Executive Summary
In the competitive market for financial advice, advisory firms often seek to find ways to differentiate themselves from one another. For firms with high-net-worth clientele, one way to do this is to offer alternative investments, such as private equity, private debt, or hedge funds, which may offer clients the ability to invest in a more diverse range of assets. In many cases, advisors place clients into funds run by third-party managers, which allows the advisor to rely on the manager's expertise in that particular investment area as well as their back-office resources to handle the administrative, legal, and regulatory hurdles of running a private investment fund. However, it's also possible for advisors to launch and manage their own private funds, which can allow them to further tailor their investment strategy to their clients' needs and to grow their business by attracting more high-net-worth clientele, while potentially cutting out some of the cost layers that clients face when using third-party alts distribution platforms.
At a high level, private funds work by pooling capital together from multiple investors, which can be deployed in a variety of ways – from traditional investments like public stocks and mutual funds to stock in private corporations, private debt lending, commodities, real estate, and even more exotic investments like art, wine, or collectibles. Additionally, private funds can employ leverage, short selling, derivative strategies, and other methods to further manage the portfolio's risk and return characteristics. The end result is that private funds may offer investors more diversification by investing in a broader range of assets than what's found in the public markets; on the other hand, they can be riskier and less liquid than other investments, which is why generally only accredited investors (i.e., generally those with over $200,000 of income or $1 million in net worth) are allowed to invest in private funds.
For advisors who launch private funds, it can be costly to navigate the legal and regulatory complexities involved in getting the fund off the ground. Attorneys are needed to draft the fund's offering documents, and if the advisor wants to avoid the need to register the securities or the investment company with the SEC, the firm will need to implement policies and procedures to ensure the fund meets the exemptions for those requirements. In addition, most RIAs will likely want to engage the services of a third-party fund administrator to facilitate many of the documentation, tracking, and recordkeeping requirements. All of which can make a private fund expensive to launch, with the typical cost for launching a small fund ranging from $40,000 to $70,000 (costs that are typically borne by fund investors) – although given that many of these costs are upfront when launching the fund, costs to manage the fund on an ongoing basis can be substantially less, depending on the costs of the third-party administrator being used and the complexity of the strategy being employed. However, advisers may also realize the operational cost benefits of launching a private fund since they would not need to execute many individual trades for clients through separate accounts.
The key point is that although private funds might not be appropriate for all advisors – since they require having clients who qualify as accredited investors, and having enough of those clients who can benefit from investing in the fund to provide enough capital to run the private fund cost-effectively given the overhead expenses involved to start and run one – they can still be worth exploring for advisors seeking to differentiate themselves and expand their service offerings for high-net-worth clients. And while the complexity and upfront cost of launching a private fund may be high, doing so may ultimately be worth it for the ability to unlock new business growth and deliver more value for clients, at least for firms that want to further differentiate themselves on the basis of their (private) investment offerings to clients!
Launching a hedge fund or private equity fund can be a game changer for an investment adviser to elevate its practice and grow its client base. As the number of high-net-worth individuals allocating a portion of their assets to alternative investments continues to rise, RIAs are increasingly exploring the advantages of not just using third-party alternatives platforms like iCapital or CAIS, but forming their own private funds. Not only does this strategy allow RIAs to offer their clients more diversified and tailored investment opportunities, but it also opens the door to significant additional revenue opportunities for RIAs to earn the performance-based management fees typical of such offerings.
Beyond the financial benefits, private funds bring operational efficiencies that can streamline asset management by pooling certain client investment assets into a single fund to manage, making it an appealing option for RIAs looking to enhance their service offerings and grow their business.
In short, forming a private fund doesn't just add a new dimension to a firm's business; it can solidify its position as a leader in a competitive market. However, entering the private fund arena comes with its own challenges. Sponsoring and launching a private fund requires careful planning to navigate the maze of regulatory and legal complexities that can pose risks for new fund managers.
To determine whether establishing a private fund is a suitable strategy, firms must understand key topics, such as how funds are structured and regulated, who manages them, how sponsors are compensated, and the essential terms that govern investments and the activities of the fund's adviser. Additionally, understanding the regulations, the types of investors allowed, necessary vendors, typical startup costs, and the required documents are critical for successfully launching and managing a private fund.
