Marketing A Private Equity Company

MARKETING STRATEGIES FOR PRIVATE INVESTMENT COMPANIES Ron S. Geffner, Esq. Sadis & Goldberg LLC 463 Seventh Avenue, Suite 1601 New York, New York 10018 Telephone: (212) 947-3793 Facsimile: (212) 947-3796 JANUARY 2000 SADIS & GOLDBERG LLC JANUARY 2000 v arious publications estimate that there are anywhere from 3,200 to 5,500 separate hedge funds in existence, with assets under management totaling between $200 billion and $300 billion. Hedge funds are being organized at a rate of more than one per day. Due to the Long-Term Capital debacle, regulators and the press have focused more attention on the hedge fund industry than ever before and we have all learned that these estimates appear to be greatly under estimated. 1 As a result of the dramatic growth of this industry and some of the recent negative publicity, money managers are experiencing increased competition to obtain new investors. The information in this guide is aimed at providing money managers with methods by which to solicit new investors. This guide is a partial reproduction of a desktop reference being designed by our firm to be utilized by money managers seeking to market hedge funds within the confines of the federal and state securities laws. It is aimed to assist those persons who are forming hedge funds, as well as those persons currently managing existing hedge funds. This desktop reference is organized into four sections: I. II. III. IV. Acceptable Methods of Marketing Information That May be Provided to Prospective Investors Issues Concerning Investors Other Issues 1 The New York Times Magazine, January 24, 1999, How the Eggheads Cracked, Page 24. SADIS & GOLDBERG LLC JANUARY 2000 SADIS & GOLDBERG LLC I. JANUARY 2000 ACCEPTABLE METHODS OF MARKETING A. Overview of the Prohibition of General Solicitation A hedge fund and any person acting on its behalf may not offer or sell its securities by any form of “general solicitation” or “general advertising,” including but not limited to the following: $ $ Any advertisement, article, notice or other communication published in any newspaper, magazine or similar media or broadcast over television or radio; and Any seminar or meeting whose attendees have been invited by any general solicitation or general advertising. To prevent the staff of the United States Securities and Exchange Commission (the “SEC”) from deeming your solicitation to be a general solicitation, the following elements are required: $ $ There be an existing prior relationship between the hedge fund and the prospective investor prior to the solicitation; and At the time an investment is made, the hedge fund has knowledge regarding the sophistication or financial condition of the prospective investor. Substantive pre-existing relationships may be established with persons who provide satisfactory responses to questionnaires that furnish the money manager with sufficient information to evaluate each prospective investor’s level of sophistication or financial condition. It is not necessary for prospective investors to have previously invested with the money manager. In the case of any relationship established as a result of a general solicitation or advertisement, however, it is important that sufficient time elapse between the establishment of the relationship and an offer so that the offer will not be considered to be made by general solicitation or advertising. 2 2 E.F. Hutton & Co., Inc., pub. avail. Dec. 3, 1985. SADIS & GOLDBERG LLC B. 1. Forms or Methods to Contact Prospective Investors The Internet JANUARY 2000 Money managers may post information on a web site, provided: $ $ $ The site is password protected; The site is only available to prospective investors that complete a questionnaire establishing that they are “accredited investors”; and The prospective investors are required to wait 30 days following their qualification to access the site before investing in any of the posted funds (other than funds in which such prospective investor already has invested, has already been solicited or is already considering as an investment opportunity). 3 2. Solicitors - Third Party Marketers A money manager, regardless of whether the money manager is registered as an investment adviser, may engage solicitors (also commonly known as third party marketers) to introduce the money manager to prospective investors. Solicitors normally enter into a referral fee agreement with the money manager, whereby the solicitor receives a monthly fee (presumably, for reimbursement of expenses), a percentage of the performance fee generated, if any, as well as the management fee, from any investor introduced to the money manager by the solicitor. Although referral fee agreements may be terminated by either party, referral fee agreements usually require the money manager to continue paying the solicitor the percentage of income generated from the performance fee and management fee charged to the investor introduced by the solicitor, until such time that the investor no longer maintains an investment relationship with the money manager. Solicitors are subject to the same legal limitations, however, as the money manager and its employees and affiliates, with regard to marketing a hedge fund. In order to receive compensation from an