss governance and a few other key features of the regulatory regime around Exchange Act Registered Private Funds before we wrap up?

Marc Rotter: I’d be happy to. The Exchange Act does not impose governance requirements on Exchange Act Registered Private Funds. Unlike, for example, operating companies that are listed on a securities exchange, there’s no requirement for Exchange Act Registered Private Funds to have an audit committee or comply with exchange rules around having a majority independent board. That said, the practice is for Exchange Act Registered Private Funds to have independent directors on the board and an audit committee with independent directors. The funds themselves are typically structured as general partnerships, with a GP that’s generally responsible for the fund. The Fund’s board of directors has certain oversight rights, including considering certain conflicts of interest related to the Fund’s sponsor. In that respect, the board can be thought of as serving a role similar to a traditional private fund’s LPAC. The members of the board are typically appointed by the GP-LPs in Exchange Act Registered Private Funds don’t have the right to vote for directors.  Again, that’s all based on market practice, expectations, and the need to have a mechanism to handle conflicts—none of it is specifically required by the Exchange Act.

Similar to traditional private funds, and unlike funds registered under the Investment Company Act of 1940, there is no statutory leverage limit on Exchange Act Registered Private Funds. However, leverage limits can be provided for in the Fund’s operating agreement. The Exchange Act Registered Private Funds currently in the market have a leverage ratio guideline of 30%. Some funds in the market have the flexibility to exceed that 30% limit if the ratio is brought down within nine or 12 months. Similarly, there is no regulatory limit on an Exchange Act Registered Private Fund’s ability to invest in illiquid investments.

Exchange Act Registered Private Funds are also not subject to the Investment Company Act’s strict restrictions on transactions with affiliates, though the Advisers Act rules around conflicts of interest are still relevant and, as we discussed earlier, are part of the reason boards of Exchange Act Registered Private Funds tend to be set up the way they are. Jess, can I turn it over to you to briefly talk about tax reporting requirements and wrap up?

Jessica Marlin: So, Exchange Act Registered Private Funds are typically taxed as partnerships for U.S. tax purposes, although the tax treatment will depend on a variety of factors, including application of the “publicly traded partnership” rules and the type of expected income. If taxed as a partnership, the income will generally pass through to investors, regardless of whether the income is currently distributed to investors. This treatment is similar to traditional private equity funds. Exchange Act Registered Private Funds are required to distribute Schedule K-1s to their investors, and the implication for LPs is that they often receive their final K-1s after April 15, and therefore have to file based on estimates and ask for an extension of their taxes, with their final return due on October 15th, and any refunds paid thereafter.

Exchange Act Registered Private Funds are becoming an increasingly common vehicle for large sponsors targeting high-net worth retail and institutional investors seeking exposure to alternative investment strategies. While Exchange Act Registered Private Funds require additional reporting requirements and liquidity considerations compared to traditional private funds, they’re similar to traditional private funds in many ways and can be a useful vehicle for sponsors seeking to offer a product similar to a traditional private fund to more than 2,000 investors. And that limitation can be a real concern when you are tacking on multiple high-net worth feeders through different REAs and other platforms. Exchange Act Registered Private Funds are likely to become more popular in the days ahead as market interest in retail alternative products continues to grow.

Thank you, Marc, for joining me in this discussion, and thank you to our listeners. Please visit our website at www.ropesgray.com/assetmanagement, or feel free to reach out to any of us at Ropes & Gray via email or phone for more information on Exchange Act Registered Private Funds or other topics of interest in the asset management industry. You can also subscribe to this Ropes & Gray series wherever you typically listen to podcasts, including on Apple and Spotify. Thanks again for listening.