What Is A Private Fund?
In short, a private fund is a pool of assets gathered from one or more investors whose capital is contributed to an entity (typically a limited partnership or limited liability company) and subsequently invested in various investments that are acquired and disposed of by a private fund adviser during the life of the private fund. Advisers often find that managing multiple client investments can be streamlined with private funds, as they can execute a single trade for the fund instead of having to execute the same trade separately for each client.
Private funds come in all shapes and sizes. Some raise as little as $500,000 before launching while others can raise $10 billion in assets. They can invest in almost any kind of asset including the following:
- Public and private companies;
- Mutual funds and exchange-traded funds;
- Fixed-income investments (including bonds, notes, and direct loans);
- derivatives (including options, futures, forward contracts, and swaps);
- Commodities;
- Crypto assets;
- Commercial and residential real estate projects;
- Trade claims or litigation claims; and
- Art, wine, and collectibles.
Nerd Note:
here are limitations on investments in mutual funds and exchange-traded funds, such as those specified by Section 12(d)(1)(A) of the Investment Company Act, which generally restricts hedge funds from acquiring more than 3% of the shares of any given mutual fund or ETF.
Private funds can utilize leverage (e.g., margin or similar borrowing to buy more assets) in their investment activities, as long as they follow applicable regulations, such as Title 12, Part 220 of the Code of Federal Regulations, more commonly referred to as Regulation T. They can also engage in short selling and securities lending activities if desired.
Most private funds fall into one of 2 categories: 1) open-end funds and 2) closed-end funds.
Open-end funds, which is the structure typically utilized by hedge funds, often invest in liquid investments such as exchange-traded or over-the-counter equities, debt instruments, and derivatives, which makes it more 'open' for investors to contribute capital to (i.e., subscribe) or withdraw capital from (i.e., redeem) from the fund more freely during the life of the fund.
Closed-end funds, such as private equity funds and venture capital funds, invest in illiquid investments, such as securities of private companies, and typically sponsors of such funds only offer subscriptions for a short period of time after the fund is launched. In turn, akin to typical closed-end mutual funds, the investors are generally not permitted to redeem their investment in the fund until after fund investments have been liquidated and the fund itself chooses to make distributions of the proceeds. Some 'hybrid' funds invest in both liquid and illiquid investments, which only allow investors to redeem the liquid portion of their investments that have not been put in a 'side pocket' for illiquid investments.
How Are Private Funds Structured?
A fund sponsor whose prospective investors are all US residents will often organize a single stand-alone fund, which is typically organized as a limited partnership or limited liability company. Most private funds (other than certain real estate funds) are established as limited partnerships to expressly limit the role of fund investors to avoid their active participation in managing the fund, which can shield such investors from paying self-employment taxes in connection with the fund's activities. Investors typically participate in the limited partnership or limited liability company by purchasing interests in the fund. Delaware is typically the forum of choice for forming private funds predominantly because of its well-established case law governing limited liability companies and limited partnerships.
Nerd Note:
If the fund sponsor also has non-US investors or tax-exempt investors, the fund sponsor may simultaneously organize an offshore fund (commonly set up in a tax-friendly jurisdiction like the Cayman Islands or the British Virgin Islands) where non-US investors and/or tax-exempt investors can invest. The fund sponsor can run the domestic and offshore funds 'side-by-side', making investments pro-rata among the funds.
For operational reasons, the fund sponsor may choose to organize the funds in a 'master-feeder' structure whereby the assets of the onshore and offshore funds feed into a master fund (typically organized in the tax-friendly jurisdiction) where all of the investments are held. Setting up funds through such a master-feeder structure allows a fund manager to trade investments for both onshore and offshore investors through a single trading account, which also facilitates automatic rebalancing.
Using a master-feeder structure also avoids having to enter into multiple contracts and arrangements with counterparties for the onshore and offshore fund and can provide negotiating leverage (through a higher combined AUM total) in dealing with counterparties and service providers, which can potentially lead to lower costs for investors.
