A course for the sophisticated high-net-worth investor
By Arthur S. Ainsberg and Steven J. Fredman
Private investment partnerships are sometimes referred to as hedge funds. They are pooled investment vehicles consisting of assets contributed by sophisticated high-net-worth individuals.
The funds are structured to be exempt under the Investment Company Act of 1940. Funds are exempt if the number of investors is less than 100 or if the investors meet the definition of a qualified purchaser. Generally, a qualified purchaser (that is, an individual or family company) must own at least $5 million in investments. Other qualified purchasers generally must own and invest at least $25 million on a discretionary basis.
Private investment partnerships invest in all markets and are usually pass-through vehicles for tax purposes.
The National Securities Markets Improvement Act of 1996 (NSMIA), among other things, creates a new exception from the definition of "investment company" under the Investment Company Act of 1940 (the 1940 Act)--one that is not premised upon the 100 beneficial owner limit set forth in section 3(c)(1) of the 1940 Act. On April 3, 1997, the SEC adopted rules under the 1940 Act to implement the provisions of NSMIA as they apply to private investment companies.
Section 3(c)(1) of the 1940 Act
Private investment partnerships, sometimes referred to as "hedge funds," are pooled investment vehicles consisting of assets contributed by high-net-worth individuals or institutional investors. The term hedge fund originally referred to private investment funds that used leverage and sophisticated hedging techniques, such as short sales, in an investment program that focused on the corporate equities markets. Today, the term is used more generally to refer to private investment partnerships, which invest in all markets and employ all kinds of investment strategies ranging from buy-and-hold strategies in equities of companies in a particular industry to fixed income and currency arbitrage. The terms of these funds often provide for fixed management fees of 1.0% to 1.5% and performance-based compensation that often ranges from 10% to 20% of net realized and unrealized appreciation in the partnership's portfolio. Hedge funds formed for U. S. investors are typically structured as pass-through vehicles for tax purposes, most often, as limited partnerships. Withdrawal rights of limited partners are often limited to once per year and are rarely more frequent than quarterly.
Hedge funds generally are structured so as to avoid registration under the 1940 Act, relying on the exception from the definition of investment company. Under section 3(c)(1) of the 1940 Act, if a private investment partnership offers its interests on a private placement basis and has 100 or fewer beneficial owners of its securities, it does not come within the definition of investment company and, hence, is not subject to the registration and other regulatory requirements imposed by the 1940 Act.
The Beneficial Owner Limit. Over the years, hedge fund managers have constantly had to grapple with the complexities of "counting to 100" for purposes of the beneficial owner limit. To begin with, in determining beneficial ownership, the staff of the SEC's Division of Investment Management has generally focused on economic interest. Thus, a single interest in a section 3(c)(1) fund by two persons, owned as joint tenants, was held to fill two slots because both have an economic interest in the fund. (However, the SEC stated that going forward, it would consider securities of a section 3(c)(1) fund that were jointly held by spouses to be held by one person for purposes of the 100 beneficial owner limit.) Two interests, one held by an individual and the other by his or her IRA, would generally fill only one slot because of the shared identity of economic interests.
In addition, beneficial ownership is sometimes attributed to the securityholders of an investor in the section 3(c)(1) fund, rather than to the investor itself, resulting in multiple slots being filled for counting purposes. Before NSMIA, a section 3(c)(1) fund had to look through any investor who (1) owned 10% or more of the section 3(c)(1) fund's voting securities (a 10%+ investor) and (2) had more than 10% of its assets invested in section 3(c)(1) funds generally.
This requirement often created problems for an institutional investor, such as a college endowment, that wished to acquire a greater than 10% interest in a section 3(c)(1) fund, had more than 10% of its assets in section 3(c)(1) funds generally, and had issued securities of its own (i.e., the endowment itself had securityholders that would fill slots in the section 3(c)(1) fund). NSMIA eliminated the second part of the test (having more than 10% of the investor's assets invested in section 3(c)(1) funds generally) and amended the first part of the test (being a 10%+ investor in a particular section 3(c)(1) fund) to apply only if the 10%+ investor is a registered or private fund excepted from the definition of investment company under sections 3(c)(1) or 3(c)(7). Thus, an entity that is not a registered or private investment fund (e.g., a bank, broker-dealer, pension plan, or endowment) could be a 10%+ investor in a section 3(c)(1) fund without being subject to a look- through.
A look-through will still be required when an entity has been formed for the purpose of permitting multiple beneficial owners to invest as one person in a private investment company. The SEC staff has expressed concern that such entities are being used to circumvent the 100 beneficial owner limit, thereby violating section 48(a) of the 1940 Act (which prohibits a person from doing indirectly that which would be directly prohibited). In a series of no-action letters (a letter responding to a request for confirmation that no enforcement action would be taken in response to a particular course of conduct), the staff has developed the following guidelines for determining whether an entity has been formed for the purpose of circumventing the 100 beneficial owner limit:
* Is the entity a common investment vehicle, or are decisions made in a centralized fashion? If the entity is managed as a common investment vehicle rather than as a device for facilitating individual investment decisions, a look- through may not be necessary. However, if each member of an entity investing in a section 3(c)(1) fund can determine whether to participate in a particular investment, then each such person is essentially making a separate investment decision and should be counted separately as a beneficial owner.