issuer in connection with having introduced an investor, solicitors need either be a registered representative of either a registered brokerdealer or a registered investment adviser. Using Soft Dollars to Pay a Solicitor A money manager of a hedge fund may use soft dollars to compensate a solicitor who sells interests in the hedge fund provided that full and proper disclosure is made and that informed investor consent is obtained regarding such arrangements prior to any payment of soft dollars. Full and proper disclosure would include an explanation of all of the potential conflicts that arise between the money manager and the fund when a money 3 Lamp Technologies, Inc., pub. avail. May 29, 1997; and Lamp Technologies, Inc., pub. avail. May 29, 1998. SADIS & GOLDBERG LLC JANUARY 2000 manager uses soft dollars to pay a solicitor (e.g. the money manager may generate excessive commissions to increase assets under management so that the money manager may generate more income for itself). In the event, however, that more than 25% of the assets of the hedge fund in the aggregate are held by “benefit plan investors,” the money manager would be prohibited from entering into any arrangements involving soft dollars. See Section III herein for a discussion regarding regulatory requirements in connection with the The Employee Retirement Income Security Act of 1974. 3. Magazines & Newsletters A money manager should avoid paying a fee to include material in a newsletter or publication. Where an issuer of unregistered securities prepared material for publication in a newsletter and paid for its inclusion in a newsletter, the SEC staff took the position that such activity constituted general advertising on behalf of the issuer, because it would appear that such information was intended to be used in connection with the offer and sale of securities. 4 A newsletter providing certain information derived totally from public records filed with the secretary of the state, however, was not deemed by the SEC staff to violate the general solicitation prohibition. The staff noted that no analysis of the issuer or the offering would be provided in the newsletter and that no issuer or anyone acting on an issuer’s behalf would be responsible for the preparation of or payment for the inclusion of such materials in the newsletter. 5 The staff took a similar position in connection with a guide which would provide information concerning several issuers derived from various public sources, as well as from responses to the publisher’s requests by written correspondence and telephonic communication to the issuing companies. The publishers of the guide explained that the guide would be sold to institutional trading and sales personnel at investment banking firms, portfolio managers and database marketers. The staff’s position was premised on the fact that limited information would be provided on completed offerings and that the publisher would not have any affiliation with any issuer nor would it be serving as an agent to any issuer. 6 4. Interviews If the money manager of a hedge fund is not registered as an investment adviser, it should not conduct any interviews which make use of the money manager’s or hedge fund’s name, otherwise the money manager may trigger the registration requirements of the Investment Advisers Act of 1940, as amended (the “Advisers Act”) or be deemed to violate the solicitation prohibitions under the Securities Act of 1933, as amended (the 4 5 6 The Texas Investor Newsletter, pub. avail. Jan. 23, 1984. Richard Daniels, pub. avail. Dec. 19, 1984. Nancy H. Blasberg, pub. avail. July 12, 1986. SADIS & GOLDBERG LLC JANUARY 2000 “1933 Act”) and the Investment Company Act of 1940, as amended (the “Company Act”). 5. Mass Mailings memorandum) (e.g. letter, brochure, confidential private placement The SEC staff allowed a general partner of a hedge fund to make offers to over 300 prospective investors of existing limited partnerships sponsored by the general partner. The staff noted that the general partner had a pre-existing business relationship with the prospective investors of the fund, which relationship was established within the last 3 years.7 A hedge fund may mass mail a letter and questionnaire, provided that the letter and questionnaire are generic in nature and do not refer to any specific investment currently being offered or contemplated for offering, and that there are procedures in place designed to reasonably ensure that the persons solicited will not be offered any such investment. Prospective investors responding to such a mailing will not be deemed to have responded to a general solicitation, provided that: (i) a substantive relationship can be established between the time of the initial solicitation and the later offer; and (ii) the prospective investor completes a questionnaire which provides the issuer with sufficient information to evaluate the prospective investor’s sophistication and financial position. 8 The SEC staff found it impermissible for a registered broker-dealer which was the general partner of two hedge funds to mail a general solicitation to: (a) a list of executive officers of 50 “Fortune 500” companies; and (b) a list of persons, which was purchased from a third party, who had invested in real estate offerings. The staff was primarily concerned that the limited partnerships did not have any pre-existing relationship with the persons solicited. 