What Are The Key Terms Related To An Investment In A Private Fund?
The terms related to an investor's investment in a private fund fall into 4 principal categories:
- Investor admission and participation in fund profits. These terms specify when and how much capital investors must contribute, as well as how the fund allocates and distributes profits, with investors generally receiving a share proportional to their capital contributions.
- Fund manager fees. These terms outline the fees the fund manager will receive.
- Allocation of fund expenses. These terms govern how operating expenses are split between the fund sponsor and the investors. Sponsors generally cover their own overhead costs (e.g., rent, office expenses, utilities, employee salaries), while investors typically pay for fund organization (e.g., attorney fees, third parties raising capital for the fund), investment-related expenses (e.g., brokerage commissions, research, due diligence), ongoing operational costs (e.g., prime brokers, fund administrators, auditors), and liabilities incurred by the fund.
- Investor withdrawals. These terms define when and how investors may withdraw from an open-end fund, allowing the fund manager to manage liquidity and sell investments to satisfy investor withdrawal requests. They include provisions like lock-up periods (i.e., the amount of time investors must wait to withdraw capital from the fund), minimum notice requirements for withdrawal requests, capital withdrawal limits from the fund on any given date, restrictions on how withdrawal proceeds will be paid out to investors, and other conditions that allow the fund manager to limit or suspend withdrawals due to unforeseen events.
The terms of an investor's involvement in the private fund are usually spelled out in the fund's governing documents. These documents are usually referred to as the "limited partnership agreement" for funds organized as limited partnerships, and the "operating agreement" for limited liability companies.
How Can Advisers Establish A Private Fund?
A financial advisory firm sponsor launching the private fund will organize one or more separate affiliates to operate the private fund. These entities will be responsible for managing the investments and operations of the private fund. One of these entities will serve as either the 'general partner' if the private fund is organized as a limited partnership, or the 'managing member' if the private fund is organized as a limited liability company.
This entity is responsible for general oversight of the private fund's corporate and financial affairs, but generally does not have any operational or investment-related responsibilities. Its main function is to sign contracts on behalf of the fund, and to collect any performance-related compensation payable to the fund sponsor (as described below).
The general partner or managing member typically delegates responsibility for managing the private fund's investments to one of its affiliates. In some cases, the RIA itself will manage these investments, particularly where the fund's strategy (or a similar one) is already being employed for other clients. However, in many circumstances, the RIA will establish a separate affiliated management company to manage the private fund's investments. There are several reasons an RIA might create an affiliated entity: to segregate potential liabilities associated with operating the private fund from those of the RIA, to establish a distinct brand for private fund advisory services, or to enable different personnel to participate in the ownership and/or management of the private fund advisory business.
Private funds often pay a management fee to the management company, often between 1% to 2% of assets under management per year. Additionally, the entity serving as the general partner or managing member also typically receives compensation, commonly known as "carried interest" or "promote", based on a percentage of the fund's profits, generally ranging from 15% to 20%.
For open-end funds, carried interest is usually taken yearly on both realized and unrealized gains, subject to a "high watermark" that ensures the sponsor cannot receive additional carried interest until the fund has fully recouped any previous losses. By contrast, for closed-end funds, carried interest is collected once investments have been sold and the contributed capital has been returned to investors.
Nerd Note:
Although double fees are not explicitly prohibited, they can be hard to justify given the RIA's fiduciary duty to clients, and the SEC closely scrutinizes recommendations of proprietary products. Generally, either the advisory fee or fund management fee is waived when RIAs invest their clients in their private funds. However, full disclosure of conflicts is still required, especially since the potential for performance fees creates an incentive for the manager to recommend the private fund to clients, potentially increasing their overall compensation.
What Service Providers Do Private Fund Sponsors Use?
Private fund sponsors typically engage several key vendors to provide essential services. First, sponsors usually retain an attorney to advise on fund structure and prepare the fund offering documents. Attorneys also provide ongoing legal guidance regarding fund operations and help sponsors navigate numerous regulatory requirements.