* Does the entity's investment in the section 3(c)(1) fund constitute a significant part of its assets? A rule of thumb is that an investment in a private fund should not comprise more than 40%. To the extent that the 40% limit is exceeded, there may be a presumption that the entity has been formed for the purpose of investing in a particular section 3(c)(1) fund, with the result that a look-through to the beneficial owners is required.
The Integration Doctrine. Also of concern to a section 3(c)(1) fund is the "integration" doctrine developed by the SEC staff. When an investment manager serving as a general partner to a section 3(c)(1) fund wishes to manage a second such fund, the manager must consider whether, for purposes of determining compliance with the 100 beneficial owner limit, the two funds must be integrated. The test generally applied by the SEC staff is whether a reasonable investor qualified to invest in both funds would view the two as being the same in economic reality. The SEC staff has generally considered three factors in analyzing this issue:
* The similarities in the investment objectives of the funds,
* The similarities in the portfolio securities that the funds invest in, and
* The risk/return profiles of the funds.
Overlap of portfolio securities is an important issue to the SEC staff, at least in terms of its willingness to extend no-action relief. For example, the staff agreed to issue a no-action letter to the manager of an arbitrage fund and a general equity fund only after the manager represented that not more than 2% of the assets of the general equity fund would be invested in any particular security also held in the arbitrage fund and that not more than 10% of the assets of the general equity fund would be invested in the aggregate in positions held in the arbitrage fund.
Integration may be necessary where the general partner of one fund serves as the primary investment manager to another fund pursuant to an investment management agreement, even if the other fund has an independent general partner. In just such a case, where the investment programs of the two funds were substantially similar, the staff has refused to grant no-action relief.
On the other hand, the staff has been more forthcoming where two funds have been structured to accommodate the needs of two different types of investors. Thus, no-action relief was granted where two hedge funds were managed by the same general partner and had substantially identical investment strategies and securities portfolios, but had materially different tax consequences for their respective investors. One fund, a U.S. limited partnership, restricted the private offering of its limited partnership interests exclusively to residents of the United States that were subject to Federal income tax. The other fund, an offshore corporation that entered into an investment management agreement with the general partner of the U.S. limited partnership, offered its shares only to non-U.S. persons or to U.S. tax-exempt investors on a private placement basis. Because the U.S. tax-exempt investors in the offshore corporation were not subject to U.S. tax on gains from leveraged investments ("unrelated business taxable income"), a result that would not have been the case had the U.S. tax exempt investors invested through the U.S. limited partnership, the staff concluded that the two funds would be viewed by such investors as materially different investments. Therefore, the U.S. tax-exempt investors in the offshore fund would not have to be integrated for purposes of section 3(c)(1) with the taxable investors in the U.S. limited partnership.
Section 3(c)(7) and the Related Rules
In May 1992, the SEC's Division of Investment Management issued a report, "Protecting Investors: A Half-Century of Investment Company Regulation," recognizing that--
for issuers whose securities are owned exclusively by sophisticated investors, the public offering prohibition and 100 investor limit [of section 3(c)(1)] are an unnecessary constraint not supported by sufficient public policy concerns. Therefore, the division recommends an amendment to the Investment Company Act to create a new exception for funds whose securities are held exclusively by "qualified purchasers" as defined by rule.
The 1940 Act and the related rules of the commission were subsequently amended and revised to include section 3(c)(7), which does not limit the number of persons that may invest.
Section 3(c)(7) provides an exception to the definition of investment company for a fund that 1) is owned exclusively by persons who, at the time of acquiring the fund's securities, are qualified purchasers and 2) is not making and does not propose to make a public offering.
A qualified purchaser is someone who is, or is reasonably believed to be, 1) a natural person or family company (generally any company owned directly or indirectly by or for two or more natural persons related as siblings or spouses, owning at least $5 million in investments), 2) a trust not formed for the specific purpose of acquiring the securities offered, so long as the trustee or equivalent decision-maker and each settlor or other person who has contributed assets is a qualified purchaser, and 3) any other person, acting for its own account or for the accounts of other qualified purchasers, who in the aggregate owns and invests on a discretionary basis at least $25 million in investments.
Under the rules, qualified institutional buyers, as defined in Rule 144A of the Securities Act of 1933, would also, in most cases, be considered qualified purchasers. A self-directed employee benefit (e.g., a 401(k) plan), even if it meets the qualified institutional buyer standard, will not itself be a qualified purchaser. Here, the SEC concluded that the appropriate focus is on the qualification of the employee making the particular investment decision.
In defining investments, the SEC was guided by the legislative history of NSMIA, which indicates that section 3(c)(7) funds should be limited to investors with a high degree of financial sophistication who appreciate the risks associated with private investment funds. Because of the legislative history's emphasis on financial sophistication, the SEC focused on financial instruments in its definition. Included are securities, real estate, commodity interests, physical commodities (e.g., silver and gold), swaps and similar financial contracts, and cash and cash equivalents held for investment purposes. Where the prospective qualified purchaser is itself a private investment partnership or commodity pool, it can include capital commitments from its investors (rather than just cash on hand) in determining its cash held for investment purposes. Investments such as art and other collectibles are not included because, in the SEC's view, they are not sufficiently indicative of financial sophistication.
