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Ropes & Gray attorneys provide timely analysis on legal developments, court decisions and changes in legislation and regulations.
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 manager practice, and Marc is part of our capital markets practice. On this episode we’ll be following up on a discussion we had over the summer about 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 ‘34 Act funds. We’ll be recapping the key features of those funds and discussing some developments since our last discussion.
‘34 Act funds are typically structured as evergreen permanent capital vehicles that provide investors with liquidity through periodic repurchases, usually on a quarterly basis. To date, the ‘34 Act funds in the market offer the following strategies: private equity, including buyout, software, infrastructure; secondaries; and fund of funds; and also fixed income strategies.
‘34 Act funds only offer securities to investors that are qualified purchasers and accredited investors, allowing them to take advantage of exemptions from registration under both the Investment Company Act and the Securities Act of 1933.
In this podcast we’ll dive deeper into the regulatory requirements, economic structures, liquidity features, and governance terms of ‘34 Act 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. So traditionally, most private funds have wanted to avoid registration under the ‘34 Act primarily to avoid being required to make public disclosures about the fund and its performance, as well as due to the costs and other obligations associated with being an SEC registrant.
The ‘34 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. That slot count limit impacts how and how many LPs can come into a fund.
As the name suggests, ‘34 Act funds take a different approach from traditional private funds, they register under the ‘34 Act. While that subjects them to SEC filing requirements requiring public disclosure about the fund and its performance, it eliminates the slot count issue, meaning those funds do not need to limit the number of holders of any particular class of securities.
Some sponsors may also see a benefit to having the fund make public SEC filings in that it may increase awareness and attractiveness of the fund among non-institutional investors and their advisors. It’s important to remember, however, that these are not retail vehicles in the same way as mutual funds or other registered investment companies.
Like traditional private funds, ‘34 Act funds are structured to take advantage of exemptions from registration under the Investment Company Act of 1940, and are 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 ‘34 Act 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 ‘34 Act funds are structured to comply with rule 506 of regulation D in order to be exempt from registration under the Securities Act.
In order to register under the ‘34 Act, a fund files a registration statement on Form 10, which is an extensive disclosure document with requirements similar to those for annual reports or IPO registration statements filed with the SEC.
The Form 10 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, ‘34 Act 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 annual reports, ‘34 Act funds are required to file quarterly reports 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 on a Form 10 also includes material updates reflecting developments during the quarter, including an updated MD&A and any updates to risk factors.
In addition to periodic reports, the Exchange Act requires registrants to file current reports on Form 8-K. Current reports 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, ‘34 Act funds are required to file 8-Ks when investors subscribe to or increase their stake in a 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.
As part of their SEC filings, ‘34 Act 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. Jess, would you like to discuss subscriptions, liquidity, and the economics of these funds?
Jessica Marlin: Sure. Thanks, Marc. So as Marc already mentioned, there’s no limit on the number of investors in these funds due to the Exchange Act registration. Without Exchange Act registration, you’re limited to 1,999 investors. While this often isn’t an issue for private funds, when you start tacking on multiple high-net-worth feeders, the numbers often creep up, hence the ‘34 Act solution.
Let’s talk a little bit more about the specific terms in ‘34 Act funds. Subscriptions to ‘34 Act funds are typically accepted and fully funded on a monthly basis. Shareholders purchase shares of the fund at the fund’s net asset value on that date or maybe as of the previous quarter end.
Because the cash is not drawn down over time, it needs to be deployed right away to avoid cash trap. And therefore, the strategies that these funds deploy need to be of the sort that can be deployed fairly regularly. It would be advised to consider starting with a seed portfolio or anchor investor so that you can pull together a portfolio at day one and avoid cash drag, as the types of underlying investments these funds make often have a longer lead time than maybe, say, a hedge fund deploying capital into the public markets.
Because of the accredited investor and qualified purchaser requirements, the target investors for ‘34 Act funds are high-net-worth, retail, or institutional investors typically seeking access to alternative investments. Shares of ‘34 Act funds are generally offered through wire houses, registered investment advisors, broker dealers, or other platforms typically used to offering private fund shares to retail investors.
Investors coming into these funds must complete subscription documents as part of a 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 fund sponsor.