Second, many private funds hire a third-party fund administrator (like NAV Consulting, Opus Fund Services, or HC Global Fund Services) to manage operational tasks, financial accounting, and reporting. These fund administrators assist with subscription and withdrawal requests, valuation of fund investments, bill payments, financial statement preparation, and preparation and distribution of reports and tax documents to investors.
Third, fund managers – particularly those registered as investment advisers with the SEC – generally engage an auditor to review and audit the financial statements, ensuring compliance with the SEC's Custody Rule (discussed in more detail below). This is necessary because the fund manager has custody by virtue of its ability to move funds out of the private fund through authority granted in the partnership or operating agreement.
Finally, funds that trade in public securities often retain a prime broker to provide custodial and brokerage services. Unlike traditional brokerage services, prime brokers offer fund managers greater access to other brokers for trade execution, enhanced securities lending and short-selling capabilities, and consolidated reporting across brokers. Many traditional RIA custodians, such as Charles Schwab and Fidelity, offer prime brokerage services, but others, such as interactive Brokers, BTIG, and StoneX, cater to smaller or first-time fund managers.
Notably, the role of a prime broker differs from that of a fund administrator, as prime brokers are involved in trading activities, while fund administrators focus solely on providing operational support, calculation of net asset value, expense management, and reporting.
What Legal Documents Are Required To Launch A Private Fund?
There are several key documents that are drafted to form a private fund, including the following:
- The limited partnership agreement or operating agreement governs the activities of the fund and outlines the key rights and obligations of fund investors and the fund sponsor.
- The private placement memorandum or offering memorandum provides information about the fund, including the objectives and strategies of its investment program, key personnel, associated risks and conflicts of interest, service providers, and the process for subscribing for interests in the fund. This document helps the fund sponsor satisfy its obligation of ensuring that investors have all the material information necessary to make informed decisions about investing in the fund.
- Subscription documents include terms agreed upon by the investors and a detailed questionnaire to confirm their eligibility to invest in the fund.
- An investment management agreement may be established between the fund and its management company (whether that's the RIA itself or one of its affiliates, as explained above), detailing their respective rights and responsibilities regarding the management of the fund's investments.
These documents are usually bundled together and provided to prospective investors and are commonly referred to as the fund's "offering documents".
How Much Does It Cost To Start A Private Fund?
The cost of starting a private fund varies based on several factors, including the complexity of the fund and its investments, the sponsor's level of preparation, the amount of negotiation with investors, and the service providers retained.
At a minimum, fund sponsors should budget between $40,000 and $70,000 to launch a domestic private fund, but depending on the complexity of the strategy and structure of the fund, expenses could be higher. Here is a list of expenses that the sponsor of a small stand-alone domestic fund could expect in connection with the launch of the fund:
- Legal fees associated with structuring the fund and preparing fund offering documents generally range from $25,000 for 'plain vanilla' funds to more than $100,000 for more complex funds.
- Marketing expenses to promote the fund, which could include the preparation of a pitch deck, typically range from $5,000 to $10,000.
- Expenses of retaining a fund administrator, which range from $10,000 to $20,000 for the first year, depending on the complexity of the fund and the services desired.
- For SEC-registered fund sponsors requiring an annual audit by an independent public accountant to comply with the Custody Rule (see below for a discussion of such requirement), such expenses tend to range from $15,000 to $35,000, depending on the complexity of the fund (and its investments) as well as the number of funds to be audited.
After the first year, the ongoing operating costs often decrease (as many initial organizational expenses are one-time costs), though they will still depend on the same factors listed above.
Who Can Invest In A Private Fund?
Because private funds virtually always rely on a securities registration exemption and an investment company registration exemption (discussed later), the eligibility of investors largely depends on the exemptions from registration the fund relies on.
Private Funds Using Rule 506, Regulation D
For private funds using Rule 506 of Regulation D (often simply referred to as “Reg-D offerings”), offerings are limited to accredited investors, with the option to include up to 35 non-accredited investors in some cases. However, most private funds choose not to admit non-accredited investors to the fund because of additional disclosures and other complexities that come with them.
Accredited investors, as defined in Rule 501(a) under the Securities Act, include the following:
- Individuals earning at least $200,000 annually (or $300,000 combined with a spouse) in each of the last 2 years, with a reasonable expectation of the same in the current year; or
- Individuals (or spouses combined) with a net worth of at least $1 million (excluding the value of a principal residence).
