The Investment Company Act of 1940 (“Investment Company Act”) requires registration of an investment company. The Investment Company Act defines an “investment company” as any 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.” Without certain exemptions, all private equity funds, hedge funds and the like (“private funds”) would require registration under the Investment Company Act.
There are two primary exemptions from registration that private funds typically rely on. The first is found under Section 3(c)(1); it exempts a private fund with “not more than 100 persons” and that is not making or proposing to make a public offering of its securities from registration.
The second exemption is found under Section 3(c)(7). This section exempts from registration any issuer whose outstanding securities are owned exclusively by qualified purchasers at the time of acquisition. The term “qualified purchaser” is most commonly defined as “any natural person […] who owns not less than $5 million in investments.” Section 3(c)(7) also allows for a private fund to issue securities to an unlimited number of qualified purchasers.
Both Sections 3(c)(1) and 3(c)(7) have further provisions that allow private funds to recruit additional investors who do not necessarily meet the definition of accredited investor or qualified purchaser. Rule 3(c)(5) under the Investment Company Act excludes certain “knowledgeable employees” of a private fund from the 100 person limitation in Section 3(c)(1) and the qualified purchaser requirement in Section 3(c)(7).
The term “knowledgeable employee” includes executive officers, directors, trustees, general partners, advisory board members and certain people serving in similar capacities with the fund. The term also includes employees of the fund “who, in connection with his or her regular functions or duties, participates in the investment activities of such [private fund] or entities managed by the same manager as the fund … provided that such employee has been performing such functions and duties for or on behalf of the [private fund], or substantially similar functions or duties for or on behalf of another company, for at least 12 months.”
Under previous guidance from the Securities and Exchange Commission, the definition of “knowledgeable employee” was not subject to a bright-line rule and required analysis on a case by case basis. However, on Feb. 6, the Division of Investment Management released a no-action letter in response to a request from a private fund industry group that provides some guidance. In its response, the staff clarified that “a research analyst who researches only a portion of the portfolio of a [private fund] and provides analysis or advice to the portfolio manager with respect to such portion of the [private fund's] portfolio is participating in the investment activities of the [private fund] for purposes of the rule. Accordingly, we believe that such a research analyst could be a knowledgeable employee.”
In addition, the no-action letter further clarified the definition of “knowledgeable employee” to include certain employees of an affiliated management person, most likely a state- or SEC-registered investment advisor. This expanded definition is limited to certain investment advisor representatives who directly participate in the investment activities of covered separate accounts. A covered separate account refers to a separate account or a portion of a separate account for qualified clients who are invested in strategies that are similar to those pursued by the private funds managed by the investment advisor. The logic behind this interpretation is that if the knowledgeable employee is conducting due diligence on similar funds or strategies, then he or she should be qualified to invest in those same or similar strategies.
Before relying on the new no-action letter or the previous definitions of “knowledgeable employee,” it is highly recommended that a private fund seek out legal counsel so as not to jeopardize its exemptions under the Investment Company Act.