Alternative Funds 2021

Last Updated October 14, 2021

USA

Law and Practice

Authors



Schulte Roth & Zabel (SRZ) 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.

In general, due to its importance in the global economy and financial markets and the extensive regulatory and legal framework that has built up over time, the United States is a major jurisdiction for alternative funds and their managers and investors. Specifically, Delaware is the most popular jurisdiction to form domestic hedge funds due to Delaware’s well-developed statutory regime and comprehensive body of case law.

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 and USD9 trillion in assets under management (which notably does not take into consideration the significant leverage utilised by many alternative funds).

The typical types of alternative funds established in the United States consist of:

  • hedge funds;
  • private equity funds;
  • real estate funds;
  • credit funds; and
  • hybrid fund types.

Open-End Funds/Strategies

The principal types of hedge funds are:

  • global macro;
  • equity (eg, long/short, long-biased);
  • relative value (eg, market neutral, capital arbitrage, convertible arbitrage);
  • credit (eg, long/short credit, fixed income, MBS, ABS);
  • event-driven (eg, activist, distressed debt, merger arbitrage);
  • managed futures;
  • multi-strategy; and
  • “niche” (eg, cryptocurrencies and other digital assets).

Closed-End Funds/Strategies

Strategies pursued by closed-end funds are generally more illiquid in nature and include private equity investments, real estate (including development), direct lending, distressed debt and infrastructure.

Credit Funds

Credit funds embrace many distinguishable investment strategies, such as capital preservation strategies (eg, those employed by mezzanine and direct lending funds), return maximising strategies (eg, those employed by distressed debt, corporate credit and opportunistic/special situation funds) and speciality finance or other niche strategies. There are also a number of credit managers that build “dislocation funds” (eg, commitment funds where the committed capital is not drawn down until a certain trigger event occurs (eg, a certain high-yield spread is reached)). Credit funds can be structured as hedge funds, private equity-style funds or a combination of both (eg, a “hybrid fund”).

Hybrid Funds

Hybrid funds are customised fund structures, often with closed-end features and “private equity lite” terms that help capture a broader range of investment opportunities. Hybrid funds are designed to hold a blend of both liquid and illiquid assets.

An alternative fund’s structure is shaped by tax, regulatory and other considerations, such as the investor base, the jurisdictions involved and the investment programme. For example, US and non-US investors face different tax considerations, while investors who are generally exempt from US income tax may have different tax sensitivities from those investors who generally pay US tax on their income. Thus, funds are often structured to allow different types of investors to invest in different ways that address their specific concerns.

Fund structures include standalone funds, side-by-side funds, master-feeder structures and “mini-master” structures. Fund structures may also include alternative investment vehicles, parallel funds, special purpose vehicles (SPVs) and blocker corporations. The most common structure, particularly for taxable US investors, is the limited partnership, although other types of vehicles, including limited liability companies, may be used.

Entity Type

US funds are often formed as limited partnerships or limited liability companies (LLCs), which offer limited liability to their limited partners or non-managing members, as well as favourable “flow-through” tax treatment to such investors. Certain types of investors may prefer to invest in non-US funds that are treated as corporations for US tax purposes, which do not offer flow-through tax treatment.

State Formation

US investment partnerships are commonly formed under the laws of the State of Delaware. Delaware corporate statutes are well developed and offer flexibility. There is a comprehensive body of law in Delaware relating to corporations, partnerships and LLCs, as well as related areas affecting alternative funds.

Specialised Structures

Variations on core structures may be used to provide investors with access to certain strategies in a tax-efficient manner, subject to special sets of rules and guidelines. For example, an insurance dedicated fund is a specialised type of fund that is used to support privately placed life insurance and annuities, which may provide tax deferral or elimination for holders of the underlying insurance policies or annuity contracts. Real estate investment trusts may provide a tax-efficient structure for investing in eligible real estate assets.

Registration Requirements

Typically, private funds are structured in a manner that does not require federal registration as investment companies. It should be noted that this chapter concerns unregistered products as opposed to registered funds such as mutual funds. The managers of private investment funds may need to be registered as investment advisers under federal or state securities laws. Several primary federal laws are set forth below.

The Securities Act of 1933 (the "Securities Act")

The Securities Act regulates the offer and sale of securities in the United States, including the offering of interests and shares by alternative funds. Section 5 of the Securities Act requires that securities offered or sold in the United States or to US persons must be registered with the SEC, unless offered or sold in reliance on an exemption from registration.

Offers and sales by alternative funds typically are made under Rule 506 of Regulation D as a “safe harbour” from registration under the Securities Act. Rule 506(b) offerings are exempt if, among other things, offers and sales are not made using general solicitation or general advertising and all purchases (except for up to 35 purchasers) are “accredited investors”, as described below. Similar to Rule 506(b), Rule 506(c) offerings are exempt if all purchasers are accredited investors (there is no exception for non-accredited investors) and the issuer has taken reasonable steps to verify each purchaser’s accredited investor status. Rule 506(c) does not prohibit the use of general solicitation or general advertising. Additionally, an alternative fund relying on Rule 506(c) is subject to heightened verification requirements regarding the accredited investor status of each investor, requiring the alternative fund to take “reasonable steps” to verify each investor’s accredited investor status.

Regulation S

Regulation S provides a safe harbour for alternative funds by generally exempting offers and sales of securities conducted outside the United States from the requirements of Section 5 of the Securities Act if:

  • the offer and sale are made in an offshore transaction; and
  • the alternative fund, a distributor or its agents do not engage in directed selling efforts within the United States.

Regulation S also offers a safe harbour to offshore resales by parties other than the alternative fund or its affiliates.

The Investment Advisers Act of 1940

See 3.2 Regulatory Regime.

The Investment Company Act of 1940 (the "Investment Company Act")

The Investment Company Act regulates investment companies in the United States. Generally, alternative funds that invest in securities would be considered investment companies under the Investment Company Act. An “investment company” is an issuer that is, or holds itself out as being, engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting or trading in securities.

Sections 3(c)(1) and 3(c)(7) of the Investment Company Act exempt qualifying alternative funds from the definition of “investment company” and therefore relieve the funds from many Investment Company Act requirements.

The Commodity Exchange Act (CEA)

The CEA is a federal statute that regulates the commodity futures and derivatives markets in the United States. The primary regulator of commodities and futures in the United States is the Commodity Futures Trading Commission (CFTC).

The CEA and rules promulgated thereunder by the CFTC may be relevant to alternative funds that engage in cryptocurrency trading, or quantitative and algorithmic trading, as well as other funds that trade in those markets.

