Alternative Funds 2020

Last Updated October 13, 2020

USA

Law and Practice

Authors



Katten is a world leader in advising hedge, private equity and other alternative funds and asset managers, proprietary trading firms, and other market participants that deploy trading strategies to reshape markets and change investor expectations. Serving at the forefront of this industry since its inception, the firm guides clients through the full scope of issues vital to their business, including regulation and compliance, litigation and enforcement, tax, corporate and transactional, trading limits, technology and cybersecurity, and employment, among others. The team continues to be a comprehensive resource for some of the world’s largest and most successful investment management firms and institutional investors in alternative investments, helping them to address a myriad of complex issues against the backdrop of rapidly changing financial markets grappling with a worldwide pandemic.

Given the breadth and depth of its economy and financial markets, the liquidity of its securities, commodity futures, swaps and options exchanges, and its robust legal and regulatory framework, the United States is understandably a predominant jurisdiction for alternative funds and their managers and investors. At the end of 2019 the US GDP amounted to USD21.43 trillion; there were over 32,000 alternative funds with more than 3,100 managers with USD9 trillion in assets under management (which notably does not take into consideration the significant leverage utilised by many alternative funds). 

Alternative funds established in the United States, whether as standalone entities or as part of master-feeder or other fund complexes, range from liquid open-end funds to closed-end self-liquidating funds (with hybrid funds in between), and finally even to permanent capital funds.

Open-End Funds/Strategies

Strategies commonly pursued by open-end funds include quantitative and algorithmic trading, credit, global macro, long/short, commodities, trade finance, currencies, ESG, and cryptocurrencies and other digital assets.

Closed-End Funds/Strategies

Strategies pursued by closed-end funds are generally more illiquid in nature and include real estate (including development), direct lending, venture capital, infrastructure, insurance-linked securities, royalties, litigation finance, life settlements, impact investing, ESG, precious metals and mining, film financing, aircraft leasing and cannabis. 

The most common fund structures utilised in the United States include standalone funds, master-feeder and parallel structures, and so-called “mini-master” funds; the latter two structures involve related investment vehicles established in other jurisdictions for tax and regulatory reasons.

Entity Type

Typically US funds are structured as limited partnerships or limited liability companies (LLCs), which offer limited liability to their members or limited partners, as well as favourable flow-through tax treatment.

State Formation

Given that there is no federal corporate law in the United States, funds must be formed under the laws of one of its states; US funds are most commonly formed under the laws of the State of Delaware because of the flexibility of its statutes and its comprehensive body of jurisprudence in corporate, partnership and related areas affecting alternative funds.

Specialised Structures

Permutations of these core structures are often used to provide investors with access to certain strategies in a tax-efficient manner. For example, insurance dedicated funds (formed as limited partnerships or LLCs) are an example of a specialised type of fund that is utilised to support privately placed life insurance and annuities, which can provide tax deferral or elimination for taxable US investors. 

Registration Requirements

Alternative funds are typically structured to be exempt from the registration requirements under various federal and state laws. Several of the primary relevant federal laws are described below: 

Securities Act of 1933

The Securities Act regulates the offer and sale of “securities” by their issuers, including issuers that are alternative funds. Pursuant to the Securities Act, all securities offered in the US must either be:

  • registered with the US Securities and Exchange Commission (SEC); or
  • offered and sold in compliance with an applicable exemption from registration. 

Safe-Harbour Exemptions: Generally, securities issued by alternative funds are offered in the United States pursuant to a “safe harbour” exemption from registration under Rule 506 of “Regulation D” under the Securities Act. Rules 506(b) and 506(c) of Regulation D allow issuers to privately place an unlimited amount of securities, subject to certain restrictions and requirements. Rule 506(b) is the older and more commonly utilised of the two safe harbours and permits the issuer to sell its securities to an unlimited number of “accredited investors”, as defined in Regulation D, and up to 35 non-accredited investors, subject to certain enhanced disclosure requirements; provided that the securities are privately placed and are not offered by means of a “general solicitation” (such as television and print ads and unsolicited “cold calling”). (Accredited investor status, though primarily determined by financial metrics, has recently been expanded by the SEC to extend to “knowledgeable employees” of the fund’s investment manager and certain limited professional categories and pertains to natural persons and entities.) In contrast, securities sold pursuant to a Rule 506(c) offering must exclusively be sold to accredited investors and general solicitation is permitted. Rule 506(c) also imposes certain heightened obligations on the issuer to confirm the “accredited investor” status of investors, and remains relatively little utilised by alternative funds.

Investment Company Act of 1940

The Investment Company Act defines and regulates “investment companies”. While the definition of “investment company” is complex and includes a number of qualifications, broadly speaking, it encompasses entities that are engaged in the business of “investing, reinvesting, owning, holding or trading in securities”, or that hold themselves out as doing such. Though most alternative funds that focus primarily or exclusively on investing in securities come within this definition, such funds are commonly structured to fall into one of the two following exclusions under the Investment Company Act:

  • Section 3(c)(1) excludes funds that do not make or propose to make a public offering of their securities and have fewer than 100 beneficial owners (or 250 if the fund is a qualifying venture capital fund) of its outstanding securities (other than short-term paper). The beneficial owner limitation is subject to detailed counting and “look-through” rules. 
  • Section 3(c)(7) similarly excludes funds that do not make or propose to make a public offering of their securities; however, instead of a numerical limit on beneficial owners, to be eligible for the exclusion under Section 3(c)(7), the outstanding securities of the fund must be owned exclusively by investors who qualify as “qualified purchasers” under the Investment Company Act (and “knowledgeable employees” of the fund’s investment manager). The term “qualified purchaser” is defined in Section 2(a)(51)(A) of the Investment Company Act and most notably includes individuals with qualifying investment portfolios of at least USD5 million and entities with qualifying investment portfolios of at least USD25 million. 

Investment Advisers Act of 1940 (Advisers Act)

See 3.2 Regulatory Regime

Commodity Exchange Act (CEA)

The CEA is the primary federal statute regulating the commodity futures and derivatives markets and is therefore relevant to the large and important segment of the US alternative funds sector that engages in quantitative and algorithmic trading, as well as other funds that trade in those markets. The associated primary regulator is the Commodity Futures Trading Commission (CFTC). 

Securities Exchange Act of 1934 (Exchange Act)

There are several aspects of the Exchange Act that may be relevant to an alternative fund’s operations:

  • broker-dealer registration – a fund itself would not qualify as a broker-dealer, as it is an issuer that deals only in its own securities (ie, the fund interests) and neither effects transactions for the accounts of others, nor is engaged in the business of buying and selling securities for its account. Certain associated persons of a fund that market interests in the fund can rely on the non-exclusive “safe harbour” of SEC Rule 3a4-1 under the Exchange Act, which provides that broker-dealer registration is not required for such persons provided (amongst other things) that they are not subject to certain “bad actor” disqualifications, are not compensated on a transaction-specific or commission basis, and are not otherwise associated persons of a registered broker-dealer.
  • Section 13 Reporting – see 3.2 Regulatory Regime.
  • public company reporting – once a company has 2,000 or more investors of record, that company becomes subject to public company reporting requirements. Therefore, alternative funds will typically limit their investors to a maximum of 1,999.

ERISA

If 25% or more of the interests in a fund are owned by certain benefit plan investors, including IRAs, 401(k) plans and other plans covered by the Employee Retirement Income Security Act (ERISA), all assets of the fund will be deemed to be attributable to benefit plan investors and the fund will be subject to fiduciary responsibility provisions under ERISA and certain prohibited transaction provisions under both ERISA and the Internal Revenue Code.

State regulation

Alternative funds must ensure compliance with state securities laws (so-called “blue-sky laws”) and related regulations. In many cases, funds’ compliance with federal laws can pre-empt, or at least limit the scope of, applicable state laws.