Under the SEC's rules, when determining whether the $5 million or $25 million threshold is met, investments must be valued either at fair market value as of a recent date or at cost. The determination of which methodology to use may be made either by the section 3(c)(7) fund or by the prospective qualified purchaser. In one of the more controversial provisions of the rule, the amount of any outstanding indebtedness incurred to acquire investments must be deducted in calculating the thresholds.
The rule also permits (for purposes of the $5 million threshold) a husband or wife to aggregate his or her own investments with jointly owned investments. If, as a result of a combination of individually owned investments and jointly owned investments, only one spouse meets the $5 million threshold, the one who does not will nevertheless be considered a qualified purchaser with respect to joint investments in a section 3(c)(7) fund--that is, when spouses make a joint investment, one spouse can get "credit" for the other's individually owned investments.
Conversion of Section 3(c)(1) Funds into
Section 3(c)(7) Funds
The legislation permits a section 3(c)(1) fund to convert into a section 3(c)(7) fund (a grandfathered fund) if, following conversion, 1) only qualified purchasers may be admitted as new investors in the fund, and 2) in addition to qualified purchasers, the fund's interests are owned by 100 or fewer nonqualified purchasers, each of whom acquired an interest in the fund on or before September 1, 1996.
The grandfathered fund must 1) notify each of its beneficial owners that future investors will be limited to qualified purchasers and that ownership is no longer limited to 100 persons, and 2) provide each beneficial owner (including any that meet the definition of qualified purchaser) with a reasonable opportunity to redeem any part or all of their interests in the grandfathered fund for such owner's "proportionate share" of the fund's net assets.
Knowledgeable Employee Exception
Pursuant to NSMIA, the SEC has adopted Rule 3c-5, whereby directors, executive officers, general partners, and other "knowledgeable employees" of the fund or the fund's investment manager can acquire an interest in the fund without being counted toward a section 3(c)(1) fund's 100-investor limit and without causing a 3(c)(7) fund to run afoul of the qualified purchaser requirement. The knowledgeable employee concept extends to employees who, in connection with their regular functions or duties, 1) participate in the investment activities of the fund or in those of other investment companies managed by the investment manager, and 2) have been performing such functions and duties for such companies, or another company, for at least the past 12 months. Personnel performing solely clerical or administrative functions cannot take advantage of this rule.
Limitations on the Number of Investors in a
Section 3(c)(7) Fund
While section 3(c)(7) imposes no limit on the number of investors in a fund, certain other legal constraints may impose such a limit. For example, sales to a large number of investors may be viewed as evidence of a general solicitation, which would be inconsistent with the required notion of private placement. In addition, if a fund has more than $1 million in total assets (which, presumably, will always be the case) and 500 or more holders of record, registration requirements under the Securities and Exchange Act of 1934 would probably be triggered.
The ability of a section 3(c)(7) fund to have more than 100 investors also raises special tax issues. IRS regulations indicate that a partnership with no more than 100 partners (including the general partner and constituent members of a single purpose general partner entity) will qualify for a safe harbor and be treated as a partnership for tax purposes. On the other hand, a partnership with more than 100 partners will be treated as a "publicly traded partnership" (PTP) and be taxable as a corporation if interests therein are "readily tradable on a secondary market or the substantial equivalent thereof." If, however, such a partnership provides for a very limited number of redemptions of a partner's interest during a year and transfers of interests are otherwise very restricted, under a facts-and-circumstances test in the regulations, the partnership should not be considered a PTP, even if it does not meet the 100-partner safe harbor.
Notwithstanding these concerns, most investment partnerships should qualify for an exemption from PTP treatment for nonregistered partnerships having more than 90% of their gross income from "passive-type" income. The IRS has issued regulations confirming that the type of income earned by most private investment partnerships will qualify as passive-type income for this purpose.
The passage of NSMIA and the adoption by the SEC of final rules implementing its provisions has proven a welcome event for hedge fund managers. Many managers have established clones of their existing section 3(c)(1) funds, limiting admission in the new funds to qualified purchasers only. To the extent that it can be achieved without creating a taxable event, many managers have asked qualified purchasers in their section 3(c)(1) fund to transfer their investments to the new section 3(c)(7) fund, thereby making room for additional investors. The end result should be a positive one for managers and investors alike, as managers that had previously closed their funds due to the 100 beneficial owner limit may now be in a position to reopen them for new investors. *
Arthur S. Ainsberg, CPA, is the chief operating officer of Brahman Partners, a private investment partnership, and serves as board chairman of the New York State Board for Public Accountancy. Steven J. Fredman is a partner at Schulte Roth & Zabel LLP. The authors thank Paul N. Roth and Daniel S. Shapiro, partners at Schulte Roth & Zabel LLP, for their assistance in the preparation of this article.
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