Accredited investors can also include certain entities with at least $5 million in assets if they aren't formed for the purpose of investing in the fund, and entities whose owners are all accredited investors may qualify if they have less than $5 million in assets. Individuals with specific securities licenses may also qualify.
Private Funds Using Section 3(c)(7), Investment Company Act
If the fund relies on Section 3(c)(7) of the Investment Company Act to avoid registering as an investment company, it must limit its investors to "qualified purchasers". As defined in Section 2(a)(51)(A) of the Investment Company Act, this group includes individuals with at least $5 million in qualifying investments, and entities not formed for the purpose of investing in the fund with at least $25 million in qualifying investments. Entities owned entirely by qualified purchasers also qualify, regardless of their asset size.
Private funds may also need to ensure that their investors are "qualified clients" if they charge a carried interest (due to existing regulatory limitations on charging performance-based fees. Qualified clients, as defined in Rule 205-3 under the Investment Act, include the following:
- Individuals or entities with at least $1.1 million invested with the fund sponsor immediately after becoming a fund investor;
- A natural person (individually or combined with a spouse) with a net worth of at least $2.2 million (excluding the value of a principal residence); or
- Qualified purchasers, as described earlier.
Additionally, private funds often prohibit or significantly limit investments through retirement accounts such as 401(k) plans or IRAs to avoid restrictions imposed by the Employee Retirement Income Security Act of 1974 (ERISA). ERISA's more stringent fiduciary regulations that outright prohibit a wide range of transactions involving conflicts of interest are typically too restrictive for most fund managers to operate effectively.
What Regulations Govern The Sale Of Private Fund Interests And The Operations Of The Private Fund?
Numerous securities laws impact how private funds can offer and sell their interests, as well as how they must operate. To operate efficiently and avoid time-consuming regulatory approvals and reporting, private funds rely on certain exemptions. These include exemptions that allow them to offer securities without having to register them, and exemptions from registering as investment companies themselves, which are requirements that apply to mutual funds or ETFs.
Exemptions From SEC Registration For Private Offerings
Because registration of privately offered securities is a time-consuming and expensive process, private funds generally seek exemptions to avoid having to register their securities with the Securities and Exchange Commission (SEC) or with any states. One such exemption, mentioned above, is offered by Rule 506 of Regulation D under the Securities Act of 1933. The key requirements for this exemption are as follows:
- Investor Eligibility: Securities must be offered to accredited investors only, though up to 35 non-accredited investors can be included in specific circumstances.
- Filing Obligations: The fund must file SEC Form D (Notice of Exempt Offering of Securities) through the SEC's Electronic Data Gathering And Retrieval (EDGAR) system and amend as necessary.
- Bad Actor Provisions: Key persons associated with the fund – including the fund sponsor, significant investors, and those raising capital – must not have been involved in "disqualifying events", such as criminal convictions, regulatory sanctions, or other "bad acts".
Rule 506(b) Vs Rule 506(c)
The specific requirements under Rule 506 vary depending on whether the fund wishes to publicly advertise to attractive prospective investors.
Rule 506(c) allows funds to engage in general solicitation and public advertising, but all investors must be accredited investors. The fund sponsor must verify each investor's accredited status through documentation such as bank or brokerage statements, tax returns, or certification from another investment adviser, licensed attorney, or CPA. Because many investors are reluctant to provide this information, most fund sponsors do not rely on Rule 506(c) and, therefore, do not publicly advertise their funds.
Rule 506(b), on the other hand, prohibits general solicitation or advertising but relaxes other requirements. For instance, Rule 506(b) allows up to 35 non-accredited investors, although most private funds avoid admitting non-accredited investors due to heightened disclosure requirements. Funds relying on Rule 506(b) do not have to comply with the strict accredited investor verification requirements imposed by Rule 506(c). Instead of reviewing detailed documentation, the fund sponsor simply needs a reasonable belief that prospective investors are, in fact, accredited, which can be confirmed through questionnaires in subscription documents completed by prospective investors.