The Employee Retirement Income Security Act of 1974 (ERISA)

ERISA is a federal law that regulates voluntarily established retirement and health plans for private businesses. If 25% or more of the class of interests of a fund are owned by employee benefit plan investors, such as an employer-sponsored 401(k) plan or individual retirement account (IRA), all of the assets of the alternative fund will be deemed ERISA plan assets and the alternative fund’s manager will be required to comply with ERISA’s fiduciary responsibility provisions. In addition, the alternative fund will be required to comply with certain prohibited transaction provisions under both ERISA and the Internal Revenue Code.

Blue Sky Laws

Alternative funds are also required to comply with applicable state securities laws (“blue sky laws”) and regulations. For example, an alternative fund offering its interests pursuant to the registration exemption under SEC Rule 506(b) may be required to make “notice filings” in a state where the alternative funds securities are sold.

Investment Limitations

Generally, there are no applicable laws that limit the amount of an investment in an alternative fund. However, there are investor-based qualifications that alternative funds must meet in order to invest in certain products and engage in certain transactions. For example, an alternative fund must be a “qualified institutional buyer” (QIB) in order to purchase SEC Rule 144A restricted securities, and must be an eligible contract participant as defined by the CEA to engage in certain over-the-counter derivative transactions.

Fund managers should analyse all aspects of their lending businesses, each of which may be subject to different regulatory regimes. For example, a loan origination entity may be regulated under the broker-dealer rules of the Exchange Act. In addition, direct lending funds must be structured to comply with investment adviser rules, CEA regulations and, on occasion, ERISA.

Tax Considerations

A fund that originates loans in the United States on a regular basis is generally considered to be engaging in a US trade or business for US tax purposes, which may result in adverse US tax consequences and filing requirements for non-US investors. The US federal, state and local tax considerations with respect to originating loans in the United States are complex. Furthermore, domestic funds are often managed in state and local jurisdictions that have their own income tax regimes.

Activities of a fund, such as loan origination activities or business operations, may cause non-resident investors to be subject to tax in a jurisdiction where the fund operates. Moreover, certain jurisdictions may impose withholding obligations on domestic funds participating in such activities, and other jurisdictions may impose an entity-level tax on such business activities (for example, New York City’s 4% unincorporated business tax).

Licensing and State Usury Law Considerations

Fund managers must consider such issues as licensing and state usury laws that may impose limits on the permissible amount of interest that can be charged on a commercial loan. With respect to licensing, fund managers must analyse all relevant factors to determine whether a state commercial lending licence is needed with respect to any given 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.

Funds can invest in non-traditional assets; please see examples below.

Cryptocurrency/Digital Assets

Funds may be focused on cryptocurrency and digital assets (such as bitcoin and ether). Cryptocurrency funds can take a number of forms, ranging from simple “wallet” funds (eg, a fund that invests in cryptocurrency and pays cash back to investors when they decide to redeem) intended to provide a custody solution for holding a particular currency to discretionary investment strategies that trade in multiple currencies, strategies investing in blockchain, venture companies, or a combination of these strategies. Depending on the mix of investments and approaches, cryptocurrency funds may be structured as hedge funds with side pocket mechanisms or as private equity-style venture capital funds. A fund invested in cryptocurrency and digital assets must contend with certain regulatory regimes and difficulties caused by the fact that this is still a developing area. For example, there is the question of which digital currencies are “securities”. The CFTC has asserted jurisdiction over pure play digital currencies, such as Bitcoin, whereas the SEC has asserted jurisdiction over “digital coins” or “digital tokens”.

If a fund manager is advising others on trading digital assets that are securities, they may have to register with the SEC as an investment adviser. If a manager is required to register, it will have to comply with the Custody Rule, which requires client funds and securities to be maintained with qualified custodians in an account either under the client’s name or under the name of an agent or trustee of the client. For registered investment advisers operating in the cryptocurrency space, compliance with the Custody Rule can be a technical challenge, especially if the sponsor plans to invest in some of the newer cryptocurrencies, the protocols of which are not supported by regulated, established custodians. See 2.9 Rules Concerning Other Service Providers – "Custody Rule".

A further challenge for sponsors in this space are the issues around the tax treatment of cryptocurrency investments, which again stem from the uncertainty of the treatment of particular investments as “securities,” “currencies” or “property”. For example, certain digital assets may be treated as property, not currency, for US federal tax purposes. Although the Internal Revenue Service has issued some guidance, many uncertainties remain as to the tax treatment of digital assets. While affecting all types of investors to varying degrees, the tax considerations may be worse for non-US investors and as a result could disadvantage US-based sponsors looking to manage non-US investor capital.

Litigation Finance

Litigation finance funds may provide capital to law firms and various types of organisations involved in legal disputes. Interest in private funds focusing on litigation finance has continued to grow in 2021, and a substantial number of private equity-style funds have been raised to pursue this strategy, as well as existing funds with broad opportunistic mandates pursuing litigation finance as a sub-strategy. There are a variety of ways in which such investments may be structured, which present different tax considerations depending on the types of investors in such funds. The regulatory issues associated with this type of investing require sophisticated expertise targeted to the locality in which the opportunity is based.

Music Catalogues

Private funds investing in music catalogues are another “niche” segment of the industry receiving increased attention. One reason for this seems to be the evolution of music-streaming services, which has created a mechanism for owners to capture licensing fees each time a particular song is played. Fund sponsors have launched private equity-style funds to acquire music properties and take advantage of this streaming revenue. The recurring nature of these fees makes these catalogues an appropriate product for syndicated asset-based financing offerings.

Alternative funds are structured to be exempt from registration requirements under both US securities and commodities laws and therefore typically are not required to obtain prior regulatory approval before issuing securities. Alternative funds that rely on a safe harbour exemption under Regulation D must make a regulatory filing with the SEC on Form D within 15 days of the first sale of the fund interests or shares. Many US states also require “notice filings” to be made in connection with the sale of fund interests within their jurisdictions.

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 governing the appointment of directors, employees, or business premises.

However, when an alternative fund is formed under the laws of a particular US state (eg, Delaware), the alternative fund is subject to all applicable laws concerning its legal form, including those related to formation, governance, rights of interest holders, and mergers, consolidations and dissolution. In addition, nearly all US states require alternative funds to maintain a registered office or a registered agent in the state where the alternative fund is formed.

Generally, alternative funds and their investment advisers have broad discretion to select service providers to appoint on behalf of the alternative fund. Where an alternative fund retains a service provider, the fund and its manager are responsible for the provider’s regulatory compliance.

Custody Rule

Most alternative fund managers have, or are deemed to have, “custody” of the alternative fund’s assets and therefore are subject to the SEC’s Custody Rule, which requires a fund manager to place a fund’s securities with “qualified custodians”, including US-regulated banks or US-registered broker-dealers, and non-US financial institutions that keep clients’ assets in customer accounts segregated from its proprietary assets.

Many alternative fund managers choose to comply with the Custody Rule requirements by delivering annual audited financial statements to fund investors within 120 days of the end of the fund’s fiscal year (180 days for funds of funds), and the auditor must be registered with, and subject to examination by, the Public Company Accounting Oversight Board.

