Contributed by Irwin Latner of Stradley Ronon
For years internally managed private funds (IMFs) have been a seldom-used business model which has not proliferated in the private funds industry. Given the current regulatory environment, however, private fund advisers may want to consider forming an IMF that is tailored to their investor base in order to organize and operate their business in a more cost-efficient manner outside the purview of the Investment Advisers Act of 1940 (the Advisers Act) and related SEC regulation and examination.
Current Regulatory Environment for Private Fund Advisers
The current regulatory environment for private fund advisers is one of increasing regulation and supervision, primarily due to a number of recently adopted and proposed new rules by the U.S. Securities and Exchange Commission (the SEC). Unlike advisers to registered investment funds, which are subject to enhanced regulation and compliance requirements under the Advisers Act and the Investment Company Act of 1940 (the 1940 Act), advisers to private unregistered investment funds have long enjoyed a less onerous regulatory regime under the Advisers Act, primarily due to the limited number and greater sophistication of the investors authorized to invest in such funds.
However, the regulatory gap between advisers to registered funds and advisers to private funds appears to be narrowing. In particular, the SEC has recently taken the following actions specifically targeting and/or significantly impacting private fund advisers:
- Adopting a new marketing rule, effective Nov. 4, 2022, with specific standards and requirements for, among other things, performance advertising, use of placement agents, testimonials and endorsements, and new Form ADV disclosures;
- Proposing new investor reporting and disclosure requirements for liquid and illiquid funds, including extensive quarterly reports detailing adviser compensation, fees and expenses and fund performance data;
- Proposing new rules prohibiting certain conflicts of interest transactions and other private fund adviser practices, including the following: (i) reducing a clawback obligation by the amount of any taxes owed; (ii) causing investment-related expenses to be allocated across funds on a non-pro-rata basis; (iii) borrowing from or lending to a private fund client; and (iv) causing a fund to bear expenses associated with a regulatory examination or investigation of the adviser. The proposal also bars certain types of adviser compensation and indemnification practices;
- Proposing new rules requiring fairness opinions in GP-led secondary transactions and prohibiting or restricting certain preferential treatment of fund investors (notwithstanding existing side letter arrangements and disclosure practices);
- Proposing amendments to Form PF reporting for private funds, including (i) decreasing the reporting threshold for large private equity fund advisers from $2 billion to $1.5 billion, as well as requiring more detailed information from such advisers, and (ii) requiring large hedge fund and private equity fund advisers to file current reports within one business day of the occurrence of any of a number of designated reporting events;
- Proposing new cybersecurity rules that would, among other things, require advisers to (i) disclose cybersecurity risks and significant incidents within the last two years on their Form ADV brochure, (ii) report significant cybersecurity incidents to the SEC within 48 hours on a new Form ADV-C, and (iii) develop enhanced and tailored cyber policies and procedures covering oversight of third-party service providers and a number of other items;
- Proposing new rules requiring advisers pursuing environmental, social and governance (ESG) related investment strategies to provide enhanced ESG-related disclosures to the SEC and fund investors; These proposals follow the SEC’s proposal to require extensive climate-related disclosures from public companies and the formation of the SEC’s Climate and ESG Task Force in its enforcement division; and
- Releasing the SEC’s Division of Examinations 2022 examination priorities report (the SEC Report), which focused on various private fund issues, including allocation of fees and expenses, preferential treatment of investors, custody rule compliance, compliance issues around cross trades, principal transactions and distressed sales, and conflicts of interest around liquidity, including GP-led fund restructurings and stapled secondary transactions.
Many of these new initiatives and the SEC’s increased focus on private funds stem from Chairman Gensler’s apparent vision for a more activist and paternalistic SEC that is increasingly advancing a more granular and prescriptive rules-based approach to regulating private fund advisers rather than the traditional principles and disclosure-based approach historically taken by Congress under the Advisers Act and reflected in prior SEC rulemaking. Though there may be sound policy reasons for many of the SEC’s new rulemaking proposals and compliance initiatives, there is no denying that the regulatory burden and related compliance costs and risks associated with being an SEC-registered private fund adviser are on the rise. Regardless of the ultimate outcome and final form of the proposed rules, registered private fund advisers will need to comply with a bevy of new rules and limitations on their activities, and can expect the SEC to pursue an increasing number of enforcement actions as it assumes a more aggressive oversight role.