9 7 Woodtrails-Seattle, Ltd., pub. avail. Aug. 9, 1982. Bateman Eichler, Hill Richards, Inc., pub. avail. Dec. 3, 1985. See also H.B. Shaine & Co., Inc., pub. avail. May 1, 1987. 8 9 In the Matter of Kenman Corporation and Kenman Securities Corporation, April 19, 1985. SADIS & GOLDBERG LLC Suggested Approach to Avoid the General Solicitation Limitations JANUARY 2000 Initial Communications: Personally direct to prospective investors a questionnaire requesting detailed financial and qualification information. Subsequent to receiving a completed questionnaire, follow up with telephone calls or other written correspondence with the sole purpose of determining the sophistication and financial condition of the prospective investor. During these initial communications do not solicit the sale of any security. The solicitation of this information will not constitute an offer to sell securities and if done correctly, is permissible. These communication will establish the necessary “pre-existing substantive relationship.” 10 Cooling Off Period: Once the questionnaire is returned and follow up telephone calls are made or general correspondence is sent to the prospective investor, there is a “cooling off” period during which no offers concerning any security may be made to the prospective investor. Lamp Technologies, Inc., pub. avail. May 29, 1997 (provides for a 30 day cooling off period). Presuming that the questionnaire and the subsequent communications provide sufficient information to evaluate the prospective investor’s sophistication and financial condition and such prospective investor meets the necessary minimum qualification requirements, subsequent to the cooling off period, the money manager may make an offer to the prospective investor because a substantive relationship exists through the completion of the questionnaire. II. INFORMATION THAT MAY BE PROVIDED TO PROSPECTIVE INVESTORS The Advisers Act generally prohibits a money manager, including those registered as investment advisers and those exempt from registration, from engaging in any activity that is fraudulent, deceptive or manipulative. 11 The SEC has defined these activities to prohibit certain forms of advertising. 12 Persons or entities that fall within the definition of an “investment adviser,” regardless of whether they are registered, are subject to these limitations. 10 Woodtrails-Seattle, Ltd., pub. avail. Aug. 9, 1982. See Section IV herein for a discussion regarding the definition of an “investment adviser” and the registration requirements under the Advisers Act. 11 12 Rule 206(4)-1 of the Advisers Act. SADIS & GOLDBERG LLC A. Past Recommendations JANUARY 2000 Money managers, including those registered as investment advisers and those exempt from registration, may distribute lists of their past specific recommendations provided that they furnish a list of all recommendations made within, at least, the last 12 months. The list of past recommendations must include the name of each security recommended, the date and nature (purchase or sale) of the recommendation, the market price at the time that the security was purchased or sold, the price at which the recommendation was executed and the present market price (or most recently practicable date) of the recommendation. In addition, the first page of the list of the past recommendations, must also prominently provide the following cautionary language: “[I]t should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities on this list.” B. Past Performance Money managers, including those registered as investment advisers and those exempt from registration, must be careful to disclose all material facts when presenting past performance to prevent unwarranted references. Money managers may distribute to prospective investors either their actual performance results or model performance results. Money managers may present their past performance net of model advisory fees rather than deducting actual fees charged to the manager’s investors, provided that the model advisory fee exceeds the fees actually charged to each of the manager’s investors. 13 When using actual past performance results, a money manager who provides performance results for a select group of its investors, is required to disclose the reasons as to their selection. When distributing performance results, the following guidelines should be followed to avoid such performance results from being deemed misleading: $ $ $ $ Discuss the effect of any material market or economic conditions on the performance advertised; Deduct advisory fees, brokerage commissions or other expenses that the investor would have paid; Indicate whether and to what extent the results reflect the reinvestment of dividends, gains or other earnings; Disclose the possibility of loss; 13 Clover Capital Management, Inc., pub. avail. Oct. 28, 1986. SADIS & GOLDBERG LLC $ $ JANUARY 2000 Discuss all material differences relevant to the comparison when comparing results to an index; and Discuss any material conditions, objectives or investment strategies used to obtain the results portrayed. When distributing model performance results, these additional disclosures, in part, should be made: $ Disclosure that the securities or strategies used in calculating the performance for the model portfolio may not or do not relate, partially or completely, to the services offered by the money manager; and If applicable, disclosure that the money manager’s investors’ accounts experienced materially different results from those provided in using the model. 