There are no legal or regulatory requirements applicable to non-local service providers.

In general, there is no entity-level US federal income tax on domestic funds that are treated as partnerships for US federal income tax purposes. Instead, each partner of such a fund reports on its own annual tax return such partner’s distributive share of the fund’s taxable income or loss. Such amounts are reported to investors by the fund on an Internal Revenue Service Schedule K-1.

If a fund that is organised as a partnership were to be treated as a “publicly traded partnership” (PTP) taxable as a corporation for US federal tax purposes, then the taxable income of the fund would be subject to corporate income tax when recognised by the fund. Distributions of income, other than in certain redemptions of interests, would be treated as dividend income when received by the investors to the extent of the current or accumulated earnings and profits of the fund, and investors would not be entitled to report profits or losses realised by the fund. A fund organised as a partnership may need to follow certain limitations on the number of investors, the type of income it has each tax year, or the frequency of permissible withdrawals and transfers in order to ensure that it is not treated as a PTP taxable as a corporation for US federal tax purposes.

Utilisation by Investors

US funds that are treated as partnerships for US federal income tax purposes generally do not qualify at the entity level for benefits under a tax treaty with the United States; however, their “flow-through” status may allow non-US investors located in jurisdictions that have such a tax treaty to claim treaty benefits (which may include a reduction in, or complete exemption from, 30% US withholding tax on certain types of US-source income). In order to establish eligibility to claim tax treaty benefits, a non-US investor will typically be required to provide an applicable Internal Revenue Service Form W-8.

Structuring Issues

Certain jurisdictions, such as Canada and the UK, may limit the availability of tax treaty benefits for a resident of those jurisdictions investing in a fund that is organised as an LLC rather than as a limited partnership. A US fund that is anticipating non-US investors may prefer to be organised as a limited partnership rather than an LLC.

Funds may form subsidiaries from time to time for various purposes, including to make or hold a particular investment or investments, to obtain financing in connection with its investments or to facilitate the distribution of investments in kind. Such SPVs may be used for the benefit of one or more funds (for instance, to facilitate the sharing of a particular asset across multiple funds via the use of participations). Tax considerations should always be considered when structuring a subsidiary and may also be the main impetus for why subsidiaries are used. For example, subsidiaries organised in appropriate jurisdictions may reduce or eliminate certain non-US taxes for certain US investors.

Because US investors are a significant presence in all types of investment funds, managers from around the world may choose to create US-domiciled vehicles to accommodate them.

Typically, investors in US alternative funds are US taxable and tax-exempt investors, though investors in US funds increasingly include those from other jurisdictions. See also 4.1 Types of Investor in Alternative Funds.

Hedge Funds

In 2020, the winning category among hedge funds was equities, delivering some +19.7%, according to Preqin. Within equities, funds pursuing investments in the technology, healthcare, and energy and basic materials sectors excelled. Other event-driven and certain niche strategies also performed well. Credit was the laggard hedge fund strategy, relatively speaking.

In 2020, the hedge fund fundraising environment was more skewed in favour of established firms that reopened previously closed funds to replace outflows or performance-based declines or build war chests to pursue specific opportunities or raised new, customised or bespoke products alongside their flagship funds (eg, more-concentrated “best ideas” funds, long-only or long-biased funds, funds that offer exposure to a specific subset of a flagship fund’s investment strategy, or other variations, such as funds with narrower geographic mandates, or sleeves within existing fund complexes). In 2021, there have been more emerging manager launches, especially those targeting niche strategies that are not overcrowded, such as the cryptocurrency and/or blockchain space, healthcare and pro-diversity governance strategies.

Private Equity

Private equity fund sponsors also raised significant capital in 2020 and 2021, with Preqin reporting some USD188 billion raised across 452 funds in the first quarter of 2021, up from USD163 billion and 431 funds in Q1 2020. In terms of investment focus and investor demand, private equity funds are targeting industries that were particularly hard hit by, and related to, COVID-19, such as airlines, hospitality, fintech and commercial real estate, with continued interests in the illiquid investments held by core real estate funds and other long-term or perpetual fund structures. There have been investment opportunities in a variety of other real estate sectors – such as logistics, self-storage and data centres – and investors are exploring opportunities for repurposing retail properties for alternative uses.

General Partner (GP)-Led Secondaries

A vast amount of activity is continuing to be seen in the market for GP-led secondary transactions with respect to interests in private equity funds and single investment funds, and even certain hedge funds offering tender offer-style liquidity to investors. The COVID-19 dislocation may have created more assets experiencing unexpected illiquidity that would be promising targets for this type of approach.

Hybrid Funds

There has also been increasing use of “hybrid funds” designed to hold a blend of liquid and illiquid assets, and invest across public and private equity markets, which raises unique issues relating to taxation, trade allocations, conflicts of interest and valuations.

Environmental, Social and Governance (ESG)

Private fund managers across strategies and structures are facing increasing demands with respect to the integration of ESG principles into investment programmes. The more recent development in this area has been a focus on diversity, equity and inclusion, both at the investment level and at the level of the manager’s own operations.

Disclosure requirements are specific to the type of alternative fund, whether its manager is registered as an investment adviser with the SEC, its asset type(s) and its investor make-up. See 2.3 Regulatory Regime and 3.2 Regulatory Regime.

In general, an alternative fund’s offering documents should contain adequate regulatory disclosure. The offering documents should include disclosures regarding, for example, performance-based compensation, certain conflicts of interest, allocations of investments, co-investments, use of “soft dollars”, withdrawal rights (to the extent applicable), certain preferential rights that may be granted to investors, and/or principal transactions.

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 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 (see 3.2 Regulatory Regimes – "Registration Process"). Additionally, 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.

Advisers that are registered as commodity pool operators (CPOs) or commodity trading advisers (CTAs) must deliver to each prospective investor a “Disclosure Document” no later than the time when they deliver the subscription agreement. See 3.2 Regulatory Regimes – "Commodity Exchange Act".

See also 4.3 Rules Concerning Marketing of Alternative Funds (in particular, discussions of Regulation D and Marketing Rule requirements).

There are no forthcoming changes that are likely to change the above responses. That being said, it is typical for the SEC and CFTC to regularly propose amendments to their regulatory and implementing strategies that may have effects on the regulatory regime described in 2.3 Regulatory Regime.

Management companies are often formed as limited partnerships, with a limited liability company serving as the GP and other persons involved in management admitted as limited partners.

US funds often have a separate GP that receives a performance allocation or carried interest. As such, this entity makes a capital contribution to the fund. The GP may be formed as an LLC.

The Investment Advisers Act of 1940 (the "Advisers Act")

Registration requirement

The SEC regulates investment advisers primarily under the Advisers Act and rules adopted under that statute. An alternative fund manager that meets the definition of “investment adviser” under the Advisers Act generally must register with the SEC. An investment adviser is 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”.