Accordingly, existing exemptions to Advisers Act registration available for single family offices, foreign private advisers, venture capital fund advisers and small private fund advisers have become more valuable in allowing emerging asset management firms to establish and structure their business in a more cost-efficient manner while still meeting investor expectations. For those investment management groups seeking to avoid Advisers Act registration and related SEC regulation and examination but whose business model may not fit within any of the above exemptions, an IMF may be an attractive option for structuring an investment management business.
What is an Internally Managed Private Fund?
An IMF is generally understood to refer to a private non-SEC registered investment fund that pursues a typical hedge, venture, real estate, private equity or other common private fund investment strategy, but rather than being managed by a separate investment manager or general partner entity, it is managed internally by a board of directors if established as a corporation, or (more commonly) by a board of managers if established as a limited liability company.11 In our experience, an IMF is often best suited for a joint venture fund or club deal (collectively, a JV) or a single investor fund (a SIF) type scenario in which one or a limited number of sophisticated institutional or family office investors engages a U.S. based management team to manage investor assets through an IMF that is internally governed and reflects highly negotiated terms, including capital contribution requirements, permitted withdrawals of capital, investor consent to major decisions, distribution waterfalls and carry participation rights for the management team, investor reporting, liquidation events and other fund like terms. Rather than paying a separate asset-based management fee, however, an IMF typically entails an agreed upon salary for management team members and an approved budget to cover annual operating expenses. Many aspects of an IMF are, therefore, similar to a traditional private fund JV or SIF arrangement that is managed by a separate general partner or investment manager entity.
Though investors in an IMF typically have more governance and information rights than investors in a traditional private fund structure, the IMF management team can typically negotiate its majority or minority representation rights on the board and/or investment committee as well as its compensation, D&O insurance coverage and the other bespoke fund like terms described above. For regulatory reasons, the management team typically would not invest its own capital alongside the investors in an IMF.
An IMF structure is often used by corporate venture arms of public and private operating companies seeking to make strategic technology investments utilizing the parent company’s capital and other resources, which investments are managed either by the parent’s own employees or by an outside management team. In such circumstances, the parent company typically retains voting control and input into investment operations while entering into negotiated compensation arrangements with the internal or external management team.
Advisers Act Analysis (12)
Under the Advisers Act, an “investment adviser” is generally defined as a person who “engages in the business of advising others” regarding securities. The Advisers Act is silent on the treatment of internal directors, managers, officers and employees (collectively, Internal Managers) of investment companies such as an IMF. Commentators have pointed out that the SEC and the industry have long understood that Internal Managers of investment companies are not advisers under the Advisers Act.13 This is mainly due to both the history of the Advisers Act and the fact that Internal Managers typically do not bear the business risk of the enterprise, generally act as a group rather than as individuals, are subject to the oversight of their superiors (in the case of officers and employees) and are subject to state law fiduciary duties (in the case of directors). As outlined in more detail below, other relevant factors include the exclusivity of the services, the lack of investment of personal capital, the non-existence of any marketing or 4 solicitation activities or holding oneself out to the public as providing advisory services, and the sophistication of IMF investors. Overall, the Advisers Act was intended to cover persons who advise clients as part of conducting a separate investment advisory business and was not intended to cover internal corporate relationships. 14
In the case of an IMF structured as a SIF, there is additional support for the exclusion of Internal Managers from investment adviser status based on the analogous precedent of a whollyowned corporate subsidiary exclusively advising the parent company and/or other wholly-owned direct or indirect subsidiaries of the parent. In such circumstances, the SEC has confirmed the lack of investment adviser status for the wholly-owned adviser subsidiary and its management personnel.15 These precedents are substantively similar to a SIF structured as an IMF employing Internal Managers to manage its own assets (i.e., the assets invested by the single investor and controlling equity owner) rather than employing a separate wholly-owned advisory subsidiary for such purpose.
