November 11, 2016

Private Fund Marketing

By Jason Cholewa, ALPS Alternative Investment Services, LLC

Private Fund Marketing Assurance

It is a common misconception that only third party marketers need to register as broker-dealers. There are situations, where capital raisers employed by investment advisors will also be subject to the same requirements. Many hedge fund and private equity fund managers have been under the assumption they are exempt from these registration rules due to the fact that they are marketing securities that are exempt from registration under the Securities Act of 1933. Although this may be the case in certain circumstances, it is important to understand when the exemptions do not apply and the ramifications of non-compliance.

Private fund investment advisors have seen an increase in regulatory requirements over the past several years in the form of both new laws and a heightened focus on certain older rules that previously flew under the radar; the broker-dealer requirements for private fund managers fall under the latter category. It is important to understand when investment advisor employees’ actions trigger broker-dealer registration requirements and how those individuals’ roles can be structured to either meet the exemption rule or possibly take advantage of broker-dealer registration.

What is the Requirement?

The requirement essentially comes down to how a private fund (or any security) is marketed. As Section 15(a)(1) of the Securities Exchange Act of 1934, as amended, states, if any person acts as a “broker” or “dealer” in securities in interstate commerce, then they are required to register as a broker-dealer with the SEC. But what does it mean to act as a “broker” or “dealer”? In 2013, the then Chief Counsel of the Division of Trading and Markets for the SEC made comments on exactly what the SEC is looking for regarding how this rule relates to private funds. If a private fund manager either employs individuals primarily for marketing the fund or pays transaction-based compensation for selling interests in a fund, then broker-dealer registration may be required.

In 2013, the SEC took action against an investment advisor and one of its employees because that advisor paid transaction-based compensation to an individual that was soliciting interests in a private fund and was not properly registered. The employee was paid a percentage of assets raised and his activities included sending private placement memoranda, subscription documents, and due diligence materials to potential investors. Furthermore, the employee urged at least one investor to adjust his portfolio allocation to allow for an investment in the fund and provided several investors with fund strategy and performance information. Unfortunately, these all sound like fairly common practice activities for marketing or investor relations staff. Most private fund investment advisors are not registered as broker-dealers, so how do they get around the rule? They are either out of compliance, outsourcing their broker-dealer activities, or utilizing an exemption to the rule.

What about the Exemption?

Rule 3a4-1 of the Exchange Act provides a limited issuer exemption, which may allow an investment advisor and its employees to engage in limited sales activities without broker-dealer registration. There is a lot that goes into how one utilizes the limited issuer exemption, but generally, if an employee of an investment advisor has primary job responsibilities outside of selling interests in the hedge or private equity fund, limits his or her activity to institutional contact, and is not compensated based on selling interests in the fund, then the exemption may apply. A clear example of proper use of the exemption would be the portfolio manager of the fund. It is reasonable to assume the portfolio manager’s primary job responsibility is making investment decisions on behalf of the fund and typically, the manager’s compensation is based on fund performance, not on the sale of a security. Under this type of scenario, it is generally deemed acceptable for a portfolio manager to speak with institutional investors without requiring licensing as a broker or dealer. The exemption becomes more questionable when looking at marketing staff of a hedge or private equity fund. Is the sole or primary function of the marketing staff to raise capital, or do they have other duties or a different primary function? How are those employees compensated? Do they have a discretionary bonus or is that bonus in some way tied to capital raising? These are the questions that every investment advisor needs to work through with their attorneys to ensure they are in compliance with the rule and are properly utilizing the exemption.

A more unambiguous instance of where the exemption would not apply is if the investment advisor has investment funds registered under the Investment Company Act of 1940, as amended (e.g. mutual funds or ETFs), as well as private funds, and the same individuals are marketing both the registered funds and the private funds. Anyone marketing a registered fund that does not fall within the Issuer Exemption also needs to be licensed. Once registered with a broker-dealer for that purpose, they are no longer eligible for the Issuer Exemption as related to private fund marketing and the broker-dealer becomes liable for oversight of all securities activity. As a result, any communications, including the provision of marketing materials for private funds, must be supervised by the broker-dealer and those communications must meet certain standards under FINRA rules.

What if the Exemption does not Apply?

If one or more of the investment advisor’s employees cannot rely on the exemption, then that employee will need to acquire a Series 7 or Series 82 license, register with the Financial Industry Regulatory Authority (“FINRA”), and be affiliated with a broker-dealer. Some private fund managers have made the decision to create their own broker-dealer and manage the process internally. Since this can be a burdensome venture, other managers have elected to affiliate with third party broker-dealers to meet these requirements. Typically in this type of setup, the third party broker-dealer acts as a marketing agent for fund offerings and the relevant investment advisor’s employees become licensed with the third party broker-dealer as a registered representative. This allows those individuals to market the fund and be compensated based on capital they have raised, while allowing the third party broker-dealer to provide all of the compliance oversight required by FINRA.

There are potential benefits if an investment advisor chooses this arrangement. Investors may appreciate the fact that things are “done right” by a regulated entity and the firm may be able to demonstrate broader operational oversight. Additionally, marketers would now be eligible to be paid transaction-based compensation. This means that the investment advisor would be able to directly compensate the individuals based on capital raised. This could be a more appealing compensation structure and could further align these individuals’ interests with that of the relevant firm.

Since the SEC’s comments in 2013, we have seen heightened awareness to this issue. Because ALPS has a broker-dealer approved for private placement activity and has been overseeing the activities of hundreds of registered representatives for decades, we’ve been in a unique position to get a feel for industry sentiment. It seems with the SEC focusing on investment advisor marketing activities, a number of private fund managers have taken a closer look at their own staff and are readdressing broker-dealer registration requirements. This is a trend that has been increasing and does not seem to be slowing down any time soon. It would be prudent for any private fund manager that is unsure of their situation to speak with counsel about their particular situation and ensure they are in compliance with the securities laws applicable to the marketing of private funds. With several major enforcement actions against private fund advisors, it appears the discussion is not simply an academic one, but a valid area of concern that needs to be addressed.

Jason Cholewa
ALPS Alternative Investment Services, LLC
Jason Cholewa heads East Coast business development for ALPS Alternative Investment Services, LLC and provides market-facing support for ALPS Distributors, Inc. Prior to this, he was instrumental in opening ALPS’ Boston office and was responsible for building the staff and overseeing all administration services and operations on the East Coast. ALPS is focused on providing a suite of asset servicing and asset management solutions to the investment management industry. Clients successfully leverage both aspects of ALPS, to combine a top-rated fund servicing model with the expertise needed to develop new products.

Related Services

Assurance, SEC Services, SEC Advisory

Related Industry

Alternative Investments