Alternative fund managers are generally presumed to be acting as investment advisers and will be required to register with the SEC unless an exemption is available. Other investment advisers may be required to register with one or more US state securities regulatory authorities or the SEC, depending upon the amount of their regulatory assets under management and whether the investment adviser has a principal place of business inside or outside the United States.

Exempt reporting advisers

An alternative fund manager may be able to claim an exemption from registration with the SEC as an “exempt reporting adviser” if it meets the following criteria:

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

In order to claim exempt reporting adviser status, a manager must file an abbreviated version of Form ADV and report information, including information about the funds it advises, other business activities and any personnel disciplinary disclosures. Non-US advisers may also file as exempt reporting advisers with the SEC under certain conditions.

Exempt reporting advisers are subject to certain limited regulatory requirements, including the requirement to have policies and procedures reasonably designed to address the general anti-fraud provisions, the SEC Pay to Play Rule, and record-keeping provision, and to guard against the misuse of material non-public information.

Alternative fund managers based outside the United States may be exempt from registration if they qualify as a “foreign private fund adviser”. A non-US fund manager may qualify as a foreign private fund adviser if it:

  • has no place of business in the United States;
  • has fewer than 15 clients in the United States and US investors in the private funds it advises;
  • has less than USD25 million in aggregated assets under management attributable to US clients and investors; and
  • does not hold itself out to the public in the United States as an investment adviser, nor acts as an investment adviser to a registered investment company or a business development company.

Unlike exempt reporting advisers, foreign private fund advisers are not subject to SEC regulation and are not required to file any reports with the SEC.

Registration process

If an alternative fund manager has the requisite amount of regulatory assets under management or is a non-US adviser that does not qualify for any of the exemptive statuses set forth above, it will be required to register with the SEC as an investment adviser.

Alternative fund managers required to register with the SEC must do the following.

  • File Form ADV with the SEC. Form ADV must be amended on an annual basis within 90 calendar days of fiscal year-end, and on an other-than-annual basis upon the occurrence of certain developments (ie, the departure of a control person or reporting a disciplinary proceeding). Form ADV consists of three parts: Part 1 requires the investment adviser to input information about its business (such as location, ownership structure and amount of regulatory assets under management) into a standard form and is publicly available; Part 2 requires the investment adviser to prepare a brochure that describes in plain English its business, conflicts of interest, certain advisory personnel and the risks associated with the investment strategies employed by the investment adviser; Part 3 (which is not required to be filed by investment advisers that solely advise alternative funds or that have no natural persons as clients) requires preparation of a client relationship summary (Form CRS). See 2.17 Disclosure/Reporting Requirements.
  • Act as a fiduciary to all clients, which includes a duty of loyalty and a duty of good faith. Investment advisers must provide to current and prospective investors full and fair disclosure of all material facts and conflicts of interest associated with an investment in an alternative fund managed by the investment adviser.
  • Adopt, maintain and periodically review 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 policies and procedures to address personal trading reporting and restrictions, the receipt of material non-public information, and enforcement of insider trading procedures).
  • Maintain books and records for specified periods of time, as set forth in SEC Rule 204-2.
  • Comply with the SEC’s rules pertaining to the marketing and advertising of alternative fund interests (see 4.3 Rules Concerning Marketing of Alternative Funds).
  • Only charge performance-based fees to alternative fund investors that are considered to be “qualified clients” under SEC Rule 205-3.
  • If a US alternative fund manager does not have the requisite amount of assets under management, it will need to register with, or seek exemptions from, regulatory authorities in states in which it operates. State regulatory regimes often have similar requirements to those of SEC-registered advisers.

Commodity Exchange Act

Registration requirements

Managers that advise or manage alternative funds that trade in exchange-traded futures contracts, options, swaps and/or any other commodity interests regulated under the CEA (referred to as a commodity pool) are required to register as a CPO and/or a CTA, and become a member of the National Futures Association (NFA), the US self-regulatory organisation for the futures industry, unless an exemption from registration applies.

A CPO is defined as any person generally “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”, with some exceptions.

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.

An alternative fund that is a commodity pool generally will have one or more CPOs and/or CTAs (whether registered or exempt). Where the amount of trading in commodity interests by an alternative fund is limited in accordance with CFTC regulations, its manager may seek exemptive relief from registering as a CPO and/or CTA.

Exemptions from CFTC registration

Whether a manager with US customers is required to register as a CPO generally turns on the amount of commodity interest trading in its managed pools. Managers that operate only pools for sophisticated investors with “de minimis” exposure to commodity interest trading, as defined under CFTC Rule 4.13(a)(3), are generally not required to register as CPOs, provided that a suitable exemption notice is filed with the NFA and appropriate investor disclosures are made. (Offshore managers operating offshore pools for non-US investors may be able to claim a jurisdictional exemption under CFTC Rule 3.10(c).)

By contrast, whether a manager is required to register as a CTA generally turns on the number of commodity interest advisory clients that it serves (a fund being deemed a single client). US managers with 15 or fewer such advisory clients are not required to register as a CTA per CFTC Rule 4.14(a)(10), provided that the manager does not generally hold itself out to the public as a CTA. This count excludes pools for which the manager already serves as the CPO of record pursuant to CFTC Rules 4.14(a)(4) and (5); non-US managers may also exclude their non-US clients from the count. Other exemptions may apply to winnow the count further. Notably, as CFTC Rule 4.14(a)(10) is a “self-executing” exemption, most fund managers are automatically exempt from CTA registration. Managers with many separately managed accounts, or many sub-advisory relationships, may need to consider this question closely.

Registering as a CPO or a CTA

For managers who must register with the CFTC, the registration process is handled by the NFA. Both registered CPOs and CTAs are subject to CFTC rules and regulations that mandate specific disclosures to alternative fund investors, which include the alternative funds investment strategy regarding the commodities, general information about the CPOs and the CTAs associated with the alternative funds, principal risk factors, and conflicts of interest. CPOs and CTAs are also subject to the CFTC’s and NFA’s periodic reporting requirements to investors and are required to keep specific records.

Registered CPOs and CTAs are also subject to compliance with NFA rules that specify a number of compliance obligations, including rules regarding the use of marketing materials, specific requirements regarding the calculation and presentation of performance information, and rules regarding the creation of written business continuity and disaster recovery plans.

CFTC Rule 4.7 – “Registration Lite”

A registered CPO that manages or advises an alternative fund in which all investors are qualified eligible persons (defined to include qualified purchasers) may claim exemptive relief under CFTC Rule 4.7, which provides relief from compliance with certain detailed disclosure, reporting and record-keeping requirements. CPOs seeking to rely on Rule 4.7 must file a notice of claim of exemption with the NFA and provide certain “boilerplate” investor notices.