Relevant Considerations for an Exempt IMF
In view of the foregoing, a U.S. management team seeking to partner with one or a limited number of sophisticated institutional or family office investors to form an IMF should consider the following factors, among others, in structuring its business and negotiating the venture’s governing documents in order to assess whether or not the Internal Managers of the IMF are subject to Advisers Act registration:
▪ The ability and willingness of the Internal Managers to provide advisory services exclusively to the IMF and not to any outside persons, and otherwise forego conducting any advisory business apart from the IMF;
▪ Whether the Internal Managers conduct any marketing or solicitation activities or otherwise hold themselves out to the public as providing advisory services;
▪ The willingness of Internal Managers not to invest their own capital in the IMF and otherwise not to assume any downside business risk;
▪ The ability to limit investment discretion to the board or investment committee acting as a group and not to any individual director or committee member;16
▪ Whether the board, the investment committee or both will exercise investment discretion;
▪ The sophistication of IMF investors and their willingness to play an active role in the venture, including negotiating terms and having board representation, an oversight role and consent rights;
▪ Which investor or group of investors are the ultimate beneficial owners and funders of the IMF for regulatory purposes;
▪ The appropriate compensation structure for the Internal Managers;
▪ Whether the IMF is a collaboration between the Internal Managers and investors or involves a more passive relationship;
▪ Whether the Internal Managers provide periodic reports or advice on whether IMF investors should redeem their interests; and
▪ Whether the IMF investors need the protections of the Advisers Act and SEC regulation; 5
Pros and Cons of Forming an IMF
With an increasingly active SEC that has significantly expanded the scope of its regulation and oversight of private fund advisers in recent years (and provides all indications that it plans to continue this trend into the future), investment groups employing a JV or SIF type structure with the proper alignment of investors’ and managers’ interests, may wish to form an appropriately structured IMF with Internal Managers who are not subject to Advisers Act registration requirements and related SEC regulation and examination.
Despite its potential regulatory advantages, an IMF normally entails some limitations and restrictions. For example, an IMF typically cannot manage capital outside of the IMF or provide investment advice to third parties. Its only source of income is attributable to the proceeds of its own investment portfolio. Accordingly, although there may be regulatory advantages to an IMF structure, one disadvantage would be its limited investor base and restrictions on its ability to advise outside clients. Also, due to an IMF’s internalized governance structure, increased investor participation and lack of a separate management fee, an IMF’s management team may have less autonomy over the scope of permitted activities, hiring practices, annual budgets, use of outside service providers, etc. than it would in a traditional hedge fund or private equity fund structure. Similarly, IMF investors should be sufficiently sophisticated and comfortable with overseeing the fund’s management activities and/or participating in the investment process, negotiating customized arms-length terms, understanding the regulatory and compliance risks, and generally being an active partner in the venture.
As noted above, given the JV or SIF type circumstances in which an IMF is typically utilized, other exemptions from SEC investment adviser registration may not be available. For example, the family office exclusion is available only for advisers to single family office clients,17 and the more limited exempt reporting adviser (or ERA) exemption is available only for small private fund advisers (i.e., those with less than $150 million in private fund assets under management and no non-private fund clients) and venture capital fund advisers. 18 Like family office advisers but unlike ERAs, Internal Managers of an IMF who are not investment advisers under the Advisers Act are not subject to the antifraud rules, fiduciary obligations or any other provisions of the Advisers Act and related SEC rules (including certain rules that are applicable to ERAs and other unregistered advisers).
While utilizing an IMF may be advantageous for purposes of avoiding burdensome SEC investment adviser regulation in circumstances in which other exemptions may not be available, an IMF should not be utilized to avoid properly addressing relevant conflicts of interest, fiduciary obligations, disclosure and consent issues, cybersecurity risks and other applicable risk management and compliance issues that would otherwise be required to be addressed by a registered investment adviser. Rather, an investment group that is considering forming an IMF should nevertheless seek to develop an internal legal and operational framework that allows them to achieve their business goals while enacting appropriately tailored risk management and compliance programs suitable for the IMF and its limited and sophisticated investor base notwithstanding the lack of SEC oversight. 6
Although the inapplicability of the Advisers Act to Internal Managers of an IMF is not incontrovertible, there is a sound basis for concluding that the Advisers Act was not intended to cover the types of properly structured SIF and JV arrangements described in this article. In view of the current regulatory environment for private fund advisers, for a SIF or JV business model, an IMF may be an attractive business structure option for management teams and investors seeking to minimize regulatory compliance costs and related risks. This is especially true for emerging managers and spinout management teams who may be more willing and sufficiently flexible to embrace an IMF business model than more institutional asset managers already operating through a traditional registered investment adviser business model.