1. Exception to the Net Fee Requirement $ Money managers, including those registered as investment advisers and those exempt from registration, may present its performance results on a “gross basis” in a one-on-one presentation made to sophisticated persons, provided that at time of the presentation, the money manager provides the following disclosures in writing: $ $ $ $ Performance results do not reflect the deduction of investment advisory fees; An investor’s return will be reduced by the investment advisory fees and other expenses; The actual fees charged by the money manager; and A narrative, table, chart or graph explaining the effect that an advisory fee would have on the value of the investor’s account, compounded over a period of years. 2. Performance Achieved At a Prior Fund A money manager may use the performance achieved while employed with another hedge fund, provided that: $ The hedge fund currently being managed by the money manager and the hedge fund previously managed by the money manager have substantially similar investment objectives, policies and the strategies of the two funds are substantially similar; The money manager did not manage any other comparable funds or private accounts; $ SADIS & GOLDBERG LLC $ $ $ JANUARY 2000 No other person played a significant role in the day-to-day management of the previous fund; The previous fund’s performance is presented separately from the current fund’s performance with no greater prominence than the current fund’s performance; and There is clear disclosure that the current fund and the previous fund are separate funds and that the past performance of the previous fund is not indicative of the past or future performance of the current fund. 14 C. Testimonials and Investor Lists Money managers may distribute bona fide, unbiased reports written by third parties. Money managers, including those registered as investment advisers and those exempt from registration, however, are generally prohibited from circulating statements of any kind by present or former investors promoting services provided by the money manager. In a no action letter, the SEC approved (i) the distribution of questionnaires to the investors of registered investment advisers, (ii) the subsequent public release of the names of registered investment advisers who satisfy certain minimum rating guidelines based upon the responses to those questionnaires and (iii) the publication of some or all of the survey results. 15 The SEC conditioned its approval of the advertisement of investor experience surveys on the representation that the survey was conducted by an unbiased third party. 16 Money managers may distribute a partial investor list to prospective investors, provided that: The manager does not use performance-based data in determining which investors to include on the list; The list has cautionary language stating that it is not known whether the investors on the list approved or disapproved of the manager’s services; and The list includes an explanation regarding the objective criteria used by the manager to determine which investors it included on the list. 17 $ $ $ 14 15 16 17 Bramwell Growth Fund, pub. avail. August 7, 1996. Dalbar, Inc., pub. avail. March 24, 1998. Id. Denver Investment Advisors, Inc., pub. avail. July 30, 1993. SADIS & GOLDBERG LLC III. ISSUES CONCERNING INVESTORS A. Qualification of Investors Under Regulation D JANUARY 2000 Interests in a hedge fund are offered to prospective investors pursuant to an exemption from registration under Rule 506 of Regulation D of the 1933 Act. Securities offered under Rule 506 may be sold solely to “accredited investors” and up to 35 “sophisticated investors”. 1. Definition of an Accredited Investor An “accredited investor” 18 is deemed to include, in part: $ $ A natural person with an individual net worth, or joint net worth with his or her spouse, at the time of purchase in excess of $1,000,000; A natural person with an individual income in excess of $200,000 or in excess of $300,000 with his or her spouse in each of the two most recent years and who has a reasonable expectation of an income in excess of $200,000 individually or in excess of $300,000 with his or her spouse in the current year; Any executive officer, director or general partner of the issuer of the securities offered; A “bank” as defined in Section 3(a)(2) of the 1933 Act; An “insurance company” as defined in Section 2(13) of the 1933 Act; Any broker or dealer registered pursuant to Section 15 of the Securities Exchange Act of 1934, as amended (the “1934 Act”); An investment company registered under the Company Act; A business development company as defined in Section 2(a)(48) of the Company Act; An employee benefit plan within the meaning of Title I of the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), (a) whose investment decisions are made by a plan fiduciary, as defined in Section 3(21) of ERISA, which is either a bank, insurance company or registered investment adviser; or (b) having total assets in excess of $5,000,000; or (c) if self-directed, the investment decisions are made solely by persons that are accredited investors; $ $ $ $ $ $ $ 18 Rule 501(a) of Regulation D of the 1933 Act. SADIS & GOLDBERG LLC $ JANUARY 2000 A trust, with total assets in excess of $5,000,000 which was not formed for the specific purpose of acquiring an interest in the hedge fund, whose purchase is directed by a sophisticated investor; and An entity in which each of the equity owners are accredited investors. 