Avoiding Investment Company Registration
Private funds also typically seek to avoid registration as an investment company with the SEC, a process required for mutual funds and exchange-traded funds. Many private funds cannot operate efficiently under restrictions imposed on registered investment companies, so they often rely on 1 of 2 exemptions in the Investment Company Act:
- Section 3(c)(1): This exemption allows private funds to avoid registration if they don't offer interests publicly, and limit investors to no more than 100 beneficial owners.
- Section 3(c)(7): This exemption allows avoidance of registration if interests are not publicly offered, and the only investors are "qualified purchasers" (discussed in the previous section).
What Areas Face Regulatory Risk Or Scrutiny When Sponsoring A Private Fund?
Private fund sponsors are generally considered “investment advisers” under Federal and state securities laws due to their management of fund investments that are classified as securities. As such, they must register as an investment adviser with the SEC or relevant state authorities unless they qualify for an exemption.
For an RIA that will manage the investments of the private fund directly itself, no separate registration is required. However, if the RIA uses a separate affiliate to manage the private fund's investments, it must determine whether that affiliate must register as an investment adviser with one or more states. The SEC and many states offer exemptions for fund managers advising only private funds, but the eligibility requirements for such exemptions will vary by regulator.
For instance, under Section 203(m) under the Advisers Act, the SEC exempts fund managers from registration if they advise only private funds (i.e., they do not also advise individual clients through separately managed accounts) and manage less than $150 million in total private fund assets. Therefore, RIAs using an affiliate to manage a private fund's investments must assess whether the affiliate must register with the SEC or state authorities or if it qualifies for an exemption.
Whether the RIA is providing investment management services to the private fund directly or having one of its affiliates perform such services, managers of private funds who must register with the SEC as investment advisers are subject to the general requirements found in the Investment Advisers Act applicable to all SEC-registered investment advisers, including those pertaining to the preparation and delivery of Form ADV, the fiduciary duty of care and loyalty, advertisements, trading, cybersecurity, and retention of books and records. There are additional regulations specific to the management of private funds that also govern the activities of SEC-registered investment advisers, discussed below.
Adherence To Investment Strategies
Private fund advisers must ensure that the operations of the fund follow the disclosures made in fund offering documents. For instance, private fund advisers must avoid style drift – a deviation from the investment strategy outlined in the fund's offering documents. The SEC takes style drift seriously, as it can mislead investors who rely on the stated investment strategy when deciding to invest. Any significant changes from the stated strategy must be communicated transparently and may require amendments to the fund's offering documents.
Managing Conflicts Of Interest
RIAs must disclose and manage conflicts of interest associated with sponsoring a private fund. For instance, when investment advisers launch a new fund and offer it to existing advisory clients, any conflicts of interest associated with the recommendation need to be disclosed and, ideally, mitigated. Since RIAs earn advisory fees for directly managing clients' assets, and either they or their affiliates can also earn compensation for managing the private fund's investments, a potential conflict arises when a client is advised to invest in that fund. To mitigate the conflicts associated with receiving two layers of fees, RIAs can waive either the advisory fee for managing the client's assets invested in the private fund or arrange for a waiver of the private fund's management fee for any amounts the client invests in the fund.
Nonetheless, mitigation does not typically eliminate all conflicts of interest, as fund managers may still earn additional compensation through any carried interest tied to the client's investment in the private fund. Therefore, RIAs must disclose both the conflict and their incentive to recommend their own private fund to clients. Regulators closely scrutinize this area, making clear and thorough disclosures essential for RIAs.
Valuation Of Fund Assets
The valuation of fund assets is another critical area of regulatory focus, especially when the fund adviser's compensation is tied to the value of assets under management. Private fund sponsors managing illiquid assets face particular challenges in valuing securities with little or no trading activity, leading to minimal price transparency. In such circumstances, private fund sponsors may need to obtain independent quotes from third parties, use valuation marks provided by the sponsor of the illiquid investment, or use observable inputs and models to value such investments, to ensure that their AUM fees are calculated properly.
Private fund advisers must also have documented policies and procedures for valuing investments, and they must also implement and rigorously follow their procedures. These valuation procedures must be fair, transparent, and align with the disclosures made in the fund's offering documents.