1 See registration exemptions under sections 3(c)1) and 3(c)(7) of the 1940 Act, which are typically relied upon by most private funds and their advisers.
2 SEC Rule 206(4)-1.
3 SEC Release No. IA-5955 (March 24, 2022), 87 FR 16886.
4 See note 3.
5 See note 3.
6 SEC Release No. IA-5950 (February 17, 2022), 87 FR 9106.
7 SEC Release Nos. 33-11038, 34-94382 and IC-34529 (March 23, 2022), 87 FR 16590.
8 SEC Release Nos. 33-11068, 34-94985, IA-6034 and IC-34594 (June 17, 2022), 87 FR 36654.
9 As stated by the SEC, its enhanced focus on private funds stems, in part, from the fact that (i) registered private fund advisers manage approximately $18 trillion in private fund assets deployed in a variety of fund types, including hedge funds, private equity funds and real estate funds, (ii) there has been a 70% increase in private fund assets under management over the past five years, and (ii) the SEC is seeking to increase protections for investors in pension plans which, in turn, invest in private funds, including working family beneficiaries, charities and endowments, notwithstanding the fact that most pension plans have sophisticated institutional plan fiduciaries who manage their assets. See SEC Report at p. 11.
10 Consistent with its increasingly activist and aggressive approach to regulating private fund advisers, the SEC has brought several enforcement actions in 2022 against private fund advisers, including sanctioning (i) a private equity fund adviser for failing to disclose that it had allocated a disproportionate share of deal expenses to its fund client instead of co-investors in the deal (In the Matter of Energy Capital Partners Management, LP, Advisers Act Release No. 6049 (June 14, 2022)); and (ii) a venture capital fund adviser for misleading investors about its fee practices and for engaging in improper inter-fund loans and cash transfers (In the Matter of Alumni Ventures Group, LLC and Michael Collins, Advisers Act Release No. 5975 (March 4, 2022)).
11 The use of corporate blockers and other tax considerations would apply in structuring an IMF to the same extent as in traditional private fund structuring.
12 This article only addresses federal investment adviser status and not state law investment adviser status, although many states adhere to the federal Advisers Act definition of “investment adviser”.
13 Regulation of Money Managers: Mutual Funds and Advisers – Frankel and Laby (3rd Edition, 2022-2 Supp.). 7
14 See note 13. Note that a general partner of a limited partnership, however, is not treated as an Internal Manager, and the SEC and the courts would normally consider a general partner to be an investment adviser to the limited partnership or its limited partners under the Advisers Act. See Abrahamson v. Fleschner, 568 F.2d 862, 869-71 (2d Cir. 1977), cert. denied, 436 U.S. 905, 913 (1978); and SEC Rule 203(b)(3)-1 under the Advisers Act.
15 See MEAG MUNICH ERGO AssetManagement GmbH, SEC Staff No-Action Letter (Feb. 14, 2014) (MEAG); and Zenkyoren Asset Management of America Inc., SEC Staff No-Action Letter (June 30, 2011) (ZAMA). Note that in MEAG and ZAMA, the SEC did not see any need to look through the wholly-owned advisory subsidiary to its Internal Managers, and treated the parent investor (and not its underlying insureds) as the ultimate beneficial owner of the managed assets for 1940 Act purposes. See also SEC Staff Report on Regulation of Investment Advisers (March 2013) at p. 4.
16 To the extent that an Internal Manager does not exercise investment discretion, there may be an argument that such person does not have “regulatory assets under management” (or RAUM) sufficient to trigger an ERA filing or full investment adviser registration (assuming such person is otherwise considered to be an adviser under the Advisers Act). See Form ADV Instructions, item 5(b)(3).
17 SEC Rule 202(a)(11)(G)-1.
18 See Advisers Act sections 203(l) (venture capital funds) and 203(m) (small private fund advisers), and SEC Rules 203(l)-1 and 203(m)-1. Note that the status of private funds investing in real estate, cryptocurrencies and/or other potential non-securities instruments which may offer similar exclusions from Advisers Act coverage while involving other types of restrictions or regulation, is beyond the scope of this article.