2. Definition of a Sophisticated Investor $ A person is a “sophisticated investor,” 19 if the investor either alone or with the investor's purchaser representative(s) has such knowledge and experience in financial and business matters that the investor is capable of evaluating the merits and risks of an investment in the hedge fund. B. 1. Exemption from Registration Under The Investment Company Act of 1940 The 100 Person Limitation of Section 3(c)(1). Hedge funds are not required to register as an investment company with the SEC in reliance upon an exemption pursuant to either Section 3(c)(1) or Section 3(c)(7) of the Company Act. Section 3(c)(1), in part, provides an exemption from the Company Act’s registration requirement for an investment company whose securities are owned by fewer than 100 “persons.” Section 3(c)(7), in part, exempts investment companies from the Company Act’s registration requirement without limitation as to the number of its beneficial owners. A 3(c)(7) fund with 500 or more investors, however, may be required to file a registration statement with the SEC. 20 There are different investor qualification requirements for Section 3(c)(1) and Section 3(c)(7). 2. Moving Beyond the 100 Person Limitation of Section 3(c)(1). A hedge fund which is exempt from registration pursuant to Section 3(c)(7) of the Company Act, is not subject to the limitation imposed by Section 3(c)(1), provided that its investors are all “qualified purchasers.” $ $ The Company Act defines the term “qualified purchaser” to include, in part: Any natural person who owns at least $5 million in investments; and Any other person (e.g., an institutional investor) that owns and invests on a discretionary basis at least $25 million in investments. 3. Converting an Existing 3(c)(1) Fund Into a 3(c)(7) Fund 19 20 Rule 506(b)(2)(ii) of Regulation D of the 1933 Act. Section 12(g)(1)(B) of the 1934 Act. SADIS & GOLDBERG LLC JANUARY 2000 A Section 3(c)(1) hedge fund may be converted into a Section 3(c)(7) hedge fund and thus, have more than 100 persons. Under Section 3(c)(7)(B) of the Company Act (the “Grandfather Provision”), certain existing 3(c)(1) funds may convert into 3(c)(7) funds without requiring investors that are not “qualified purchasers” to dispose of their interests in the fund as a result of its conversion (“Grandfathered Funds”). The outstanding securities of a Grandfathered Fund may be beneficially owned by as many as 100 persons that are not qualified purchasers, provided that these persons acquired the securities of the Grandfathered Fund on or before September 1, 1996. Prior to any such conversion, however, a Grandfathered Fund must make certain disclosures to each “beneficial owner” and provide such beneficial owner with a reasonable opportunity to redeem any part or all of their interest in the fund. The SEC staff believes that the conditions in the Grandfather Provision must be complied with by any 3(c)(1) fund that wishes to convert, even if each beneficial owner of the 3(c)(1) fund meets the definition of qualified purchaser. The Grandfathered Provision, however, does not override provisions in fund documents, other agreements or applicable law that could have the effect of preventing a fund from converting into a Section 3(c)(7) fund. For example, if a fund's partnership agreement prohibits the fund from having more than 100 persons, the fund may have to seek to amend the agreement before selling its securities to qualified purchasers (if the fund already has 100 persons). 4. Creating an Offshore Fund for Foreign & U.S. Tax Exempt Investors Offshore funds provide tax based benefits to offshore investors, as well as U.S. tax exempt investors. Offshore investors investing in offshore funds, generally, are not subject to U.S. taxes regardless of whether the general partner of the fund is domiciled in the U.S. Whereas, U.S. tax exempt investors who would ordinarily be subject to unrelated business taxable income (“UBTI”) on profits generated from the use of leverage if they invested in a U.S. hedge fund, under current law, are not subject to UBTI on dividends paid to such investors by a foreign corporation engaging in leveraged investment practices. 