Fees And Expense Transparency
The SEC has increasingly focused on the transparency of private fund fees and expenses to protect investors from hidden or excessive charges that could erode investment returns. Private fund advisers must provide detailed disclosures about fees, including management fees, performance fees, and deal-related fees that can be earned by the sponsor or its affiliates.
Similarly, private fund sponsors must provide transparency around organizational, operating, and investment-related expenses to be borne by investors which could include, among others, legal expenses, marketing expenses, fund administrator expenses, accounting expenses, and expenses associated with the acquisition, holding, and disposition of investments.
Expense Allocation
The allocation of expenses is another area that has drawn regulatory scrutiny. For starters, fund sponsors must ensure that expenses are clearly allocated so that fund investors do not bear expenses that should be covered by the sponsor, such as rent, salaries, utilities, and overhead expenses.
Additionally, fund sponsors that manage multiple funds must allocate investments across the various funds they manage to ensure that such expenses are allocated in a fair and equitable manner across all of the funds so as to avoid favoring funds (by allocating such funds fewer expenses) where the fund sponsor can earn more compensation.
For instance, if a fund sponsor acquires an investment for multiple funds and/or other client accounts, the expenses associated with acquiring that investment should be borne by the participating funds/clients in a fair and equitable manner. Regulators expect that fund sponsors will adopt policies and procedures designed to ensure that expenses are allocated across funds and other clients in a fair and equitable manner.
Compliance With The Custody Rule
Private fund sponsors registered as investment advisers are deemed to have custody of client funds and securities (either by virtue of serving as the general partner of the fund organized as a limited partnership or by serving as a managing member of the fund organized as a limited liability company). However, depending on whether they are regulated by the SEC or one or more states, they may be exempt from certain Custody Rule requirements (including the need to obtain an annual surprise custody examination conducted by an accountant to inventory the fund's securities and cash).
For instance, if the fund sponsor is regulated by the SEC, Rule 206(4)-2(b)(4) under the Advisers Act exempts fund sponsors from the requirement to obtain an annual surprise examination if they obtain and distribute on an annual basis audited financial statements prepared in accordance with US generally accepted accounting principles within 120 days of the end of the fund's fiscal year (or 180 days for funds of funds). These statements must be audited by an independent accounting firm registered with and regulated by the Public Company Accounting Oversight Board.
SEC Scrutiny Of Preferential Treatment
Although certain SEC rules meant to increase the regulation of private fund advisers were ultimately struck down by the Fifth Circuit Court of Appeals, the SEC remains concerned about private fund advisers giving preferential treatment to select investors. This includes offering special information rights or allowing certain investors to redeem their investments ahead of others through side letters.
Additionally, the SEC is focused on advisers charging fund investors with expenses that, in its view, should be covered by the adviser. It's conceivable that the SEC will continue to address these concerns by invoking advisers' fiduciary duty to clients, so advisers must be mindful of these when managing a private fund.
Regulatory Filings
Private funds may need to make certain regulatory filings depending on their specific circumstances. For instance, advisers managing more than $150 million in private fund assets are required to file Form PF, required by the SEC. This filing involves detailed reporting on the fund's assets, liabilities, and risk profile, including information on fund strategies. Larger funds are required to disclose more granular data on leverage, liquidity, counterparty risk, and other factors to aid in systemic risk assessment.
Additionally, as with other advisers, private fund managers that acquire beneficial ownership of more than 5% of a public company's securities must file either Schedule 13G or Schedule 13D with the SEC through the SEC's EDGAR system.
This is not an exhaustive list of potential regulatory filings, so it's vital for private fund managers to evaluate any additional filing obligations depending on the nature of their private fund business.
While launching a private fund comes with its share of complexities, there can be many substantial rewards that make doing so worthwhile. For many investment advisory firms, private funds offer a unique path to growth – expanding the adviser's client base, diversifying service offerings, unlocking new revenue streams, and boosting operational efficiency. Ultimately, private funds present an attractive alternative for many investment advisory firms looking to grow while still delivering value to their clients!
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