No Investment Limitations

While there are no generally applicable limitations with respect to permissible fund investments, there are specific investor-based qualifications that alternative funds must meet in order to invest in certain products. In addition, alternative funds must meet certain criteria in order to purchase certain types of products and engage in certain types of transactions. For example, a fund must be a so-called “QIB” in order to purchase restricted securities transacted under SEC Rule 144A and must be an “eligible contract participant” under the CEA to engage in over-the-counter derivative transactions. 

No Limitations

Alternative funds are permitted to originate loans.

State Licensing

An analysis of all relevant factors must be undertaken to determine whether a state commercial lending licence is needed with respect to a transaction. This typically includes an analysis of:

  • the location of the borrower;
  • the location of the lender;
  • the location of the collateral;
  • the place from which the loan proceeds will be originated;
  • policy considerations; and
  • applicable state law.

If licensing is required, information concerning the fund, its affiliates, its owners, and its business plan is often necessary.

State Usury Laws

Certain states impose limitations on the permissible amount of interest that may be charged on a commercial loan. Relevant determining factors include the type of borrower and size of the loan.

Tax Considerations

As originating loans may be considered to be engaging in a US trade or business, US federal and state tax considerations with respect to originating loans are complex.

Alternative funds can invest for their own accounts in cryptocurrencies as well as other non-traditional assets, generally without implicating special rules. However, by way of example, if a fund is managed by a CFTC registrant, express disclosure requirements are imposed by the National Futures Association (NFA) that are different than if the virtual currencies are accessed in the spot market or as futures. Furthermore, it is worth noting that certain crypto-assets are deemed to be securities under US securities laws and that a fund’s activities need to be limited strictly to investment and trading to avoid falling within the ambit of, for example, state custody or money transmission laws.

Because alternative funds typically offer their securities in compliance with exemptions or exclusions from registration requirements under US securities and commodities laws, no prior approval or review is required for an alternative fund to issue securities, although alternative funds relying on Regulation D are required to make a regulatory filing with the SEC on Form D within 15 days of the first sale of fund interests and, in many cases, corresponding “notice filings” under state blue-sky laws where the fund has sold its securities.

There is no requirement under federal or state law that a US fund must have a US investment manager.

Generally, there are no US legal requirements that mandate local directors, general partners or business premises. However, nearly all US states require that a legal entity formed in a particular jurisdiction should have a registered office and/or a registered agent designated in that jurisdiction.

When an alternative fund is formed under the laws of a US state (eg, Delaware, New York), such fund is subject to applicable state laws and regulations governing its chosen legal form, including concerning formation, governance, rights of equity holders and mergers, consolidations, or dissolutions.

Broad Discretion to Appoint Service Providers

As a general matter, under relevant federal law, alternative funds and their managers have discretion to appoint service providers; however, where a fund has engaged a service provider, the fund and its manager ultimately remain liable for such fund’s regulatory compliance.

Custodians — SEC Custody Rule

Under the Advisers Act, where an alternative fund’s adviser is deemed to have “custody” of the fund’s assets, the adviser becomes subject to the Custody Rule which, among other things, requires the adviser to place the fund’s securities with custodians who meet the definition of “qualified custodian”. This includes US regulated banks and brokers, as well as foreign financial institutions that segregate customer assets from the institution’s proprietary assets. If the adviser chooses to comply with the Custody Rule by delivering audited annual financial statements of the fund to its investors, the auditor must be registered with and subject to examination by the Public Company Accounting Oversight Board.

There are no specific regulatory requirements for non-local service providers. 

No Entity-Level Income Tax on Flow-Through Funds

The United States generally does not impose any entity-level income tax (other than withholding tax on certain types of income or gain allocable to non-US investors) on unincorporated domestic funds such as limited partnerships and LLCs. Instead, the beneficial owners of such funds report and pay the applicable federal income taxes on their allocable share of the fund’s taxable income and gain as reported to them annually by the fund on an Internal Revenue Service Schedule K-1. However, in certain circumstances a fund could be treated as a “publicly traded partnership” and taxed as a corporation for federal income tax purposes unless the fund satisfies an annual 90% “qualifying income” test.

Corporate Income Tax

In the usual circumstance where a US fund is treated as a corporation, such fund is subject to US federal income tax and may be subject to state income tax.

Utilisation by Investors

US funds (that are taxed as partnerships for federal income tax purposes) generally do not themselves qualify for benefits under double-tax treaties with the United States. However, their flow-through status may allow non-US investors to claim tax treaty benefits (typically, a reduction in or complete exemption from 30% US withholding tax) under an income tax treaty between their jurisdiction of residence and the United States. In order to establish eligibility to claim tax treaty benefits, a non-US investor will typically be asked to provide an applicable IRS Form W-8.

Structuring Issues

Certain jurisdictions, such as Canada and the UK, may limit the availability of tax treaty benefits to a resident of those jurisdictions who or which invests in a fund organised as an LLC rather than as a limited partnership. For this reason, US funds that are targeting non-US investors will commonly be organised as limited partnerships rather than as LLCs.

The use of subsidiaries for investment purposes is relevant in the following contexts:

  • Depending on the investment strategy, special purpose vehicles and other subsidiary entities may be used if it is prudent to ring-fence assets in light of liability or bankruptcy concerns.
  • Subsidiaries, such as so-called master funds or trading subsidiaries, may serve as collective investment vehicles for different types of investors. Such subsidiaries may be formed as, or elect to be treated as, flow-through entities for US federal income tax purposes in order to avoid a separate layer of taxation.
  • Non-US subsidiaries may be formed by a US fund in order to hold investments or conduct activities outside the United States. 

US promoters and sponsors predominate relative to US alternative funds, though managers and sponsors from around the world establish US funds for various purposes.

Typically, investors in US alternative funds are US taxable and tax-exempt investors, though investors in US funds increasingly include those from other jurisdictions.

No geographic limitations are imposed on US alternative funds in terms of the location of their portfolio investments. However, tax considerations may impact the situs of investments, depending on the type of instrument involved. 

Key trends impacting alternative funds in the United States include the following:

Investment Strategies

Certain investment strategies have become more prevalent, including quantitative/low latency, distressed debt and credit opportunities, litigation finance, life settlements, insurance-linked securities, royalties, venture, ESG and impact investing, and strategies involving cryptocurrencies.

Manager Trends

Proprietary trading firms that previously managed only internal capital are increasingly creating funds with the goal of providing affiliated and unaffiliated investors the opportunity to gain exposure to specific strategies. These efforts have involved the creation of new advisory entities and, in some cases, joint ventures with more established fund managers. Also, institutional multimanager allocators have continued to show significant interest in gaining exposure to funds that deploy low latency and quantitative trading strategies. Managers of these funds have received significant capital inflows, both pre- and post-launch.

Hybrid Liquid/Illiquid Strategies

Certain managers have begun launching funds that pursue a blended liquid/illiquid strategy. These funds typically involve bifurcated investment terms with respect to investors’ exposure to the liquid and illiquid portions of the applicable fund’s portfolio.

Economic Trends

Economic trends relating to manager compensation have shifted to structures and terms that seek to achieve greater alignment with investors’ interests, including multi-year performance periods, increased use of benchmarks and hurdles, rolling performance periods, and management fee offsets (including, eg, 1%/30% and zero management fee structures).

With the SEC

If a manager is registered as an investment adviser with the SEC, the manager must file certain periodic reports with the SEC with respect to the funds it manages or advises. 

  • All registered advisers must file Form ADV, which contains private fund-specific disclosures, including, but not limited to, fund type (eg, hedge, private equity), assets under management, aggregate investor totals and composition by investor type, and data on service providers used by the fund. 
  • Certain registered advisers must complete Form PF filings, which contain more detailed information on the funds they manage or advise than is disclosed in Form ADV. Form PF is required to be filed on an annual or a quarterly basis, with more frequent filings required for larger private fund advisers.