5. The Integration Doctrine When a hedge fund which is operating pursuant to an exemption from registration under Section 3(c)(1) of the Company Act begins to approach the 100 person limitation, the money manager may not form another hedge fund identical to the prior fund pursuant to the exemption offered under Section 3(c)(1) and avoid registration of the fund. To prevent money managers from evading the 100 person limitation by creating identical hedge funds each time they approach the limitation, the SEC applies the “integration” doctrine. In the event that two or more hedge funds which are managed by the same money manager are substantially similar, the SEC will “integrate” such funds so that they will be deemed to constitute one issuer. If the SEC integrates two or more funds, it will count the number of each fund’s investors and add them together to determine whether the funds, in the aggregate, have more than 100 persons. When determining whether to integrate two or more funds, the SEC applies a “reasonable person test”; if a reasonable SADIS & GOLDBERG LLC JANUARY 2000 investor would conclude an investment in one of the funds is materially different from an investment in the other fund(s), the funds are not integrated. Some of the factors looked at by the SEC staff, include the funds’ investment objectives (e.g. one fund’s performance geared to an index), investment styles (e.g. use of leverage, different portfolio securities) and whether the funds are targeting different groups of investors (e.g. taxable and tax exempt investors, domestic and offshore investors). Even if a 3(c)(1) fund and a 3(c)(7) fund are identical, the SEC staff will not integrate the funds. Additionally, the SEC staff normally does not integrate U.S. hedge funds and their offshore counterparts. 6. Looking Through Certain Investors For purposes of counting investors in connection with the 100 “person” limitation imposed by Section 3(c)(1), normally, each person is counted separately. The Company Act defines “person” to mean a “natural person or a company.” Pursuant to the “look through” provisions of Section 3(c)(1), however, the SEC staff will look-through a company that invests in a hedge fund and count each of the security holders of that company as a separate investor of the hedge fund, if: $ The investor is either a registered investment company or a private investment company organized pursuant to an exemption from the Company Act pursuant to either Section 3(c)(1) or Section 3(c)(7); and The investment company beneficially owns 10% or more of the outstanding voting securities of the hedge fund. In addition to looking through an investment company in certain circumstances, the SEC staff has also looked through other investment groups or entities. For example, certain employee benefit plans will be looked through if they provide their individual investors investment discretion. 21 7. Knowledgeable Employees The SEC adopted Rule 3c-5 under the Company Act which permits “knowledgeable employees” of a hedge fund and certain of its affiliates to acquire securities issued by the fund without either: (i) being counted for purposes of a (3)(c)(1) fund's 100 person limit; or (ii) having to meet the definition of a qualified purchaser for purposes of a 3(c)(7) Fund. Rule 3c-5 defines knowledgeable employees to include the directors, executive officers or general partners of the fund or an affiliated person of the fund that oversees the fund's investments, as well as persons who serve in capacities similar to directors, such as trustees and advisory board members. $ Standish, Ayer & Wood, Inc., pub. avail. Dec. 28, 1995 and Tyler Capital Fund, L.P., pub. avail. Aug. 28, 1987. 21 SADIS & GOLDBERG LLC C. JANUARY 2000 The Employee Retirement Income Security Act of 1974 (“ERISA”) In the event that the investment assets of “benefit plan investors,” in the aggregate exceed, at any time, 25% of the aggregate equity of a hedge fund, the fund’s general partner will be deemed to be managing “plan assets” and thus, become a “plan fiduciary” under ERISA. As a plan fiduciary, the general partner will be subject to the “Prudent Man Rule.” As a fiduciary under ERISA, the general partner, in part, would be prohibited from participating in or entering into any transaction that would result in a conflict of interest with the benefit plan investors. Employee benefit plans, individual retirement accounts and Keogh accounts are some of the types of investors considered to be “benefit plan investors.” Each time there is an investment or withdrawal in a hedge fund, the money manager or an agent of the money manager is required to calculate the percentage of assets held by benefit plan investors in the aggregate. The value of the money manager’s account(s) is not included in the calculation to determine percentage of assets held by benefit plan investors in the aggregate. D. Pre-Existing Investors Money managers are advised that investors who make subsequent capital contributions in a hedge fund should be required to represent, in writing, that their financial condition has not changed and that they are able to afford the risks associated with making an investment in the fund at the time of the subsequent investment. IV. OTHER ISSUES A. 1. Registration Requirements for Investment Advisers The Investment Adviser Definition The Advisers Act defines an “investment adviser” generally to include a natural person or entity who for compensation engages in the business of providing advice to others regarding securities. Each of the elements to the definition of an “investment adviser” are broadly interpreted, some of which are provided below: $ Compensation is deemed to include any form of direct or indirect economic benefit (e.g. compensation paid directly from the person receiving advice, compensation paid by a third party). The “In the Business” element is determined by the frequency and regularity with which a person or entity provides advice with regard to securities. 