Determining Whether a Client Can Invest in a Private Investment

I often receive questions from investment advisers on whether their clients can invest in a hedge fund, private equity fund, private company or some other type of private investment. For purposes of this article, I refer to them all as “private investments”. For example, clients will ask “can John Doe’s Trust invest in 123 Capital, LP?” My inevitable answer is always let me review the law and the offering documents and get back to you, because the federal securities laws are a nightmare in this area.

Federal securities laws require investors to meet certain qualifications in order for the securities transaction in question to be exempt from registration. These exemptions are found in two bodies of law–the Securities Act of 1933 (the “Securities Act”) and the Investment Company Act of 1940 (the “1940 Act”). Issuers of these investments have to be careful not to disregard these laws or else they could be found to have engaged in public offerings of non-exempt securities or investment companies, which would have a pretty draconian impact on their business.

The Federal Securities Laws

In practice, the Securities Act exempts from registration securities offered exclusively to “accredited investors”. The 1940 Act permits investment by (i) up to 100 “accredited investors”, or (ii) an unlimited number of “qualified purchasers”, in a pooled investment vehicle without registering as an “investment company”. The Securities Exchange Act of 1934 could also require registration if an issuer has a class of equity securities “held of record” by 2,000 persons.

Where to Begin?

The starting point in conducting analysis on whether a client can invest in a private investment should always be the investment’s governing documents. You should review the partnership agreement or operating agreement, the investment’s offering memorandum, and any subscription agreement that the client will need to execute in order to make an investment. These documents will typically describe what qualifications the investor must maintain in order to be eligible to invest. As alluded to above, these qualifications are determined based on business and regulatory considerations. You will want to primarily search for the terms “accredited investor” and “qualified purchaser”.

Identifying the Standard

The easiest and best place to begin in determining the standard for investment is the investor questionnaire that is usually part of the subscription agreement. As examples, click here and here. You should always be able to determine what the standard is by reviewing the subscription agreement.

Determining Client Eligibility

Once you have identified the standard required of an investor, then you must determine whether your client meets that standard. In a high percentage of instances, you will review a subscription agreement and know pretty quickly whether your client is eligible to invest.

Is your client an “accredited investor”?

Rule 501 of Regulation D under the Securities Act sets forth which investors qualify as “accredited investors”. The determination is made “at the time of the sale of the securities to that person”. While not an exhaustive list, the definition includes:

(1) banks, savings and loan associations, broker-dealers, insurance companies, registered investment companies,

(2) government benefit plans having assets in excess of $5,000,000;

(3) employee benefit plans if the investment decision is made by a fiduciary that is a bank, savings and loan association, insurance company, or registered investment adviser,

(4) employee benefit plans with total assets in excess of $5,000,000 ,

(5) employee benefit plans where investments are self-directed so long as investment decisions are made solely by persons that are accredited investors;

(6) nonprofit organizations (so long as they are not formed for the specific purpose of acquiring the securities offered) with total assets in excess of $5,000,000;

(7) Any natural person whose individual net worth, or joint net worth with that person’s spouse, exceeds $1,000,000 (the “accredited investor net worth test”).

(8) Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year (the “accredited investor income test”);

(9) Any trust, with total assets in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a person with knowledge and experience in financial and business matters that is capable of evaluating the merits and risks of the prospective investment; and

(10) Any entity in which all of the equity owners are accredited investors.

Is Your Client a “Qualified Purchaser”?

Rule 2(a)(51) under the 1940 Act defines who is a “qualified purchaser”. This determination is also made at the time of acquisition. While not an exhaustive list, the definition includes:

(1) any natural person who owns $5,000,000 in investments (the “qualified purchaser investment holdings test”),

(2) any company that owns $5,000,000 in investments and that is owned directly or indirectly by or for 2 or more immediate family members (the “family member test”);

(3) any trust that is not covered by the family member test and that was not formed for the specific purpose of acquiring the securities being offered, so long as the trustee or other person authorized to make decisions with respect to the trust, and each settlor or other donor of property to the trust is a qualified purchaser; and

(4) any person, acting for its own account or the accounts of other qualified purchasers, who in the aggregate owns and invests on a discretionary basis, not less than $25,000,000 in investments.

Fuzziness Surrounding Standards

Most lawyers, compliance officers, and people who routinely invest in private investments don’t have issues determining the status of a person as an “accredited investor” or a “qualified purchaser” where they are advising investors who are natural persons (i.e., Joe or Nancy Smith) and they clearly meet the accredited investor net worth test, the accredited investor income test, or the qualified purchaser investment holdings test. However, the other standards all require a bit more analysis which will inevitably be covered in future posts.

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