With the CFTC/NFA

Some funds and managers are also required to prepare and distribute certain reports pursuant to the CEA and the rules promulgated by the CFTC and the NFA.

  • Generally, managers that are registered as commodity pool operators (CPOs) must file commodity pool-specific annual reports with the NFA and must also distribute these reports to pool participants (ie, fund investors). These reports contain information on the pool, including financial details and aggregate information on fund investors. CPOs must also prepare and distribute certain pool-specific periodic investor reports (which are not required by the NFA).
  • CPOs also typically need to file pool quarterly reports, on Form CPO-PQR, with the NFA or the CFTC, reporting certain fund-specific details.
  • Commodity trading advisors (CTAs) that direct commodity pool assets, typically need to file quarterly and annual reports, on Form CTA-PR, which includes general information with respect to such pool assets.
  • Some commodity pools are subject to significantly less extensive disclosure requirements than those outlined above, including:
    1. pools that qualify for relief under CFTC Rule 4.7; and
    2. funds that engage in trading of commodity interests only “incidentally” to their securities trading activities and that commit less than 10% of their assets to commodity interest margin and option premium, qualify for relief under CFTC Rule 4.12(b).

Other

See 2.6 Regulatory Approval Process with respect to securities-level filings and 3.2 Regulatory Regime with respect to manager-level filings.

The SEC and the CFTC regularly propose amendments to their regulations implementing the statutes described in 2.3 Regulatory Regime. As of August 2020, there are relatively significant proposed changes pending with respect to the Advisers Act’s advertising and cash solicitation rules, discussed in 4 Investors.

Management companies are often formed as LLCs that are wholly owned by holding companies structured as limited partnerships to address the specific tax and economic considerations impacting the principals of those entities.

Entities receiving performance allocation or carried interest, which are often owned outside of the holding company mentioned above for tax reasons, are typically structured as LLCs.

Certain managers (such as those who utilise quantitative strategies or proprietary intellectual property) may also form separate subsidiaries or affiliated entities to hold intellectual property, employ employees, or engage in estate or financial planning. 

Investment Advisers Act

Registration requirement

The Advisers Act establishes registration and other obligations for “investment advisers”, generally defined as “any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities”. In general, the investment manager of, or investment adviser to, an alternative fund will be presumed to be acting as an investment adviser and will be required to register as such unless an exemption from registration is available. Depending on the amount of “regulatory assets under management” that the adviser is managing and where the adviser has its principal office and place of business (ie, whether inside or outside the United States, and if within the United States, in which state), the adviser may be required to register at either the state level with one or more state securities regulators, or federally with the SEC. 

Exempt reporting adviser status

In lieu of registration with the SEC (but not necessarily with the states), a manager may be able to claim an exemption as an “exempt reporting adviser” in the following circumstances: 

  • if the manager acts as an adviser solely to “private funds” (meaning funds that are excluded under Section 3(c)(1) or 3(c)(7) of the Investment Company Act) and has “regulatory assets under management” of less than USD150 million; or
  • if the manager acts as an investment adviser solely to one or more “venture capital funds”, as defined under SEC rules.

Importantly, exempt reporting adviser status is not self-effectuating and must be affirmatively claimed by filing and periodically updating an abbreviated version of the Form ADV. Non-US advisers may also claim these exemptions under somewhat modified conditions. Exempt reporting advisers are only subject to certain limited regulatory requirements (eg, policies designed against misuse of material non-public information, the Advisers Act’s “pay to play” rule, general anti-fraud requirements, and general record-keeping obligations).

A manager based abroad may qualify as a “foreign private fund adviser”, which is not subject to SEC regulation and does not need to file any reports with the SEC, if it:

  • has no place of business in the United States;
  • has fewer than 15 clients in the United States and US investors in private funds it advises;
  • has aggregate assets under management, attributable to such US clients and investors, of less than USD25 million; and
  • neither holds itself out to the public in the United States as an investment adviser, nor acts as an investment adviser to any registered investment company or business development company. 

If a manager has the requisite amount of assets under management (USD25 million or USD100 million depending on the state in which it is located) or is a foreign adviser and does not qualify for any of the exemptive statuses described above, it will need to be registered with the SEC as an investment adviser. Among other things, a registered investment adviser must:

  • File Form ADV with the SEC and amend such filing on an annual basis, within 90 calendar days of fiscal year end, and on an other-than-annual-basis, upon certain developments. Form ADV consists of three parts: Part 1 consists of entering data into a standard information-collection form; Part 2 requires preparation of certain plain-language brochures describing the adviser’s business and certain advisory personnel; and Part 3 (which is not required to be filed by advisers who solely advise alternative funds or who otherwise have no natural persons as clients) requires preparation of a client relationship summary (also known as “Form CRS”). Form ADV disclosures include required information regarding certain disciplinary actions to which a firm or its personnel may be subject.
  • Act as a fiduciary with respect to all its clients. Advisers owe duties of loyalty and good faith to clients, and must act in accordance with those duties, including by providing full and fair disclosure of all material facts to current and prospective investors. Certain disclosures are required to be provided to clients and investors on a periodic basis.
  • Adopt and maintain written policies and procedures that are reasonably designed to prevent violations of the Advisers Act and related regulations and have a code of ethics governing employee behaviour (including personal trading reporting and restrictions and enforcement of certain insider trading procedures).
  • Maintain certain books and records for specified time periods. These records are subject to inspection by the SEC, including as part of periodic routine inspections of registered firms by the SEC.
  • Comply with certain restrictions and guidelines with respect to advertising and marketing of services and funds, as well as with respect to arrangements with third-party solicitors.
  • Only charge performance-based fees to investors that are “qualified clients”, as defined in Rule 205-3 under the Advisers Act.

If a US manager does not have the requisite amount of assets under management, the manager will need to register with, or seek exemptions from, the state(s) in which it operates. State regulatory regimes often have many analogous features to those of the federal regime described above.

Commodity Exchange Act

Registration requirements

Firms managing or advising alternative funds that invest in exchange-traded futures contracts, swaps and/or other “commodity interests” regulated under the CEA (referred to as “commodity pools”) are generally required to register as CPOs and/or CTAs under the CEA (unless an exemption is available) and become members of the NFA. A CPO is defined as “any person engaged in a business which is of the nature of a commodity pool, investment trust, syndicate, or similar form of enterprise, and who, in connection therewith, solicits, accepts, or receives from others, funds, securities, or property, either directly or through capital contributions, the sale of stock or other forms of securities, or otherwise, for the purpose of trading in commodity interests”, and a CTA is defined as “any person who, for compensation or profit, engages in the business of advising others, either directly or through publications, writings or electronic media, as to the value of or the advisability of trading” in commodity interests, with some exceptions. If an alternative fund is a commodity pool, it will have at least one CPO (whether registered or exempt), but a commodity pool may have multiple CPOs and/or one or more CTAs providing it with commodity interest trading advice, depending on the fund’s structure. Where the degree of commodity interest trading by an alternative fund is sufficiently limited, its managers and advisers may be able to claim exemption from registering as CPOs and/or CTAs.

Registered CPOs and CTAs

Registered CPOs and CTAs are subject to CFTC rules and requirements mandating:

  • specified disclosures to pool investors and clients, including, but not limited to:
    1. specified regulatory legends;
    2. information about the CPO or CTA, its trading strategy, principals and service providers;
    3. principal risk factors and conflicts of interest;
    4. associated fees and expenses;
    5. disclosure of certain litigation matters and detailed prior performance information;
  • periodic reporting both to pool investors and to the CFTC and NFA; and
  • specific record-keeping practices.

In addition, as NFA members, most registered CPOs and CTAs are also subject to compliance with NFA rules, which set out a number of compliance obligations related to supervision, approval and use of promotional material, collection of customer information and provision of customer risk disclosures, calculation and presentation of performance information and the creation and maintenance of a written business continuity and disaster recovery plan, and written information systems security programme and internal controls systems, among others. 

