General Advertising of Private Investment Funds

An 80-year ban on general advertising and solicitation of private investment funds is coming to an end. The revised SEC rules apply to hedge funds, private equity groups, venture capital firms and other private funds. Previous to the change, firms could only solicit to “accredited investors” after they’ve been properly verified as accredited. The revised rules will allow advertising by methods previously prohibited such as television ads, brochures, full-page print advertisements, and content rich websites with information about the fund’s philosophy, process, risk controls, investment team, etc.

Purchasers of private funds must still be considered “accredited investors” with assets of at least $1,000,000 (excluding primary residence) or annual income of at least $200,000 in each of the two most recent years with a reasonable expectation of similar earnings in the current year. Since general advertising increases the possibility of risk of sales to unqualified buyers, the SEC has actually tightened the verification procedures of accredited status by firms using general advertising. No longer will investors be able to simply check a box stating that they qualify as an accredited investor. Firms utilizing general advertising will need to document, a) income with 1040’s or W-2’s, and b) net worth requirements with bank and brokerage statements or written confirmation from third parties like broker-dealers, registered investment advisers, attorneys or CPA’s.

The revised general advertising rules may open the door to fresh sources of capital by reaching smaller accredited investors that do not have assets of at least $5,000,000. The SEC estimated that at least 8.7 million households qualified as accredited investors in 2010 but only 234,000 participated in Rule 506 offerings . This new source of capital may be especially important to start-up funds who may be willing to accept a $250,000 or $500,000 investment which is well below the $1,000,000+ minimums that many larger more established firms have established.

This broader access to smaller accredited investors poses other potential problems, including:

• Larger number of smaller investors with less experience will require more cost and attention, necessitating increased operations and staffing.
• More advertising will bring increased SEC attention
• Designing, executing and evaluating the performance of advertising is expensive and generally beyond the scope of a small fund.

While the revised rules on general advertising may open the door to more investors and capital, spurring growth in new offerings, the larger well-established funds with access to institutional money may be less responsive to the increased ability to advertise. Having 5 investors with $500,000,000 each is much less work than 5000 investors with $500,000 each.

SEC Guidance to Fund Advisers Serving “at cost” or for no Compensation

The U.S. Securities and Exchange Commission’s Division of Investment Management has recently offered guidance with regards to Fund Advisers serving “at cost” or for no compensation (No. 2013-09 Oct 2013). At the heart of the guidance are a couple of Sections of the Investment Company Act of 1940 (Company Act) that appear to question whether a person or company that temporarily serves a fund “at cost” or for no compensation is an investment adviser under the Company Act. Section 2(a)(20) of the Company Act defines an investment adviser of an investment company to include, any person “who pursuant to contract with such company regularly furnishes advice to such company with respect to the desirability of investing in, purchasing or selling securities or other property, or is empowered to determine what securities or other property shall be purchased or sold by such company.” Section 2(a)(20)(iii) on the other hand excludes from this definition “a company furnishing such services at cost to one or more investment companies, insurance companies, or other financial institutions.”

A common example of an investment adviser offering temporary advisory services to a fund at cost or for no compensation involves an “assignment” of an investment advisory contract. Section 15(a)(4) of the Company Act says it is unlawful for a person to act as investment adviser for a fund except pursuant to a written contract which must be approved by the vote of a majority of the fund’s outstanding voting securities and must provide for the contract’s automatic termination in the event of its assignment. Since assignment can include any direct or indirect transfer or hypothecation of a contract by the assignor or of a controlling block of the assignor’s outstanding voting securities, it can be difficult for a fund to get timely shareholder approval of a new advisory contract.

However, Rule 15(a)(4) also provides a temporary 150-day period during which a person may act as an investment adviser for a fund under an interim contract without shareholder approval, subject to specified conditions. Under Rule 15(a)(4), in the event of a failure to obtain shareholder approval as provided for in the rule, the investment adviser may be paid its costs incurred in performing the interim contract. Although rule 15(a)(4) provides relief for substantially all circumstances in which a fund might need additional time to obtain shareholder approval of an advisory contract in the case of an assignment, division staff occasionally have also provided similar relief in no-action letters for particular circumstances.

And while the Commission has granted certain temporary exemptions from the provisions of Section 15(a)(4) conditioned on such person’s serving during the interim period on an “at cost” basis or for no compensation, it did not interpret such persons to not be investment advisers as defined in Section 2(a)(20) which would be inconsistent with the investor protections mandated by the Company Act.

Sample SEC Exam Request Letter - Dec 2013

If you are interested in seeing what a recent SEC Exam Request Letter is asking, you can click here to download a Dec 2013 version.

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