A parallel exemption under Rule 4.7 is available for registered CTAs, which similarly obviates various detailed brochure and record-keeping requirements, contingent on a notice of claim of exemption being filed with the NFA and certain boilerplate investor notices being made.

Securities and Exchange Act of 1934

Broker-dealer registration

Generally, individuals or entities that engage in the business of effecting securities transactions in the United States or for US persons are required to register with the SEC as broker-dealers and become members of the Financial Industry Regulatory Authority (FINRA).

However, the SEC has indicated that an investment adviser, such as a manager of an alternative fund, is not required to register as a broker-dealer, provided that the investment adviser:

  • does not receive transaction-based compensation;
  • executes trades though a registered broker-dealer; and
  • does not hold client funds or client securities.

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 a certain public company’s voting equity securities (Schedule 13D or 13G);
  • manage discretionary accounts that, in aggregate, hold USD100 million or more in certain securities (as defined by the SEC) (Form 13F); and
  • manage discretionary accounts trading in national market system (NMS) securities that (i) transact in NMS securities equal to or exceeding 2 million shares or USD20 million during any calendar day or (ii) transact in NMS securities equal to USD200 million during any calendar month (Form 13H).

Privacy and cybersecurity

Gramm–Leach–Bliley Act (GLBA) Regulation S-P and Regulation S-ID provide specific rules requiring how managers handle non-public personal information. Regulation S-P requires that a manager’s written policies and procedures are reasonably designed to:

  • ensure the security and confidentiality of customer records and information;
  • protect against any anticipated threats or hazards to the security or integrity of customer records and information; and
  • protect against unauthorised access to, or use of, customer records or information that could result in substantial harm or inconvenience to any customer.

Regulation S-ID requires managers to implement an identity theft prevention programme that includes policies and procedures reasonably designed to identify relevant red flags for the covered accounts and incorporate them into an identity theft prevention programme.

US Manager

Fund management companies operating in the United States are generally formed as limited partnerships due to US self-employment tax considerations that may make the use of a limited partnership more attractive than using an LLC. As a “flow-through” entity from a US federal income tax perspective, such a management company is generally not subject to tax at the entity level.

US managers often utilise a separate entity to receive any performance allocation or carried interest in its capacity as a GP, which offers several benefits, including flexibility among participants in the economics of each entity. Subject to special carried interest rules, amounts allocated to the GP as carried interest generally retain the character that they would have at the level of the relevant fund (ordinary income, short-term capital gain or long-term capital gain).

Non-US Manager

A non-US manager could become subject to US federal income tax if the manager is doing business in the United States. The determination is based on the applicable facts and circumstances. A management company located outside the United States for which non-US persons perform investment management services from such non-US location would not expect to be subject to US federal income tax (assuming it has no other business activity in the United States). Hiring US employees or leasing office space in the United States would generally be expected to cause a non-US manager to be considered as doing business 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 expecting to have a physical presence in the United States may be advised to form a US subsidiary treated as a corporation for US federal income tax purposes or other separate US entity that has an arm’s-length contractual relationship with the non-US fund manager.

The activities of a US manager may be attributed to a non-US fund for US federal income tax purposes and cause such a fund to have a “permanent establishment” in the United States, unless the manager qualifies as an independent agent. However, if the activities of a fund consist of investing or trading in securities or commodities for the fund’s own account (and do not involve loan origination, acting as a “dealer” in securities or commodities, or similar activities), then the presence of a US manager is generally not expected to cause a non-US fund to be subject to US federal income tax on the income and gain generated by the activity. Similar permanent establishment considerations may apply in non-US jurisdictions with respect to the activities of non-US managers.

A performance allocation, also known as a carried interest, made to a GP or managing member with an interest in the relevant fund is not treated as traditional compensation in the same manner as a fee for services. The character of the allocation of profit as ordinary income, short-term capital gain or long-term capital gain is preserved; provided that, with respect to partnership interests held in connection with the performance of services, capital gain recognised by a partnership on the disposition of an asset that is held for not more than three years is treated as short-term capital gain when allocated to a non-corporate GP or managing member of certain alternative funds. Short-term capital gains are taxed at the same rates as ordinary income.

Alternative fund managers may outsource a substantial portion of their investment functions or business operations.

Use of Service Providers

Certain managers may have a much smaller number of middle- and back-office staff and may choose to rely on an external network of service providers for certain middle- and back-office functions. An external network can provide a manager with many advantages, such as the ability to choose between, and have access to, an array of “expert” service providers. For example, many alternative fund managers retain placement agents to assist in the marketing of funds they advise as well as independent administrators to provide accounting and back-office services (such as investor due diligence).

Managers remain responsible for the oversight of any outsourced investment functions or business operations, as well as ensuring that the firms carrying out such functions or operations are competent and, where applicable, licensed or registered with the appropriate agencies.

For example, placement agents marketing in or from the United States are governed by federal securities laws and the laws of the states in which a placement agent solicits investors. Placement agents are considered “brokers” as such term is defined under Section 3(a)(4)(A) of the Exchange Act. As a broker, placement agents must register with the SEC before selling unregistered securities, including securities that are exempt from registration under Regulation D of the Securities Act. Placement agents must comply with the general solicitation, advertising and supervisory rules of FINRA and the SEC.

Assignment of Investment Management Functions

It is important to note that while a manager may outsource many of their functions or business operations, Section 205(a)(2) of the Advisers Act prohibits the assignment of a client’s advisory contract to another adviser without the client’s consent. “Assignment” is broadly defined by Section 202(a)(1) of the Advisers Act, and includes any direct or indirect transfer of an advisory contract, as well as any transfer of a controlling block of the adviser’s outstanding voting stock by a security holder of the adviser. However, Rule 202(a)(1)-1 provides that transactions that do not result in an actual change of control or management of the manager, such as some business reorganisations, are not “assignments” under the Advisers Act. The determination of whether an actual change of control has resulted from a transaction is an inherently factual determination, and the SEC generally does not respond to no-action letters on this question.

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.

There are no specific local regulatory requirements for non-local managers. See 3.2 Regulatory Regime.

Typically, US investors consist of high net worth individuals, family offices, funds of funds, registered investment companies, corporations, partnerships, trusts, insurance companies, other types of entity investors, foundations, endowments, charitable institutions, and benefit plan and retirement plan investors. There is also significant interest from investors in other jurisdictions. Over the past couple of years, we have seen increased investments by sovereign wealth funds. For example, with respect to hedge funds, while endowment plans and foundations have decreased their allocation (on a relative basis), sovereign wealth funds are allocating to hedge funds more than ever (and are also the most willing of the major investor types to leave their funds locked up and have the lowest return expectations).