Rule 4.7 exemptive relief

A registered CPO may claim exemptive relief under CFTC Rule 4.7 in respect of one or more commodity pools, which exempts the CPO from certain of the more prescriptive disclosure, record-keeping and reporting requirements under CFTC rules (as well as certain marketing limitations under NFA rules), if the applicable pool is only offered and sold to investors who are “qualified eligible persons”, as defined in Rule 4.7. 

Securities Exchange Act

Broker-dealer registration

In general, entities that engage in the business of effecting securities transactions for US persons are required to be registered with the SEC as broker-dealers under the Exchange Act. However, the SEC has indicated that an investment adviser, such as the manager of an alternative fund, need not register as a broker-dealer as long as the adviser does not receive transaction-based compensation, does not hold client funds or securities, and executes client transactions through a registered broker-dealer. 

Section 13 public reporting

Managers may be subject to Section 13 public reporting requirements if they:

  • beneficially own more than 5% of a class of voting equities in certain public companies (Schedule 13D or 13G);
  • manage discretionary accounts that hold, on aggregate, USD100 million or more in any of a specified list of US exchange-traded securities (Form 13F); and
  • manage discretionary accounts that trade, in the aggregate, an amount of covered securities exceeding specified volume or value thresholds (Form 13H).

US Manager

Fund managers to US alternative funds are generally formed as limited partnerships or LLCs and are “flow-through entities” from a US tax perspective. As such, these entities are not subject to tax at the entity level and, subject to the special carried interest rules discussed under 3.5 Taxation of Carried Interest, the character (as ordinary income, short-term capital gain or long-term capital gain) of amounts allocated to the manager as its carried interest is the same as it was when recognised by the relevant fund. In addition, US self-employment tax considerations may make the use of a limited partnership as the structure of the entity receiving management fees more attractive than using an LLC. If the US manager is formed as a limited partnership, a separate entity is generally formed to act as the general partner of such limited partnership. US fund managers often utilise two entities: one to receive the management fee, and the other to receive the carry. This has several benefits for US managers, including providing flexibility as to who participates in the economics of each entity.

Non-US Manager

Whether a non-US manager will be subject to US federal income tax will depend on whether (based on the applicable facts and circumstances) the manager is doing business in the United States. If the manager is performing its investment management services from an office located outside the United States, then the manager should not be subject to US federal income tax (assuming it has no other business activity in the United States). Hiring US employees will generally cause a non-US manager to be considered as doing business in the United States, as will leasing office space in the United States. State and local tax consequences (which may vary depending on the tax laws of the applicable state) also need to be considered. A non-US fund manager which expects to have a physical presence in the United States may be advised to form a US subsidiary taxable as a corporation to conduct the US-based activity so that the parent company does not have any direct nexus with the United States. 

The activities of a fund general partner or investment manager are normally attributed to the fund, for US federal income tax purposes, unless the investment manager qualifies as an “independent” agent. Qualifying as an independent agent may be difficult for investment managers that have not sponsored multiple funds (and do not perform investment management services for other clients).

Safe Harbours

However, if the activities of the fund consist of investing in or trading securities, commodities (as defined) or notional principal contracts for the fund’s own account (and do not involve loan origination or investing in flow-through entities conducting a business, such as master limited partnerships), then the presence of a US general partner or investment manager generally should not cause a non-US fund or investor to be subject to US federal income tax on the income and gain generated by the activity. Safe harbours are provided for such activities, under which they do not give rise to income or gain that is treated as effectively connected with a US trade or business as long as the fund is not a “dealer” (whether inside or outside the United States) in such instruments. Hedge funds and commodity funds typically structure their investments and activities with a view to qualifying under one or more of these safe harbours.

Activities That Fall Outside Safe Harbours

A fund which is acting as a “specialist” or “market maker” in securities will need to analyse whether such activities would cause it to be treated as a “dealer” for US federal income tax purposes, such that it will be unable to rely on the foregoing safe harbours with respect to its securities trading. Acting as a dealer will cause the fund to generate effectively connected income for its non-US investors, if its dealer activity is being conducted in the United States, and unrelated business taxable income for its US tax-exempt investors.

Certain US activities, such as loan origination, acting as a dealer in securities or commodities, and investing in real estate and certain so-called “US real property holding corporations”, fall outside the foregoing safe harbours and can be expected to generate US trade or business income (including so-called “FIRPTA gain” in the case of US real property investments) for non-US investors. As such, these types of investments are likely to raise US tax issues for non-US investors and may require complex structuring in order to mitigate the adverse US federal income tax consequences for such investors. 

Carried interests (commonly described as incentive allocations with respect to hedge funds) are not taxable upon receipt, and carried interest allocations are not taxed as compensation even though the carried interest is issued for services. Instead, the character (as ordinary income, short-term capital gain or long-term capital gain) of amounts allocated with respect to carried interest is the same as it was when recognised by the partnership, except that long-term capital gain recognised by a partnership on the sale of an asset held for not more than three years is treated as short-term capital gain (which is not eligible for federal income taxation at reduced rates) when allocated to a non-corporate holder of carried interest. Also, capital gain recognised by a carried-interest holder on the sale of its carried interest is treated as short-term capital gain, rather than long-term capital gain, if the carried interest was not held for more than three years prior to being sold.

Managers are permitted to outsource a substantial portion of their investment functions or business operations. Firms that provide those services must be appropriately registered, or exempt from registration, with the relevant US authorities.

Managers remain responsible for ensuring effective compliance with their regulatory obligations, even with respect to outsourced services.

See 2.8 Other Local Requirements. Registered investment advisers, CPOs and CTAs managing alternative funds are not subject to any regulatory capital requirements or other local substance requirements under applicable federal law and related SEC, CFTC and/or NFA rules (as applicable).

See 3.2 Regulatory Regime

US taxable investors are keen to invest in US alternative funds, though investors in US funds increasingly include those from other jurisdictions. These investors include:

  • high net worth individuals;
  • family offices;
  • funds of funds;
  • corporations, partnerships, trusts, insurance companies, and other entity investors;
  • foundations, endowments and charitable institutions;
  • benefit plan and retirement plan investors; and also, from outside the US,
  • sovereigns and sovereign wealth funds.

See 2.3 Regulatory Regime and 3.2 Regulatory Regime for descriptions of the applicable investor qualification standards under the Securities Act, Investment Company Act, Advisers Act and CEA.

Marketing in General

No general advertising or solicitation

As highlighted in 2.3 Regulatory Regime and 2.6 Regulatory Approval Process, alternative funds typically offer their interests to US investors in Rule 506(b) offerings and thus may not engage in general solicitation or general advertising in connection with the offering. Regulation D defines general advertising or solicitation to include:

  • any advertisement, article, notice or other communication published in any newspaper, magazine or similar media, or broadcast over television or radio; and
  • any seminar or meeting whose attendees have been invited by any general solicitation or advertising.

As noted in 2.3 Regulatory Regime, Rule 506 of Regulation D also contains a safe harbour provision, Rule 506(c), which allows for general advertising and general solicitation but which has not been widely used by alternative funds.

No “bad actors”

Note that in order to rely on either of the Rule 506 safe harbour provisions discussed above, an offering cannot involve the participation of certain “bad actors” in the roles specified under the Rule. In particular, persons covered under Rule 506 (including the fund, its manager, its directors and executive officers, beneficial owners of 20% or more of the fund’s voting interests, and other promoters, placement agents or solicitors acting on behalf of the fund) cannot be subject to any of an enumerated list of disqualifying events, such as criminal convictions, court injunctions and restraining orders, and certain regulatory or disciplinary orders.

Placement Agents and Solicitation Arrangements

Broker-dealer registration generally required

Many alternative funds will utilise third-party placement agents or “finders” to solicit potential investors. These parties are usually required to be appropriately registered or qualified as broker-dealers at federal and/or state level. Fund managers should be wary of engaging unregistered parties to provide “finding” services, as these services may involve solicitation and marketing activities that require such persons to be registered broker-dealers, and sales of fund interests by persons who are (improperly) unregistered may be subject to rescission rights under the Exchange Act.

