The Simplest Fund

Emerging managers don’t have the time or resources to deal with risky and complex regulations. Three simple rules will keep you safe from regulations and focused on your fund.

When you’re launching an investment fund of any sort, you’re heading into highly regulated, legally risky territory. You’re opening an investment company (your fund), acting as an investment adviser (the manager of your fund), and selling securities (LP interests in your fund). All three of those activities are regulated by the federal government and the states, and penalties for violating those regulations can be harsh.

Larger, more established funds have plenty of money from management fees to deal with these regulations - they can afford general counsels, back office compliance officers, and outside professionals to keep them safe. But the average emerging manager is operating on a shoestring budget, often without any staff, so grappling with complex regulations isn’t possible.

So how do you jump into a highly regulated field when you don’t have the time or resources for compliance? You stay in the (officially sanctioned) loopholes - called “exemptions”. Luckily, if you follow just three rules, your fund will likely be exempt from just about every regulation, and avoid almost all compliance-related tasks - the simplest fund possible.

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And if you’re serious about launching a fund and want to understand how other emerging managers handle compliance, schedule a call with me here. My law firm, Lidow PC, exclusively works with emerging managers and focuses on their unique fund formation and compliance needs.

Some (very quick) background

Federal and state regulations are structured around “registration” - lengthy and time consuming public disclosures that need to be regularly reviewed and updated. “Compliance” for an investment fund mostly consists of three registration requirements:

1. registration of securities,

2. registration of investment companies, and

3. registration of investment advisers.

At the federal level, these 3 things need to be registered with the SEC. At the state level, securities and investment advisers usually need to be registered with state agencies unless they’re registered with the SEC. The regulatory goal of the emerging manager is to avoid registration.

Three rules to avoid registration

Rule 1: focus on direct venture investments.

VCs are good at lobbying. We know this because venture capital has special exemptions from two of the three federal statutes that emerging fund managers need to worry about: the Investment Company Act and the Investment Adviser Act. Most importantly, classic venture firms are exempt from registration under the Investment Adviser Act, no matter how much money they manage.

To qualify as a venture fund, your fund needs to:

• hold itself out as a pursuing a venture strategy,

• invest at least 80% of its AUM in securities purchased directly from startups,

• avoid leverage (investing borrowed money), and

• prohibit LPs from withdrawing before the end of the fund.

Many (although not all) states mirror this exemption in their own regulations, so often being a VC is good enough to exempt you from 1 of the 3 registration requirements (investment adviser).

Rule 2: raise money from well-off first or second degree connections.

Selling securities in the US is a tricky thing to do. The federal and state governments, upset about the great depression, enacted burdensome laws to reign in the selling of securities. Under those laws, sales of securities (including LP interests in an investment fund) need to be registered with the SEC unless an exemption applies, and registration of securities is extremely costly and time consuming.

Luckily, the federal government and the states were mostly concerned with protecting the general public from fraud, and there are exemptions available for “private placements” of securities. The one that’s most commonly used by emerging managers allows you to raise an unlimited amount of money, as long as you’re doing it from “accredited investors” and without “general solicitation”.

What this means in practice is: if you’re raising money from first or second degree connections who likely have at least $1M in net worth, not including their house, you won’t have to worry about registering any securities.

If you follow Rules 1 and 2, you don’t have to worry about registering securities or registering as an investment adviser. That’s 2 of the 3 forms of registration that emerging managers need to deal with - you only need one more exemption.

Rule 3: don’t exceed 100 investors.

The final registration requirement you need to avoid through an exemption is investment company registration. Investment companies - companies whose business is investing in securities - have often been used to commit fraud and steal from their customers. To address that tendency, congress adopted the Investment Company Act, which requires investment companies to register with the SEC unless an exemption applies.

As with security sales and investment advisers, there are a handful of exemptions to registration under the Investment Company Act. The one that’s used by almost all emerging managers applies to funds that have no more than 100 “beneficial owners” (or 250 if you’re a venture fund with under $12M AUM). In most cases, that means that you should have no more than 100 investors in your fund. If you have a fund-of-funds as an LP, that counts as 1 beneficial owner unless it holds 10%+ of your voting partnership interests or was formed for the purpose of investing in your fund - if either of those apply, then you have to count each beneficial owner of the fund-of-funds as a beneficial owner of your fund.

Some final notes

Following these three rules will almost always make a fund exempt from the 3 forms of registration that make up the bulk of "compliance” for a fund. But:

• Just because you avoid registration doesn’t mean that you don’t have to do anything for compliance. There are still some forms to file, boxes to check, and policies to adopt when you sell securities or act as an investment adviser, even if you’re exempt from full registration. But the remaining forms are pretty easy and cheap to manage - well within the resources of even tiny emerging managers.

• Following these three rules is one way to avoid high compliance overhead from registration, but it isn’t the only way. If you’re starting a fund and can’t follow one of these rules - don’t worry. There are many other ways to avoid registration and keep your compliance costs low.

Thanks for reading! If you’re an EM or aspiring-EM and need help launching or running a fund, schedule a call with me here. My law firm, Lidow PC, is devoted to working with EMs like you.