Answer ... US private equity funds are formed to be exempt from registration under the Investment Company Act of 1940 and thus are not directly regulated by the US Securities Exchange Commission (SEC). The various states do not regulate them either.
Although private equity funds are not regulated entities, the offering by a private equity fund of its own interests and the acquisition by a private equity fund of securities in portfolio companies may implicate numerous US federal and state laws. The following laws are the most relevant to those activities.
Securities Act of 1933: This federal act regulates the offering and sale of securities in the United States, and is thus relevant to the offering by a private equity fund of its own interests and to the acquisition of by a private equity fund of portfolio company securities. Private equity funds must be offered pursuant to an exemption from registration under the Securities Act, most commonly relying on Section 506 of Regulation D for sales to ‘accredited investors’ and Regulation S for sales to non-US persons. Private portfolio companies rely on the same or other exemptions from the Securities Act when offering their own securities to investors.
Investment Company Act: This federal act regulates investment companies and other pooled investment vehicles (including mutual funds) that engage primarily in investing, reinvesting and trading in securities, and whose own securities are offered to the investing public. Private equity funds must be structured and offered pursuant to an exemption from the Investment Company Act, typically relying on Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act.
Section 3(c)(1) provides an exemption for any fund:
- whose outstanding securities (other than short-term paper) are beneficially owned by not more than 100 persons (or, in the case of a qualifying ‘venture capital fund’, 250 persons); and
- which offers its securities in a private placement that is exempt from registration under the Securities Act.
Section 3(c)(7) provides an exemption for any fund whose outstanding securities are owned exclusively by persons who, at the time of acquisition, are ‘qualified purchasers’, and which offers its securities in a private placement that is exempt from registration under the Securities Act. In the case of a natural person, the investor (alone or together with a spouse or spousal equivalent) must own not less than $5 million in investments to satisfy the definition of ‘qualified purchaser’.
Investment Advisers Act of 1940: This federal act regulates investment advisers – meaning any person or firm that, for compensation, engages in the business of providing advice to others or issuing reports or analyses regarding securities. The term ‘investment adviser’ includes private equity fund managers. An investment fund manager to a private equity fund must register with the SEC under the Investment Advisers Act, unless it can claim an exemption. Exemptions from the Investment Advisers Act upon which private equity fund managers rely include the following:
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Private fund adviser exemption (Section 203(m) and Rule 203(m)-1 of the Investment Advisers Act): This exempts:
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an investment adviser with its principal office and place of business in the US (‘US investment adviser’) which:
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- acts as an investment adviser only with respect to ‘qualifying private funds’; and
- manages total private fund assets of less than $150 million; and
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an investment adviser with its principal office and place of business outside of the United States (‘non-US investment adviser’) which:
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- has no clients that are US persons except for one or more qualifying private funds; and
- manages at a place of business in the United States only private fund assets valued less than $150 million.
- Notably, a non-US investment adviser relying on the exemption:
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- could manage an unlimited amount of capital in the United States through qualifying private funds, so long as it does not manage $150 million or more at a place of business in the United States; and
- could manage assets of clients other than qualifying private funds at a place of business outside of the United States, so long as its only US person clients are qualifying private funds.
Venture capital fund exemption (Section 203(l) and Rule 203(l)-1 of the Investment Advisers Act): This exempts an investment adviser that acts as an investment adviser solely to one or more venture capital funds. A non-US investment adviser may rely on the venture capital fund manager exemption; however, it cannot claim the exemption unless it solely advises venture capital funds as defined under the rule, so it is narrower than the private fund adviser exemption in that it does not exclude the non-US investment adviser’s activities outside the United States.
Foreign private adviser exemption (Section 203(b)(3) of the Investment Advisers Act): This exempts an investment adviser which:
- has no place of business in the United States;
- has, in total, fewer than 15 clients and investors in the United States in private funds advised by the investment adviser;
- has aggregate assets under management attributable to clients in the United States and investors in the United States in private funds advised by the investment adviser of less than $25 million; and
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does not:
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- hold itself out generally to the public in the United States as an investment adviser; or
- act as a US registered investment adviser or a ‘business development company’ under the Investment Company Act.