Cash solicitation rule

Note that fund managers that are SEC-registered investment advisers are also subject to the cash solicitation rule under the Advisers Act, Rule 206(4)-3, which imposes certain disclosure and documentation requirements on advisers that hire third-party solicitors to introduce clients to the firm. Historically, this rule has not been applied to the solicitation of investors in private funds; however, the SEC has proposed changes to the cash solicitation rule that would apply the rule’s requirements to such solicitation arrangements.

Marketing to US State and Local Government Entity Investors

If a fund manager or its personnel market to, or solicit investments from, certain US state or local government entities (including employee pension funds), the manager and/or its personnel may be subject to registration and regulation as a “lobbyist” in that jurisdiction. If a manager intends to market to such government entities, it must familiarise itself with the relevant lobbying regulations and filing requirements in the applicable jurisdictions and comply with, or ensure exemption from, those provisions.

In addition, some government entities have adopted restrictive policies with respect to fund managers’ use of, and compensation paid to, placement agents or third-party solicitors.

CPO Associated Person Registration

Where personnel of a registered CPO solicit commodity pool investors, those personnel – as well as any persons in the supervisory chain overseeing them – must generally be individually registered with the CFTC and NFA as “associated persons” of the CPO, subject to certain exceptions. In most cases, associated persons must pass the Series 3 examination administered by the Financial Industry Regulatory Authority and, if the CPO is engaged in swaps business, meet the swaps proficiency requirements administered by the NFA.

Qualified local investors can invest in alternative funds established in the United States.

See 2.6 Regulatory Approval Process with respect to required securities-level filings for funds offered in the United States, and see 4.3 Rules Concerning Marketing of Alternative Funds with respect to potential registration requirements for marketing in the United States.

Disclosure of Investors' Information

To other investors

The identity of investors is not required to be disclosed under US law. In addition, under certain state statutes, the governing documents of alternative funds may be drafted so as to preclude disclosure of the identity of investors to other investors. Lastly, investors that are governmental plans are often required to disclose the names of the funds that they are invested in, and certain other information relevant to the fund.

US taxing authoring

A US fund taxable as a partnership files annual federal and state income tax returns that include identifying information as to the partners in the fund. A non-US fund earning US effectively-connected income (see 3.4 Rules Concerning "Permanent Establishments") must file a US federal (and, if applicable, state) income tax return reporting such income and identifying the non-US partners to whom it was allocated. In addition, a fund may be required to disclose identifying information as part of the fund’s compliance with FATCA.

Anti-money laundering (AML)

During regulatory examinations, the SEC staff routinely request information from investment advisers to alternative funds regarding AML compliance policies and procedures. Information requested frequently includes the identity of private fund investors.

Securities and commodities laws – beneficial ownership

Under certain circumstances, including if an investor is deemed to be a beneficial owner of a security or commodity that it indirectly owns through an interest in an alternative fund, the SEC and the CFTC require investors to aggregate their direct and indirect holdings of securities and commodities for reporting purposes. As a result, investors in alternative funds may have to make disclosures directly to the SEC or CFTC if certain thresholds are exceeded.

Privacy protection

The Gramm-Leach-Bliley Act (GLBA) permits disclosure of an investor’s identity in certain enumerated circumstances, generally to persons related to the fund and its operations, regulators, and/or to prevent fraud, provided that disclosure to that effect is provided to investors in advance. GLBA mandates that fund investors be given the ability to opt out of any disclosure of their personal information in any other circumstances. California and New York have similar statutes governing the obligations on fund managers related to the use of investors’ personal information.

Different federal income tax rules and tax rates apply depending on the tax status of the investor. 

US Tax-Exempt Investors

US tax-exempt investors, such as charitable organisations, pension funds, private foundations and individual retirement accounts, among others, are generally exempt from federal income taxation except to the extent that they earn unrelated business taxable income, as defined (UBTI), which most commonly arises when an alternative fund (ie, a flow-through entity for US federal income tax purposes) obtains third-party financing to fund its investments. Acting as a dealer or investing in flow-through entities conducting a business can be expected to generate UBTI for a domestic fund’s US tax-exempt investors.

US Non-corporate Investors

A typical US non-corporate investor is subject to regular federal income tax at a rate of 37% plus an additional 3.8% tax applicable to the investor’s net investment income. Reduced federal income tax rates apply to such an investor’s long-term capital gain, qualified dividends and certain qualifying business income. Various limitations apply to such an investor’s ability to deduct certain losses and expenses, including capital losses, state and local income taxes, investment interest expense and other investment expenses. 

US Corporate Investors

A typical US corporate investor is subject to regular federal income tax at a rate of 21%. While such an investor does not obtain beneficial treatment of long-term capital gain, it is not subject to many of the limitations on the deduction of losses and expenses by non-corporate taxpayers. Certain small business corporations, known as subchapter S corporations, are generally not subject to corporate income tax and, because their taxable income generally passes through and is taxable to their shareholders, they are generally subject to the rules applicable to non-corporate investors.

Non-US Investors

Withholding tax

US withholding taxes of 30% (subject to reduction under an applicable income tax treaty) generally apply to certain types of non-business income (typically, US source dividends and certain dividend equivalent income, and limited types of US source interest income – commonly referred to as FDAP) allocable by a US fund to non-US investors. US withholding tax applies to the gross amount of FDAP, without reduction for expenses. Foreign governments and sovereign wealth funds are not subject to US withholding tax on certain types of US source income, including dividends and interest. Capital gain is not generally subject to US income or withholding tax unless it is attributable to investments in US real estate or US real property interests, as defined. 

Income tax

Non-US investors are subject to regular US federal income tax on income and gains that are effectively connected with a US trade or business (ECI), and are subject to US withholding tax on their FDAP. For example, loan origination by a fund (other than a business development corporation) may be treated as generating ECI. Domestic funds with non-US investors are required to make quarterly tax payments to the IRS on account of ECI allocable to non-US investors, and must withhold US tax from redemption payments to the extent attributable to ECI-generating investments. Loan origination and other activities that generate ECI may be tabled by the state in which the fund is making loans or operating, depending on applicable state law.

Preferential Tax Treatment of Certain Entities

US tax laws include provisions allowing preferential tax treatment of certain specialised corporate investment vehicles, such as regulated investment companies and real estate investment trusts. In order to obtain the applicable preferential tax treatment, these entities must satisfy and comply, on an ongoing basis, with various requirements relating to their organisation, share ownership, assets and operations. These requirements make them much less flexible and significantly more expensive to administer than customary investment vehicles such as “regular” partnerships and LLCs, but they are useful alternative fund vehicles for “retail” investors. 

FATCA

Under FATCA, US funds are generally required to collect a 30% US withholding tax on their payments of US source dividends and interest to a non-US “foreign financial institution” or “non-financial foreign entity” (each as defined) unless such non-US person makes certain certifications or provides certain information relating to its US owners or qualifies for an exemption from FATCA. Typically, a US fund will obtain the appropriate IRS Form W-8 from such investors that will include the requisite FATCA certifications. Different rules may apply to foreign financial institutions located in jurisdictions that have an intergovernmental agreement with the United States governing FATCA.

CRS

US funds are not subject to the CRS. 

Katten

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Trends and Developments


Authors



Schulte Roth & Zabel was founded in 1969 and has been at the forefront of the alternative investment management space from offices in London, New York and Washington, DC. SRZ lawyers provide advice on both UK and US law to a wide variety of funds, managers and investors worldwide. The firm’s market-leading investment management group provides counsel on structuring hedge funds, private equity funds, debt funds, real estate funds, hybrid funds, structured products, UCITS and other regulated funds, as well as providing regulatory and tax advice. SRZ handles all aspects of fund formation and operations on a full-service basis, adopting a cross-disciplinary approach to client service by employing the expertise of multiple practice groups. Notably, SRZ is one of only a few law firms with a dedicated regulatory and compliance practice within its private funds practice. The authors thank David Cohen for his input regarding recent DOL pronouncements, John Mahon for his input regarding recent SPAC market activity and Carol T Ivanick for her helpful input.