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

Regulation D (Securities Act)

As discussed in 2.3 Regulatory Regime, alternative funds typically offer their interests via exempt securities offerings under Rule 506 of the Securities Act. Alternative funds relying on an exemption under Rule 506(b) are prohibited from engaging in any form of general solicitation or general advertising. Regulation D defines advertising 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 general advertising.

Alternative funds relying on the exemption provided by Rule 506(c) may engage in general soliciting or general advertising. See 2.3 Regulatory Regime for additional detail.

In order to rely on the safe harbour provisions provided by Rules 506(b) and 506(c), an offering cannot involve the participation of certain “bad actors” specified under the Rules. In particular, certain covered persons under Rule 506 – including the alternative fund, the fund’s 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 a number of disqualifying events, such as criminal convictions, court injunctions and certain regulatory or disciplinary orders.

Placement Agents and Solicitation Arrangements

Many alternative funds use third-party placement agents or “finders” to solicit potential investors. These parties generally are required to be appropriately registered or qualified as broker-dealers at the federal and/or state level. Fund managers should be wary of engaging unregistered parties as “finders”, as the finders’ services may involve solicitation and marketing activities that require such persons to be registered broker-dealers. Sales of fund interests by unregistered persons may be subject to rescission rights under the Exchange Act. See 3.6 Outsourcing of Investment Functions/Business Operations.

Cash Solicitation Rule

Advisers Act Rule 206(4)-3, the Cash Solicitation Rule, requires that an investment adviser that utilises solicitors to provide clients with certain disclosures and documentation. Private fund advisers generally had not been required to comply with the Cash Solicitation Rule given it applied to the solicitation of fund advisers or referral of “clients” to advisers, which in the context of a private fund adviser applied to the private fund itself and not its investors. Under the amended SEC marketing rule (see below), the Cash Solicitation Rule requirements extend to solicitation of private fund investors.

Marketing Rule (Advisers Act)

Advisers Act Rule 206(4)-1 (the “Marketing Rule”) is the primary federal regulation governing the marketing communications of fund managers, including managers of alternative funds. The Marketing Rule defines what constitutes an advertisement and describes what types of marketing activities or advertisements are permitted or prohibited. The Marketing Rule governs the activities of not only the fund managers, but also third-party solicitors or placement agents engaged by the managers.

In December 2020, the SEC adopted a new “modernised” marketing rule (the “New Rule”) that will affect many aspects of alternative fund marketing. The New Rule amends and consolidates the current Marketing Rule and Cash Solicitation Rule, discussed above, which have not been substantively amended since they were adopted in 1961 and 1979, respectively. Managers must comply with the New Rule by 4 November 2022.

Marketing to Federal, State and Local Governments

An alternative fund manager registered with the SEC that has government entities (such as pension funds) as investors in its funds or solicits such entities to invest (through internal marketing personnel or external placement agents) must comply with SEC Rule 206(4)-5, the Pay to Play Rule. The Pay to Play Rule prohibits an investment adviser from receiving management fees for a two-year period after the adviser or certain of its personnel makes a political contribution to an official of a government entity that is in a position to influence the award of advisory business to the adviser.

The SEC’s Pay to Play Rule does not pre-empt the pay-to-play requirements that have been adopted by numerous states and local governments; therefore, alternative fund managers also need to address compliance with potential limitations on certain types of political contributions that arise under such laws. For example, state law may require a fund manager’s personnel to register as a “lobbyist” in that jurisdiction. Fund managers will need to carefully consider the SEC and the state/local restrictions to ensure that they are in full compliance.

CPO-Associated Persons

Like registered investment advisers, CPOs and CTAs must comply with marketing rules promulgated by the NFA. In particular, the NFA requires that certain principals and associated persons of CPOs and CTAs undergo background checks and pass the Series 3 licence (administered by FINRA) if they are engaged in certain marketing activities for a CPO or CTA.

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

Managers must generally follow a certain regulatory approval process in the United States to offer alternative funds, as discussed in 2.6 Regulatory Approval Process. Managers are also generally required to follow the marketing rules discussed in 4.3 Rules Concerning Marketing of Alternative Funds.

The identity of investors is not required to be disclosed under US law. Certain US alternative funds are commonly formed as limited partnerships in the State of Delaware. Under Delaware law, each limited partner has the right to obtain information reasonably related to its interest as a limited partner, including the right to access the books and records of the fund. An alternative fund’s governing documents typically contain provisions restricting the disclosure of certain fund and investor information to other investors. Disclosure requirements are typically mandated by US federal laws, GLBA, AML, ERISA, US taxing authority and/or other regulatory requirements.

US Federal Laws

Certain state pension plans and governmental investors are subject to the US Freedom of Information Act (FOIA) and therefore may be required to publicly disclose certain information regarding investors in response to requests made by third parties.

Additionally, federal laws, such as the Corporate Transparency Act, may also require the disclosure of investor information such as the investor’s name, date of birth, current address and unique identification number.

Gramm–Leach–Bliley Act

The GLBA permits disclosure of an investor’s identity in certain circumstances, generally to persons related to the fund and its operations. The GLBA also requires that investors have the ability to opt out of an alternative fund’s sharing of their non-public personal information with unaffiliated third parties. California and New York have similar statutes governing the disclosure of investors’ personal information. Alternative funds are also subject to privacy notice delivery requirements, which describe how they use investors’ non-public personal information and investors’ rights to opt out.

Federal and State Taxing Authorities

Alternative funds may be required to disclose certain investor information as part of their federal and state tax filings. A US fund that is 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 manager must typically file tax returns in the United States if it is deemed to have earned US effectively connected income (ECI). Alternative funds may also be required to disclose identifying information as part of the fund’s compliance with the Foreign Account Tax Compliance Act (FATCA).

Anti-money Laundering (AML)

During regulatory examinations, the SEC staff routinely request information from alternative fund managers regarding AML compliance policies and procedures, which may include the identity of fund investors.

Regulatory Disclosures

In certain instances, the SEC or CFTC may require the disclosure of the identities of “beneficial owners” of investors in alternative funds. During regulatory examinations, the SEC Division of Examinations staff routinely request investor lists from managers specifying the investor’s name, address, capital account balance and investment positions. Managers may also be required to disclose certain investor information if they are subject to a subpoena by the SEC or CFTC.

Different US federal income tax rules and tax rates apply depending on the tax status of the investor, the source and type of income and gains generated, and the tax status of the fund.

Tax-Exempt US Investors

Tax-exempt US investors – such as charitable organisations, pension funds, private foundations and individual retirement accounts – are generally exempt from US federal income taxation except to the extent that they earn “unrelated business taxable income” as defined in the US Internal Revenue Code of 1986, as amended (the “Code”), which commonly arises for such investors when an alternative fund that is treated as a partnership for US tax purposes (i) obtains financing to acquire its investments or (ii) invests in an operating business with trade or business activity that is also treated as a partnership (or other “flow-through” entity) for US federal income tax purposes.