Note that ‘34 Act 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 any time of any offer. Those thresholds are usually 3-5% of the fund’s net asset value. When the fund receives repurchase requests in excess of that threshold, redeemers are then cut back pro rata.
Investors are typically subject to a soft lock of one to two years with a 5% fee charge for any early redemption during that one- to two-year period. Lastly, ‘34 Act funds are required to publicly report repurchases on their 10-Qs and 10-Ks like Marc discussed.
The economics of ‘34 Act 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 those funds vary by class of units and typically range from 875 basis points to 125 basis points per annum of the fund’s net asset value.
All or a portion of the management fee for certain classes of units, including founders’ units, may be waived for a special period following the initial closing date. Some ‘34 Act funds in 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, depending on the underlying deal with those investors. ‘34 Act funds are permitted to charge performance or incentive fees based on income and capital gains. Generally in the market today, the performance fee is equal to 12.5% or even in some cases 15% of the fund’s total return, subject to a 5% annual hurdle amount and a high water mark, with 100% GP catch-up.
In other words, a 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 or class. As mentioned, certain classes of units of ‘34 Act funds may pay an initial subscription fee and ongoing servicing fees 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 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.
These fees are paid to the intermediaries. Certain classes may not charge subscription fees or servicing fees depending on the deal struck with the particular intermediary. As for expenses, certain funds have expense caps for the first year of life or so, capping them at 70 basis points but then typically repaying those amounts in later years.
These funds also employ leverage, almost universally capping the leverage at 30% of the fund’s net asset value, with various ability to exceed those limits in certain cases. Generally, the funds have a lot of flexibility around leverage.
As for the documentation, documents for these funds in addition to the documents Marc already discussed include a traditional limited partnership agreement, a private placement memorandum, and a subscription agreement. Those documents generally look like traditional private fund documents. The PPM is not disclosed publicly, but the LPA and the IMA will be disclosed.
There is also a subscription agreement, which is not disclosed, and we would generally recommend using an electronic subscription agreement given the volume of investors that are typically coming into these vehicles. Marc, do you want to discuss governance and a few other key features of the regulatory regime around ‘34 Act funds before we wrap up?
Marc Rotter: Yes, I’d be happy to. The Exchange Act does not impose governance requirements on ‘34 Act funds. Unlike, for example, operating companies that are listed on a securities exchange, there is no requirement for ‘34 Act funds to have an audit committee or comply with exchange rules around having a majority independent board.
That said, while there are some different approaches taken by funds that have recently filed, generally the practice is for ‘34 Act funds to have independent directors on the board and an audit committee with independent directors.
The funds themselves are typically structured as partnerships, with a GP that is generally responsible for running the funds. The fund’s board of directors has certain oversight rights, including considering certain conflicts of interest related to the fund sponsor.
In that respect, the independent members of the board can be thought of as serving a role similar to a traditional fund’s LPAC. Members of the board are typically appointed by the GP. LPs in ‘34 Act 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.
Like traditional private funds and unlike funds registered under the Investment Company Act of 1940, there is not statutory leverage limit on ‘34 Act funds. As Jess discussed earlier, funds in the Market have a leverage ratio guideline of 30%, with some ability to exceed that guideline.
Similarly, there’s no regulatory limit on a ‘34 Act fund’s ability to invest in illiquid investments. ‘34 Act funds are also not subject to the Investment Company Act’s strict restrictions on transactions with affiliates, though the Advisors Act rules around conflicts of interest are still relevant and—as we discussed earlier—are part of the reason boards of ‘34 Act 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: Yeah, sure. Thanks, Marc. So ‘34 Act 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 from the underlying investments.
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. ‘34 Act 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 their taxes based on estimates and ask for an extension of their tax returns, with their final return due on October 15 and any refunds paid thereafter.
‘34 Act funds are becoming an increasingly common vehicle for large sponsors serving high-net-worth retail and institutional investors seeking exposure to alternative investment strategies. While ‘34 Act funds require additional reporting requirements and liquidity considerations compared to traditional private funds, they’re otherwise very 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 limit can be a real concern when you’re tacking on multiple high-net-worth feeders through different RIAs and other platforms, like we discussed earlier. ‘34 Act funds are likely going to become more popular in the days ahead as market interests and 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/asset-management or feel free to reach out to any of us at Ropes & Gray via email or phone for more information on ‘34 Act 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.