The following provides an overview of recent developments regarding alternative investment funds and their investment programmes.

COVID-19

The past months have been dominated by the spread of COVID-19 and the various reactions to it. Indeed, the COVID-19 pandemic has brought both challenges and opportunities to the alternative funds space. While the initial illiquidity in the credit markets, as the pandemic began to spread, has eased and alternative fund sponsors (GPs) and their investors (LPs) have generally been able to function with relative normality through this period of repeated lockdowns, one major change has continued throughout – reduced travel. This has made it particularly difficult for new fund managers to take off, as it has not been possible to hold in-person diligence meetings with LPs. Large asset managers with established LP bases have not been as disadvantaged. Ares Management Corporation successfully raised USD15.7 billion in new capital through the first half of this year and is on track to have one of its best fundraising years ever according to its CEO, at 25% more than over the same period last year. CVC Capital Partners raised EUR22 billion in the six months ending in July 2020 and Brookfield Asset Management referred to the three months ending in June as the “best fundraising period ever” in their letter to shareholders, having raised USD23 billion across strategies. However, overall fundraising in the first half of 2020 is down compared to 2019 and large managers have, in some cases, faced difficulty. For example, while New Mountain Capital has been able to successfully raise a fund six for its flagship product, reports indicate that it has resorted to offering discounted fees to its existing LP base in seeking to reach its hard cap of USD9 billion, presumably because it was more difficult to raise capital from less familiar LPs.

Large asset managers gain market share

We expect that the trend over the last decade of large asset managers gaining market share will continue despite the continued support for emerging managers from some of the largest state pension plans and some allocators. However, while it seems the large alternative asset managers may see market share grow as a result of their ability to rely on existing LP relationships, competing forces may affect the size of the industry as a whole. On the one hand, the California Public Employees’ Retirement System (CalPERS) has indicated a desire to increase allocations to private equity and private debt, including by potentially leveraging its existing portfolio to make increased allocations to these asset classes (though the CIO of CalPERS who made this pronouncement has since resigned). Also, in 2014, CalPERS indicated a lack of need for external hedge fund managers, expressing confidence that its performance would not suffer and it would reap significant savings by migrating management of its public securities portfolio in-house; and in 2019, New Jersey’s pension plan followed by cutting its allocation to hedge funds in half. On the other hand, a survey indicates that family offices have shown a loss of faith in private equity’s ability to deliver outsized returns, as reflected in 51% of family offices, down from 73%, expecting private equity returns to exceed those from public investments. Thus, the debate continues as to whether private equity, after fees and expenses, outperforms the public markets. However, a recent Preqin survey indicates that 29% of investors aim to allocate more capital to the alternatives space in the long term, and we therefore conclude that investors have certainly not abandoned alternatives as an asset class.

Increased revision of mandates

Another development coming out of COVID-19, and related to the increased difficulty associated with raising new funds, is an increase in GPs seeking to revise their mandates, as noted in response to Private Equity International’s recent surveys. The same survey responses indicate that GPs have sought to extend their ability to put capital to work through amendments that seek to revise recycling provisions, expand authority to consummate follow-on investments, extend investment periods and, to a lesser extent, allow for increased use of fund-level credit. GPs have also similarly sought extensions of fund terms. COVID-19’s effects cannot be ignored and will have an effect on fundraising and the ability of new funds to launch and, as a corollary, will favour the existing large managers and funds that have dry powder or have increased access to existing capital by virtue of such amendments. 

Liquidity crisis

While the above trends may be more relevant to closed-end funds than open-end funds, the latter have also faced challenges from the pandemic. In March 2020, as COVID-19’s breadth and ease of infection was starting to be understood, public equity markets saw significant increases in volatility. Furthermore, while public equities experienced price volatility, formerly liquid credit markets, such as the repo market, began to dry up. At the time, many hedge funds, in particular in the credit space, had been highly reliant on repurchase arrangements to finance their operations and provide structural leverage for their funds. As liquidity left the repo markets, short-term interest rates rose and hedge funds began to receive redemption requests. In a well-publicised reaction, EJF Capital LLC suspended redemptions in its over USD2 billion Debt Opportunities Fund due to “unprecedented volatility and dysfunction in the credit markets” (Wall Street Journal, “Credit Hedge Fund Suspends Redemptions in Sign of Market Stress”). At the time, investors seemed to expect further limitations on their ability to obtain liquidity from other structured credit funds. The expectations in March may have been for an expansion of a liquidity crisis into a solvency crisis and a death-spiral for leveraged funds. Although liquidity appears to have returned to the markets in the last few months, due to unprecedented involvement by the Federal Reserve, the volatility in March did reveal that certain fund managers were relying too much on short-term credit to fund and support long-term investing and other operations.

ILPA

The Institutional Limited Partners Association (ILPA) has been active on many fronts this year, particularly relating to themes that have been heightened due to the COVID-19-induced financial crisis.

Subscription lines of credit

In 2017, ILPA issued its first criticism of the expanded reliance by fund managers on subscription lines of credit, referring to these lines as “short-term financing” whose use evolved into a “broader tool used to manage the overall cash of the fund” (ILPA, “Subscription Lines of Credit and Alignment of Interests: Considerations and Best Practices For Limited and General Partners”). ILPA further noted the liquidity risk to LPs – as more and more managers relied on these lines to provide structural leverage and the size of eventual capital calls kept growing, the more likely it became that a single, wide-ranging market event could trigger “the simultaneous calling of capital across multiple lines at once”. While managers, through sufficient disclosure, could prepare their LPs for the possibility of a large capital call to satisfy borrowings on subscription facilities that had been, or remained, outstanding for longer than the previously customary 90 days, ILPA felt such disclosures were inconsistent across GPs. ILPA also highlighted the potential conflict of interest between managers and investors, noting that increased use of a subscription facility generates a higher internal rate of return (as capital is invested in the fund by investors for shorter periods of time), though ultimately a lower investment multiple (because the interest and other expenses of the subscription facilities are borne by the investors).

Ultimately, while ILPA’s recommendations in 2017 centred almost entirely on increased disclosures (whether to LP advisory committees in due diligence meetings or quarterly reports), ILPA did have some substantive, economic recommendations. The first, requiring the waterfall provisions in partnership agreements to calculate the preferred return from the date of capital draws off of a facility (as opposed to when ultimately called from LPs), would largely eliminate the conflict and would, were it broadly adopted, likely revert subscription facility usage to merely smoothing out capital calls as infrequently as once per quarter (which, it seems, is ILPA’s stated appropriate use of a subscription facility). In addition, ILPA suggested caps of such borrowings at 15–25% of uncalled capital and requiring such borrowings to be repaid within 180 days. By and large, however, LPs have not pursued these recommendations. We believe that, because LPs experience a benefit from fund managers' taking advantage of the low interest rates applicable to these borrowings and from being able to manage reduced capital calls by investing elsewhere, we have not seen LPs negotiate for changes to the accrual of the preferred return, but have seen increased disclosure and communication regarding the use of subscription facilities. It is worth noting that while some smaller LPs may feel the need to reserve liquid capital in an aggregate amount equal to uncalled capital commitments in order to satisfy capital calls, larger LPs are able to, and do in fact, reserve less than all uncalled capital commitments, thereby benefiting alongside the GPs from the higher internal rates of return that these facilities make possible. In June 2020, ILPA elaborated on its recommendations, noting that the hard and fast amount and time limits were “most relevant to private equity” and reiterated the need for consistent and robust disclosure. Combining the ILPA recommendations with the lessons learned in the early days of the COVID-19 pandemic, we believe fund managers should be keenly aware of the leverage they have incurred and the risks they accept, and force their LPs to accept, when they make use of short-term financing options (whether subscription facilities or repos) to generate and support long-term investment performance.