Non-corporate Taxable US Investors

Although tax rates are subject to change, the current maximum ordinary income tax rate for individuals is 37% and, in general, the maximum individual income tax rate for “qualified dividends” and long-term capital gains is 20%. An individual may be entitled to deduct up to 20% of such individual’s “qualified business income” each year, although income from alternative funds is often not expected to constitute qualified business income. In addition, individuals, estates and trusts are subject to a Medicare tax of 3.8% on “net investment income”. Various limitations apply to 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. Certain limitations depend on whether a fund takes the position that it is an “investor” or a “trader” for US federal income tax purposes.

Corporate Taxable US Investors

A typical corporate US investor is subject to entity-level US federal income tax at a rate of 21%. Corporate investors are not subject to all of the same limitations on the deduction of losses and expenses as non-corporate investors. Capital losses of a corporate taxpayer may be offset only against capital gains, but unused capital losses may be carried back three years (subject to certain limitations) and carried forward five years.

Non-US Investors

A non-US investor that receives an allocation or distribution of certain types of US-source income from a fund that is treated as a partnership for US tax purposes is generally subject to US withholding taxes of 30% (subject to reduction under an applicable income tax treaty) on such gross income (typically, non-business income such as dividends, certain dividend-equivalent income and certain interest income). Foreign governments and sovereign wealth funds may claim an exemption under Section 892 of the Code from such US withholding tax.

Capital gain of a non-US investor is not generally subject to US withholding tax unless it is attributable to the disposition of a US real property interest, including the disposition of stock or securities (other than debt instruments with no equity component) of a US real property holding corporation.

Non-US investors are also subject to regular US federal income tax on any income and gains that are “effectively connected” with the conduct of a US trade or business. For example, loan origination by a fund may be treated as generating ECI. Effectively connected earnings from a fund that are allocated to a non-US corporate partner may also be subject to a “branch profits tax”. US funds with non-US investors are subject to withholding and reporting obligations with respect to such investors.

Under FATCA, in order to avoid a US withholding tax of 30% on a non-US investor’s share of certain payments made with respect to certain actual and deemed US investments, (i) such non-US investor will generally be required to provide identifying information with respect to certain of its direct and indirect US owners, or (ii) if such non-US investor is a “foreign financial institution” within the meaning of Section 1471(d)(4) of the Code, such non-US investor generally will be required to register with the Internal Revenue Service in a timely manner and identify and report information with respect to certain direct and indirect US account holders (including debt holders and equity holders).

Non-US funds also have reporting and registration obligations under FATCA. Different and/or additional rules may apply to foreign financial institutions located in jurisdictions that have an intergovernmental agreement with the United States governing FATCA or that are subject to the Organisation for Economic Co-operation and Development’s Standard for Automatic Exchange of Financial Account Information in Tax Matters (the Common Reporting Standard, or CRS). The United States is not a party to the CRS.

Schulte Roth & Zabel

919 Third Avenue
New York
NY 10022
USA

+1 212 756 2000

+1 212 593 5955

stephanie.breslow@srz.com www.srz.com
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Trends and Developments


Authors



Schulte Roth & Zabel (SRZ) 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 and John Mahon for his input regarding recent SPAC market activity.

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

COVID-19

The past year and a half has been dominated by the spread of COVID-19, quarantines, variants, political debate and fiscal stimulus. The current political and economic environments, as shaped by this pandemic, brought to the alternative funds space challenges, which were generally fleeting and easily overcome, and opportunities that will shape the future of private fundraising and investment.

The pandemic’s most long-lasting structural change is likely the reduction in travel and the need to adapt to a world in which in-person diligence may not always be practical, or even necessarily desired. Initially, new fund managers were particularly disadvantaged by the inability to conduct in-person diligence; however, as quarantines and restrictions on travel persisted, investors became more flexible. As noted by Preqin, according to Alex Brooks of Capstone Partners, 76% of investors (limited partners, or LPs) were able to complete a full virtual underwriting of an alternative fund sponsor (general partner, or GP) they met pre-COVID and, more importantly, 37% completed a full virtual underwriting of a GP they had never met in person. LPs have gone so far as to amend their investment policies to allow for a full virtual underwriting where necessary to commit to a highly desirable GP.

Of course, continuing well-established trends, large asset managers with established LP bases have continued to grow their market share. Ares Management Corporation recorded its fastest growth in assets under management in over a decade, supported by a record USD41 billion in gross commitments. CVC Capital Partners raised the largest fund of the year at EUR21.3 billion and Ardian raised the second largest at USD19 billion, with an extra USD5 billion in co-investments. However, overall fundraising in 2020 was down compared to 2019 and the total number of funds closed was also down. 2021 seems to be continuing the trends of 2020.

Large asset managers gain market share

The authors expect that the trend over the past 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. For instance, first-time fund managers raised 15% less in 2021 than in 2020. Furthermore, while the debate continues as to whether private equity, after fees and expenses, outperforms the public markets, LPs have made it clear that they now intend to either maintain or increase their allocations to alternative investments and the private markets. In fact, LPs have particularly noted the benefit of investing in a “crisis vintage”, noting the outperformance of the funds raised in the wake of the global financial crisis of approximately a decade ago.

Evolution of deal activity

While the potential for opportunistic investing has increased, and may have served to support some fundraising in an overall down year, private equity deal activity in 2020 was down. Acquisition volume was down 5% from 2019 and aggregate value was down 7%. However, the latter half of 2020 indicated a recovery on the horizon as deal activity was up relative to the earlier part of the year. Reversing a different trend, aggregate exit value was up overall in 2020, though exit activity was still down by number relative to 2019, continuing a trend that began in 2018. The rebounds in the public markets allowed for an increase in IPOs (which exceeded the numbers of both 2018 and 2019), and sales of portfolio companies to other private equity funds (including continuation funds) remained healthy, though down from a relatively strong 2019.

On the other hand, venture capital saw robust growth in 2020, with aggregate value of consummated investments up 3% from its prior peak in 2018 and up 21% relative to 2019. In particular, the healthcare and information technology sectors saw robust investment growth. Furthermore, special purpose acquisition companies (discussed further below) saw continued investment and expansion, notwithstanding increased SEC scrutiny and attempts to cool an extremely hot market.

While it may have been expected that COVID-19 would cause deal activity to be volatile overall, consistent with recent history, the volatility was generally witnessed in the venture capital space, with relatively minor fluctuations in the larger private equity space. As continuation funds and other creative means to provide liquidity while keeping portfolio companies in the hands of sponsors continue to grow, deal activity is expected to remain robust, while seeing growth in the more creative deal structures.

