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Main Points
- What are the two types of investors allowed to invest in hedge funds?
- What qualification requirements must these investors meet?
- What structuring requirements must the hedge fund meet?
- Provide a high-level overview of a 3(c)(7) hedge fund and who can participate.
In a previous article, we shared the primary reason hedge funds are not under the thumb of as many regulatory agencies. Why is that so? Because hedge funds are not available to the guy on the street. Individuals interested in alternative investments must meet specific financial criteria, which infer a deeper understanding of investments, what to expect, and the risks involved.
In other words, these individuals or companies are responsible for making investment decisions. Therefore, regulatory agencies are not as concerned and ordinarily only exercise oversight once the fund surpasses $150 million in assets under management (AUM).
However, that's not the end of the story. Another class of investor that many fund managers actively pursue is a qualified purchaser.
Why you can trust this information
Hedge Fund Launch© training has refined the skills of over 900 fund managers with over $2.7 billion AUM combined.
Qualified Purchaser: Definition and Criteria
The Investment Company Act of 1940 defines the requirements to be considered a qualified purchaser, the main points being:
The SEC has set the thresholds for meeting qualified purchaser status:
Individuals must have a minimum of $5 million of invest-able assets, which can be any combination of stocks, bonds, investment properties, commodities, cash, and cash equivalents.
Qualified purchaser status can also include a family business, trust, or institutional investor with a minimum of $25 million in invest-able assets. An important note regarding trusts: all individuals serving as trustees must meet the criteria of being qualified purchasers.
An accredited investor, as defined under the Securities Act of 1933, has a different financial benchmark: a minimum annual income of $200,000 as an individual or $300,000 with a spouse during the past two years. Another necessary clarification is that the $1 million net worth assessment cannot include the value of the primary residence.
Another important note. A qualified purchaser is allowed to invest in a 3(c)(1) hedge fund; however, an accredited investor cannot invest in a 3(c)(7) fund. As a fund manager, you must decide on the filing type and the implications for your marketing efforts.
A 3(c)(7) fund offered as an investment opportunity to qualified purchasers is generally exempt from SEC registration requirements. Of course, the exemption does not mean fund managers can do as they please.
- The manager must comply with any SEC reporting requirements.
- The manager must confirm that a potential investor is a qualified purchaser.
- Permanently retain the investor status due diligence proof.
- Cannot make a public offering of securities.
Given their perceived level of expertise and knowledge, qualified purchasers can engage in opportunities with increased risks and potential rewards. There are opportunities to explore venture capital funding, private equity, and other alternative investments.
Qualified purchasers with substantial capital may expect to secure more favorable terms during negotiations, including reduced fees or increased transaction ownership shares.
Benefits of Targeting Qualified Purchasers
The participation of qualified purchasers can significantly enhance a hedge fund's reputation and contribute to its overall success and stability in several ways.
Enhanced Credibility Reputation
The participation of qualified purchasers can boost a fund's credibility by signaling sophisticated investor confidence in the fund's strategy and management, resulting in positive word-of-mouth within each investor's social circle, fueling social buzz, and generating more fund prospects.
Increased Fund Size and Capital Base
Qualified purchasers typically have substantial investable assets, allowing them to make more significant capital commitments. This increased capital base enables hedge funds to execute larger trades and strategies and potentially generate higher returns through economies of scale.
Improved Fund Stability
Qualified purchasers often provide longer-term capital commitments; they are generally more patient during market downturns, avoiding liquidation challenges for the fund and allowing managers to focus on long-term strategies.
Key factors That Will Attract Qualified Purchasers to Your Fund
Exclusive Opportunities
Access to investment strategies that are not available to retail investors. Strategies like long/short equity, global macro, event-driven, and non-market-associated investments such as commercial real estate. These alternative investments and strategies diversify their portfolio beyond traditional stocks and bonds and offer an opportunity for enhanced returns.
Flexible Portfolio Adjustments
3(c)(1) Hedge funds have fewer regulatory restrictions, allowing them to adapt quickly to changing market conditions. The regulatory environment improves even more with a fund filed as a 3(c)(7). As mentioned, these funds are only available to qualified purchasers who accept greater responsibility for the financial judgment. That said, sophisticated investors are not necessarily gamblers, so they will want to see appropriate risk management techniques if the strategy begins to go south.
Personalized Service and Transparency
High-net-worth investors expect more detailed reporting and tailored investment solutions. They may expect a separately managed account when the investment capital meets or exceeds a certain amount. Another attractive benefit is if your fund can create a sense of prestige and access to an exclusive network. As the saying goes, "Birds of a feather flock together."
Qualified Purchaser Legal and Regulatory Requirements
Even though a 3(c)(7) fund has greater management latitude and less regulatory oversight, fund managers must adhere to a laundry list of standard operating procedures. Also, please note that even when federal exemptions apply, some states may require their notice filings.
Investor Verification
Fund managers must take specific steps to verify that each potential investor meets qualified purchaser status. The fund manager must keep the documentation permanently. Security laws change occasionally, which may require re-verification of qualified purchaser status to maintain compliance.
Disclosure Requirements
The fund manager must provide every investor with a detailed offering memorandum or private placement memorandum, and the investor must sign a delivery receipt. These documents follow a strict outline that discloses all material information, risks, and conflicts of interest. It also requires ongoing reporting to investors on fund performance and material changes.
Anti-Fraud Provisions
All hedge funds are subject to the anti-fraud provisions of federal securities laws, which prohibit making false or misleading statements concerning the offer or sale of securities.
Custodial Rules
SEC Rule 206(4)-2 requires proper custody of client funds. From time to time, surprise examinations by independent public accountants are not unusual. Here's a word to the wise: the day-to-day business operations should always be fully compliant. In the event of a surprise audit, you will be ready.
Performance Fee Restrictions
Qualified purchasers are considered "qualified clients" under the Advisers Act. Allows for charging performance-based fees without restrictions.
ERISA Considerations
Investments from employee benefit plans must comply with ERISA fiduciary standards. Limit employee benefit plan investors to less than 25% of each class of fund equity to avoid ERISA plan asset rules.
Investors' attitude when it involves retirement money differs from discretionary investment capital. The investment world has done a great job of creating an out-of-sight, out-of-mind relationship with a person's retirement funds. Since tapping into these funds is some unknown date on the financial horizon, investors are less inclined to ride herd on these funds, giving fund managers breathing room to concentrate on fund performance.
Here is another nugget of knowledge: an IRA or 401(k) is a trust, not a natural person, so accredited investor or qualified purchaser requirements pierce through to the account holder themselves.
Let's Recap
As you can see, there are quite a few steps to structuring a qualified purchaser 3(c)(7) fund. There are also ongoing compliance and recordkeeping issues. Keeping up with the paperwork may seem overwhelming initially, but like any business, once the systems are in place, it just boils down to regularly updating the records.
Fund launch© will educate you on creating and running a successful hedge fund. We have years of real-world experience and have developed a templated process that will save you buckets of money and shortcut you to reach the exciting day you roll out your fund.
That's why over 900 fund managers have chosen Fund Launch© to hone their skills and implement our proven system that gets them to market fast. To learn more, please visit us at: www.fundlaunch.com/training