ILPA templates

In addition to the aforementioned guidance on subscription lines of credit, ILPA revised its model LPA in July 2020, and also published a “deal-by-deal” version to complement its “whole of fund” distribution waterfall version. As part of these revisions, ILPA has expanded its reliance on its previously published reporting templates, requiring in its model LPA that capital call and distribution notices be consistent with the ILPA Capital Call and Distribution Notice Template. While broad-based adoption of the ILPA model LPA has yet to occur, more and more GPs are getting comfortable with at least complementing their existing notices with disclosures consistent with the ILPA templates.

Secondary fund restructurings

Furthermore, ILPA's previously published guidance with regards to GP-led secondary fund restructurings has also continued to gain support from both LPs and GPs, as the scope of secondary transactions has significantly expanded over the years. As ILPA notes, these transactions originated in the context of “zombie funds” or in the “end-of-life” or “key person event” context, but have continued to grow in significantly different contexts. Now, more than ever, a GP-led secondary is not a solution to a bad problem no one wanted to have. Rather, GP-led secondaries are being structured as a solution to a good problem – how to inject capital into an investment that is performing so well that the fund and its sponsor would prefer not to dispose of the asset as the end-of-life date of the fund approaches. The GP-led secondary is now a broadly acceptable way to grow a business in a manner that allows LPs and GPs to benefit from continuing upside in a way that a traditional exit would not offer. We expect that, in light of the impediments imposed on fundraising by COVID-19, institutional limited partners’ increased appetite for private equity and the uncertainty around prevailing market forces, and the industry’s acceptance of the ILPA principles as a means of implementing GP-led secondaries in funds whose terms were agreed upon years ago, GP-led secondary volume will continue to grow, offering powerful flexibility to invest for extended growth. 

Investors are also seeing growth in the secondary space as a whole and have been expanding their investment programmes to take advantage of this. BlackRock recently closed on USD1 billion for its debut secondaries fund, BlackRock Secondaries and Liquidity Solutions, targeting a total fund size of USD1.5 billion. Moreover, BlackRock’s new fund explicitly targets investing in “complex deals”, clearly expanding beyond the simple portfolio acquisitions from LPs seeking to rebalance or obtain liquidity on existing portfolios. BlackRock has described co-investments as a source of opportunities in the secondary space and made use of capital on its balance sheet before closing on its fund to lead, alongside Neuberger Berman, Coller Capital and GIC, a restructuring of Thomas H Lee Partners’ Fund VI. Not surprisingly, given the increased reliance on subscription line credit facilities noted above, BlackRock has stated a belief that this use of credit facilities may also generate transaction volume. The common theme among secondary deals, investors and the GP-led process is that secondary transactions have evolved from being driven by a supply of LPs seeking liquidity on otherwise illiquid portfolios to a means of satisfying the change in investor appetites and portfolio company needs. As noted above, investors are seeking to increase their allocation to private equity, while also seeking to avoid the uncertainty that is inherent in the typical blind-pool private equity fund. Secondary funds and their related transactions have responded to that demand by becoming a strong source of private investments without blind-pool risk. Where the larger investors, such as CPP Investments, have been able to build their own direct private equity investment capabilities, and others, such as The California State Teachers’ Retirement System, have indicated a plan to do so, secondary funds, dedicated co-investment funds and GP-led secondary transactions all work to provide increased access to private investments without that uncertainty.

ERISA

While the Employee Retirement Income Security Act of 1974 (ERISA) does not expressly restrict private equity as an investment in defined contribution plans, the inherent qualities of private equity have restricted it from being offered directly as an investment alternative in a participant-directed plan. Accordingly, investments in private equity are more commonly utilised by defined benefit pension plans. In compliance with general fiduciary principles imposed by ERISA, however, various defined contribution plans have also offered managed investment portfolios with private equity components (as well as other private investment fund components).

DOL information letter

In response to encouragement from the chairman of the SEC and the president of the United States, and requests from the Committee on Investment of Employee Benefit Assets Inc and others, the Department of Labor (DOL) issued an information letter concluding that a “plan fiduciary would not… violate the fiduciary’s duties under… ERISA solely because the fiduciary offers a professionally managed asset allocation fund with a private equity component”. In the letter, the DOL cites the “reduction in the number of public companies over the past 20 years, and that many companies access private capital in lieu of public markets for longer periods of time”, echoing chairman of the US Securities and Exchange Commission Jay Clayton’s sentiments. In particular, Jay Clayton honed in on the important issue that “public equity markets – eg, IPOs – are being used more for liquidity by venture capital and private equity investors than for accessing new growth capital”. For the same reason, institutional investors have increased their exposure to the private markets (or, perhaps more as the cause than the effect, institutional investors’ increased exposure to the private markets has had the effect of the public markets being the market of last resort – only once a company has exhausted all private sources of capital will it resort to the public markets, in which case, it is typically for liquidity instead of growth capital). We find it interesting that in response to the demonstrated aversion to being a public company by existing and potential issuers, the SEC has decided to increase investor access to the private markets as opposed to reducing the regulations that have made the public markets so disfavoured. 

Noting the important differences between private equity funds and publicly traded investments (eg, more complex organisational structures, investment strategies, fee structures and longer-term horizons), the DOL information letter describes a number of considerations that plan fiduciaries of defined contribution plans must evaluate when contemplating an investment portfolio using private equity. The DOL does not, however, clarify in its letter what weight plan fiduciaries should assign to each of these considerations. None of the considerations and issues noted by the DOL are unexpected and would likely otherwise have been a necessary part of a fiduciary’s analysis to meet ERISA’s obligations.

Among the reasons for the DOL’s issuance of the information letter is “to address uncertainties regarding ERISA that may be impeding plan fiduciaries from considering private equity investment opportunities”. Importantly however, the DOL also cautioned that the information letter “does not address any fiduciary or other ERISA issues that would be involved in a defined contribution plan allowing individual participants to invest their accounts directly in private equity investments. Such direct investments in private equity investments present distinct legal and operational issues for fiduciaries of ERISA-covered individual account plans”.

Democratisation of investment

The pronouncement by the DOL is in line with the SEC’s general policy changes over the years that seek to democratise investing. For instance, in August 2020, the SEC adopted revisions to the definition of “accredited investor” under Regulation D to allow more institutional and individual investors to participate in the private capital markets. Similarly, in 2013, the SEC revised Regulation D promulgated under the Securities Act of 1933 to allow for general solicitation. This revision to Regulation D was adopted as part of broader revisions to the regulations around the capital markets enacted as part of the JOBS Act, whose stated goal, according to the Obama administration, was to “expand access to capital for young firms in a way that is consistent with sound investor protections”. Furthermore, the JOBS Act resulted in amendments to the Exchange Act, raising the threshold to 2,000 (or 500 non-accredited investors) that would trigger mandatory reporting under the Exchange Act. While the original purpose may have been to allow a private company to become more broadly owned (eg, by its employees) prior to becoming a reporting issuer (which historically would trigger an IPO whether an issuer needed access to the capital markets or not), one by-product was the increased breadth with which private funds could be marketed and, therefore, the number of investors that could be admitted. The combined aspects of this consistent march to democratisation of the private markets – (i) acceptance of general solicitation, (ii) increased ownership thresholds of private companies, (iii) access to private equity by defined contribution plans governed by ERISA, (eg, 401(k)s), and (iv) a proposed easing of the definition of “accredited investor” – while perhaps presented as a means of providing more equal access to the private markets, have had their intended effect of expanding access to capital within the private markets. Given the expense associated with being a public company, it should be no surprise that companies now stay private for as long as possible. In response, institutional investors, who ostensibly do not need the protections afforded by SEC scrutiny of public companies, have continued to increase their focus on private companies, increasing their allocations to private equity and private credit. 