Environmental, Social and Governance (ESG) and Diversity, Equity and Inclusion (DEI)

ESG and DEI have continued to rise in the considerations of LPs. The Institutional Limited Partners Association (ILPA) has made ESG a clear area of focus, and more and more GPs have risen in prominence by explicitly including ESG as part of their investment programmes. DEI concerns continue to be a source of diligence and more moderate encouragement, though DEI’s prominence has gained pace among the large asset managers in their seeding programmes.

ILPA

In August 2021, ILPA published a draft DDQ 2.0 and Diversity Metrics Template, seeking feedback from all interested parties. Consistent with its prior areas of focus, the new DDQ includes brand new sections on GP-Led Secondaries/Continuation Funds, Co-Investments and Credit Facilities, as well as Succession Planning/Key Persons and Data Security. Furthermore, the new DDQ requests the DEI policy (both for the GP and the portfolio companies) and asks enhanced questions regarding governance.

ILPA continues to seek to assist its members as they clearly indicate interest in DEI and ESG as part of their decision-making. However, ILPA has stopped short of requiring any specific requirements from GPs. As adoption of ILPA’s reporting templates has continued, the authors expect to see industry coalescence around ILPA reporting on ESG and DEI reporting as well (it is worth noting that the ILPA limited partnership agreement (LPA) has not gained similar traction). Forward-thinking GPs expecting to raise substantial institutional capital are encouraged to develop such policies and begin the process of incorporating these considerations into their investing activities and businesses as a whole.

GP activism

ESG became particularly interesting and reached broad-based exposure in one of 2021’s biggest “David v Goliath” news stories (and we do not mean the GameStop short squeeze). Engine No. 1, a 0.02% Exxon shareholder, secured three board seats after an activist campaign focused on Exxon’s need to adapt to ESG considerations. The success of Engine No. 1’s campaign should make it clear that LPs (and shareholders generally) are no longer going to be satisfied with non-binding policies and considerations that have already been referred to as mere “greenwashing”, and are focused on change. While Engine No. 1 may have been one of the most prominently featured funds focusing on ESG as a core focus of its investing activities, it is not alone. It is a growing trend for GPs to raise funds or acquire businesses with ESG and DEI as material, if not key, features of the investment thesis.

Employee Retirement Income Security Act (ERISA) and the Department of Labor (DOL)

The DOL has, over the years, issued interpretive bulletins on ESG investing in light of ERISA’s fiduciary rules. The position taken in the interpretive bulletins varied with Republican v Democratic administrations. The Trump administration attempted to end the back and forth by going down the regulatory path, which provides more permanence. Accordingly, the DOL issued a proposed rule regarding ESG with the stated purpose of “providing further clarity on fiduciaries’ responsibilities in ESG investing”.

The proposed rule stated 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 required 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”.

The proposed rule met significant criticism and comments because it was viewed by many in the pension community as inhibiting ESG investing by pension plans. As a result, the final rule eliminated all ESG-specific references inhibiting ESG investing by pension plans and clarified there is no prohibition per se on selecting or considering investment strategies that incorporate ESG so long as this approach is based solely on material economic considerations. However, despite the elimination of the ESG-specific references, many, including the Biden administration, view the final regulation as continuing to inhibit ESG investing by pension plans. Accordingly, shortly after the inauguration, the Biden administration listed the final regulation as one requiring further review and in March the DOL issued a policy statement that it would not enforce the final rule, stating that the rule-making “failed to adequately consider and address the substantial evidence submitted by public commenters on the use of environmental, social and governance considerations in improving investment value and long-term investment returns for retirement investors”.

With LPs, GPs and even the DOL acknowledging the importance of addressing ESG as part of a long-term investment decision, the focus on ESG can only be expected to grow.

Special Purpose Acquisition Companies (SPACs)

While the SPAC is not per se an alternative fund or alternative investment, it provides an interesting intersection of the private and public markets. SPACs look to capitalise on the disparity between private and public markets – 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 this provides an alternative path to a public listing. As a result, alternative asset managers increasingly sought to raise their own SPACs during the past two years, with those efforts reaching a crescendo in late 2020 through the first few months of 2021. During that period, SPAC volume rose exponentially, with new SPAC IPOs raising over USD80 billion in 2020 alone – more than the amount raised by the structure in the preceding decade, rising to an aggregate of USD100 billion through April 2021.

While enhanced SEC scrutiny of the structure generally, coupled with a material decline in post-IPO secondary market demand, has significantly curtailed the SPAC IPO market since the first quarter of 2021, new SPAC IPOs continue to price at high levels, reflecting the ongoing interest in the structure. Furthermore, given the large number of existing SPACs currently looking for prospective target businesses, managers with late-stage venture capital or traditional private equity portfolios continue to look to SPACs as potentially attractive acquirers for mature portfolio positions in lieu of a traditional IPO.

In addition, managers with their own dry powder to invest have looked to SPAC-related investments as attractive options, including at the front end as part of SPAC sponsor vehicle formations, or at the back end as part of a SPAC’s private investment in public equity (PIPE) placement in connection with a proposed business combination. 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. Forge Global, a marketplace for buyers and sellers of private equity interests, has also announced plans to merge with a SPAC sponsored by Motive Capital.

However, the SPAC ecosystem is facing increased headwinds as a result of SEC scrutiny and various litigation brought by the plaintiffs’ bar. In view of the significant increase in SPAC activity in 2020 through early 2021, the SEC has issued multiple alerts and guidance indicating a desire to take a significantly closer look at SPAC transactions and the disclosures made in the public markets. The SEC has further indicated a desire to increase regulatory enforcement of violations of existing law and has even opened the door for a potentially stronger ability for plaintiffs to succeed in private securities litigation against SPAC sponsors and their advisers.

Given the downward pressure the recent regulatory scrutiny and pending litigation has had on new SPAC IPOs generally, the authors expect to see fewer alternative fund managers looking to SPACs as a source of fundraising in the near term, though, as with prior SPAC downturns, we will likely continue to see new SPAC IPOs going forward, albeit at a slower pace. Also worth noting is that once a previously private company is acquired by a SPAC, the company is then public and subject to all the same requirements as any other public company, regardless of the path taken to the public markets. In view of the current iteration of the SPAC model, though, completing an acquisition by a SPAC may continue to be viewed as a less rigorous process than the traditional IPO, barring SEC regulatory actions that may modify the relative difficulty of completing a SPAC business combination. As such, SPACs are likely to remain an attractive means by which alternative fund sponsors take a private company into the public markets.

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, GPs and LPs continue to work together to advance their common goals in ESG and otherwise, and GPs continue to lock up more long-term capital in more and more creative structures, 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
New York
NY 10022
USA

+1 212 756 2000

+1 212 593 5955

joseph.smith@srz.com www.srz.com
Author Business Card

Law and Practice

Authors



Schulte Roth & Zabel (SRZ) 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.

Trends and Development

Authors



Schulte Roth & Zabel (SRZ) 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 and John Mahon for his input regarding recent SPAC market activity.

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