This exemption is useful for a non-US investment adviser which has minimal activities in the United States, but any non-US investment adviser with more substantial activities in the United States should seek to rely on a different exemption.
Even if a private equity fund manager is exempt under the Investment Advisers Act, its activities could subject it to registration as an investment adviser under the securities laws of one or more US states (often referred to as ‘blue sky laws’ for arcane historical reasons). Blue sky laws vary by state, so must be considered state by state based on the location of the manager’s activities. Some but not all states provide an exemption from registration for an investment adviser that advises a small number of clients and/or a minimal amount of capital in the state. Those states will typically treat a private fund as a single client for the purposes of any de minimis exemption.
Securities Exchange Act of 1934: This federal act regulates the securities industry and public companies, including with respect to the corporate reporting and disclosure obligations of public companies, and investor activity with respect to public securities – for example:
- reporting of holdings and activities in public companies;
- reporting and restrictions with respect to tender offers and proxy solicitations; and
- prohibitions of fraudulent activities in connection with the offer, purchase or sale of securities (eg, insider trading).
In the case of private equity funds, the Securities Exchange Act is mostly relevant to their investments in public company securities, including in portfolio companies that go public after the private equity fund’s initial investment.
Employee Retirement Income Security Act of 1974, as amended (ERISA): This is a federal tax and labour law that establishes minimum standards for pension plans in private industry. In the case of private funds, under a look-through rule set forth in the US Department of Labor’s ‘plan assets regulations’, absent an exemption, the assets of a fund would likely be treated for the purposes of ERISA as if they were assets of any investors that are employee benefit plans subject to ERISA or Section 4975 of the Internal Revenue Code. Furthermore, the manager of a private equity fund would be deemed a fiduciary with respect to those assets, which would make operating the private equity fund impractical for various reasons. Accordingly, US private equity funds seek to rely on an exemption, such as:
- by qualifying as a ‘venture capital operating company’; or
- by ensuring that benefit plan investors (as defined in Section 3(42) of ERISA) hold less than 25% of each class of the fund’s equity interests (excluding certain interests held by the fund’s manager and its affiliates).
Foreign Account Tax Compliance Act (FATCA): This is a federal law aimed at tax evasion by US persons using foreign entities to hide assets and income from the US Internal Revenue Service (IRS). FATCA generally requires foreign financial institutions (FFIs) and certain other non-financial foreign entities to report on the assets of their US account holders or be subject to a 30% withholding tax on US source investment income. To avoid the withholding tax, an FFI that invests in the United States must afford the IRS a significant level of transparency with regard to its US investors. Some non-US jurisdictions have entered into intergovernmental agreements (IGAs) with the United States to address local privacy issues implicated by sharing owner information. Although IGAs vary in scope and mechanics, they generally permit non-US FFIs organised in those jurisdictions to report information regarding the FFI’s investors to the local taxing agency, which will then share with the United States specified information on the US investors.
State ‘blue sky’ laws: As mentioned above, various states have their own securities laws, which may be implicated by a private placement of interests to investors in a state or by acting as an investment adviser in the state. Private equity fund managers will typically seek to avoid registration as investment advisers under state blue sky laws. A private equity fund that makes a private placement under Regulation D of its interests to investors in a state may be required to make Form D filings in that state accordance with Regulation D under the Securities Act, unless an exemption is available.
State corporate law: Legal entities can be formed in any US state and the laws of any state with a connection to a transaction could be relevant in any particular situation. However, most corporations in the United States are Delaware corporations, and most investment funds and management entities are formed as Delaware limited partnerships or Delaware limited liability companies (LLCs), so the most relevant state laws for the offering by a private equity fund of its own interests and the acquisition of securities of portfolio companies are:
- the Delaware General Corporation Law;
- the Delaware Revised Uniform Limited Partnership Act; and
- the Delaware Limited Liability Company Act.
This Q&A focuses on Delaware law because it is prevalent in US corporate transactions; but readers should understand that in any particular situation, the law of a different US state may apply and that law may differ from Delaware law.