The DOL and ESG investing

Cognisant of the growing focus on Environmental, Social and Governance (ESG) matters, as discussed below, the DOL also issued a proposed rule regarding ESG with the stated purpose of “providing further clarity on fiduciaries’ responsibilities in ESG investing”. The proposed rule confirms that “ERISA requires plan fiduciaries to select investments and investment courses of action based solely on financial considerations relevant to the risk-adjusted economic value of a particular investment or investment course of action”. The proposed rule requires a plan fiduciary to confirm that it “[h]as not subordinated the interests of the participants and beneficiaries in their retirement income or financial benefits under the plan to unrelated objectives, or sacrificed investment return or taken on additional investment risk to promote goals unrelated to those financial interests of the plan’s participants and beneficiaries or the purposes of the plan”. Olena Lacy, assistant labour secretary heading the Pension and Welfare Benefits Administration (now the Employee Benefits Security Administration) during the Clinton administration, phrased the change in layman’s terms – “Democrats say the standard is that it’s OK for you do to this as long as [risk and returns] comes out the same. Republicans say it’s illegal for you to do this unless it comes out the same” (New York Times, “Labor Dept Seeks To Restrict Social Goals in Retirement Investing”). While not a drastic sea-change in terms of the overall attitude of ERISA towards ESG, the proposed rule was met with significant criticism and comments. The proposed rule builds on prior pronouncements, consistent with the Democrat/Republican division Ms Lacy describes. In 1994, the statement was that ERISA does “not prevent plan fiduciaries from deciding to invest plan assets in an [investment that is selected for the economic benefits it creates in addition to the investment returns to the employee benefit plan as an investor (ETI)] if the ETI has an expected rate of return that is commensurate to rates of return of alternative investments with similar risk characteristics that are available to the plan, and if the ETI is otherwise an appropriate investment for the plan in terms of such factors as diversification and the investment policy of the plan” (Pension and Welfare Benefits Administration, “Interpretive Bulletin Relating to the Employee Retirement Income Security Act of 1974”). Additional guidance was published in 2008 and again in 2015. All such guidance, consistent with even the latest proposed rule, provides that expected returns for the level of risk to the employee benefit cannot be subordinated to other interests. However, the proposed rule, unlike earlier guidance, goes much further in requiring significant decision-making documentation regarding the decision to provide an ESG-focused fund, likely causing fiduciaries to avoid including such products.

ESG

The DOL’s pronouncement on ESG matters discussed above are, of course, responsive to general interest in the topic pervading the industry. In its 2019 published principles 3.0, ILPA provided guidance to GPs on maintaining and communicating appropriate policies to assist individual LPs seeking to understand how a GP’s investment strategy and operations align with an individual LP’s ESG policies. This is in keeping with increased focus on systemic racism in the United States, continued interest in climate change and increased income inequality and wealth disparity, undoubtedly amplified by COVID-19 and the government’s response. Combined with the outsized growth of the private markets relative to the public markets, it would seem that institutions seeking to effect change through renewed focus on ESG would be even more inclined to do so through their private investments. While activist strategies focusing on public companies may have been helpful and effective in the past, as more of the American economy remains private for longer, many institutional investors have taken the view that they must increase these efforts in their private investments to achieve results.

Disclosure and transparency

As investors have increased their exposure to private equity, in order to continue with their historic views on ESG, which is not by any means new generally, just new to private equity, these same institutional investors have now been scrutinising the gate-keepers of access to private companies (ie, private equity fund sponsors) through imposing ESG principles on their GP counterparties. Where a socially-conscious LP may have historically been able to voice its ESG opinions directly to a board of directors of a company it was invested in, it is now the case that, because such LP is invested in the same types of companies through a private equity fund, the LP must express its concerns through the GP. Given the blind-pool nature of such investments, the LP voices those concerns in advance of investing in the blind-pool. However, instead of solely seeking advance covenants, LPs are also seeking disclosure and transparency. Given the finite term of blind-pool funds, LPs can revise their allocations among GPs every few years, if they feel GPs are not adequately responsive to their ESG requirements. As for public investments, LPs can now invest in regulated products that avoid entire industries. Of course, institutional LPs that have the resources can take further control through increased participation in secondaries which can provide these investors with insight that a blind-pool investment would not.

SPACs

While the Special Purpose Acquisition Company (SPAC) is not per se an alternative fund or alternative investment, it provides an interesting intersection of the private and public markets. While the SPAC model has existed for well over a decade, SPACs have seen a significant uptick in popularity recently, as evidenced by Pershing Square Tontine Holdings, which raised USD4 billion through its IPO, but may have up to USD7 billion to spend when taking into account commitments from Pershing Square Capital. SPACs look to capitalise on the disparity between private and public markets noted above – if private companies only use traditional IPOs as an exit, then perhaps they are ripe for acquisition by large pools of capital while they are still private, particularly if it provides an alternative path to a public listing. As a result, not only have alternative asset managers increasingly sought to raise their own SPACs, but such managers with late-stage venture capital or traditional private equity portfolios have similarly looked to existing SPACs as potentially attractive acquirers for mature portfolio positions in lieu of a traditional IPO. Demonstrating the intersection between public and private markets, GCM Grosvenor, an alternative asset manager, went public through a merger with a SPAC affiliated with Cantor Fitzgerald. Of course, once a previously private company is acquired by a SPAC, the company is then public and subject to all the same requirements as if the company had gone through a traditional IPO, and is no longer as easily able to raise capital privately. If the capital is flowing in such a way as to cause private companies to become public, eschewing only the IPO process, then perhaps the issues noted by Jay Clayton, discussed above, are not issues with the costs of being a public company, but rather with the costs of becoming a public company. It is worth noting that, in view of the current iteration of the SPAC model, completing an acquisition by a SPAC may be a less rigorous process than the traditional IPO.

Conclusion

It is often commented that the COVID-19 pandemic has only accelerated recent trends, and this has proved true in the alternative funds space. As the private capital markets continue to grow, and GPs continue to lock up more long-term capital, the private equity industry may find itself in an ideal position to promote economic stability and long-term growth during, and in the wake of, the ongoing pandemic and other times of instability.

Schulte Roth & Zabel

919 Third Avenue
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+1 212 756 2000

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joseph.smith@srz.com www.srz.com
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Law and Practice

Authors



Katten is a world leader in advising hedge, private equity and other alternative funds and asset managers, proprietary trading firms, and other market participants that deploy trading strategies to reshape markets and change investor expectations. Serving at the forefront of this industry since its inception, the firm guides clients through the full scope of issues vital to their business, including regulation and compliance, litigation and enforcement, tax, corporate and transactional, trading limits, technology and cybersecurity, and employment, among others. The team continues to be a comprehensive resource for some of the world’s largest and most successful investment management firms and institutional investors in alternative investments, helping them to address a myriad of complex issues against the backdrop of rapidly changing financial markets grappling with a worldwide pandemic.

Trends and Development

Authors



Schulte Roth & Zabel was founded in 1969 and has been at the forefront of the alternative investment management space from offices in London, New York and Washington, DC. SRZ lawyers provide advice on both UK and US law to a wide variety of funds, managers and investors worldwide. The firm’s market-leading investment management group provides counsel on structuring hedge funds, private equity funds, debt funds, real estate funds, hybrid funds, structured products, UCITS and other regulated funds, as well as providing regulatory and tax advice. SRZ handles all aspects of fund formation and operations on a full-service basis, adopting a cross-disciplinary approach to client service by employing the expertise of multiple practice groups. Notably, SRZ is one of only a few law firms with a dedicated regulatory and compliance practice within its private funds practice. The authors thank David Cohen for his input regarding recent DOL pronouncements, John Mahon for his input regarding recent SPAC market activity and Carol T Ivanick for her helpful input.

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