2. Various Exemptions to Investment Adviser Definition $ Irrespective of the broad definition of the term “investment adviser,” Congress SADIS & GOLDBERG LLC JANUARY 2000 specifically excluded from the definition certain persons whose activities are already regulated, such as: $ Broker dealers and registered representatives, provided that the investment advice provided is solely incidental to their brokerage business, and that the broker or registered representative does not receive any special or additional compensation for providing the investment advice. The publisher of a bona fide publication of general and regular circulation which provides “impersonalized” investment advice. 22 This exemption has been expanded to include telephonic stock recommendation services 23 and stock recommendation services provided through electronic mail. 24 3. Exemptions to Investment Adviser Registration Requirement $ Even if the money manager falls within the definition of an “investment adviser,” the money manager may not be required to register as an investment adviser pursuant to various exemptions (e.g. adviser to insurance companies only, advisers that are charitable organizations). 25 Please note, however, that the SEC and each of the states imposes different registration requirements upon money managers. For example, a money manager is exempt from the registration requirements of the Advisers Act which are enforced by the SEC, if such person or entity: 26 $ $ $ Has had fewer than 15 investors within the past 12 months; Does not hold itself out to the public as an investment adviser; and Does not provide advisory services to a registered investment company or a business development company. Counting Investors The money manager may count a limited partnership as a single investor provided, in part, if the manager provides advice to the limited partners based upon the partnership’s 22 23 24 25 26 Lowe v. SEC, 472 U.S. 181 (1985). Mary Lee Botsaris, pub. avail. Mar. 25, 1993. Russell H. Smith, pub. avail. May 2, 1996. Section 203(b) of the Advisers Act. Section 203(b)(3) of the Advisers Act. SADIS & GOLDBERG LLC “Holding Out” to the Public JANUARY 2000 objectives, rather than tailoring advice to each individual limited partner’s objectives. 27 The element of “holding out” has been interpreted broadly to include the following: $ $ $ $ Advertising related to advisory activities; Maintaining a listing as an investment adviser in either a telephone directory or building directory; 28 Using letterhead or business cards with reference to investment advisory services; 29 and Letting it be known by word of mouth or through some other method of communication that the person will accept new investment advisory investors. 30 In two recent no action letters regarding a web site which provides information about hedge funds, the Staff concluded that a money manager would not be deemed to be “holding itself out generally to the public as an investment adviser” provided that: (i) the investment adviser posted information solely related to a hedge fund and did not provide any information regarding other services or products offered by the investment manager; and (ii) the web site is accessible only to accredited investors.31 The Staff specifically approved the posting of “descriptive information” (such as a confidential private placement memorandum) and “performance information” relating to the hedge fund. B. Registered Investment Adviser; Limitation on Charging Performance Fees Although registered investment advisers are generally prohibited from receiving compensation based on a share of the capital appreciation, a registered investment adviser, generally, may receive performance based compensation from its investors, if each of the investors is an “eligible investor.” 32 27 28 29 30 Rule 203(b)(3)-1 under the Advisers Act. Dale M. Muller, pub. avail. Feb. 20, 1984. Richard W. Blanz, pub. avail. Jan. 28, 1985. Peter H. Jacobs, pub. avail. Feb. 7, 1979. Lamp Technologies, Inc., pub. avail. May 29, 1997 and Lamp Technologies, Inc., pub. avail. May 29, 1998. 31 32 See Section 205(a) and Rule 205-3 of the Advisers Act. SADIS & GOLDBERG LLC JANUARY 2000 A person is deemed to be an “eligible investor” if the investment adviser has a reasonable belief that the investor has a net worth in excess of $1,500,000 at the time of investment or the investor has at least $750,000 under the management with the adviser. $ $ A hedge fund relying on an exemption pursuant to Section 3(c)(1) is deemed to be an “eligible investor” if each of its beneficial owners are “eligible investors.” A 3(c)(7) fund, however, is automatically deemed to be an eligible investor. A money manager to a hedge fund may charge its investors who are “eligible investors” a performance fee, and waive the performance fee for investors who do not qualify as “eligible investors.” 33 C. Registration Requirements for Solicitors A person who receives compensation for selling securities may be deemed a “broker,” and thus, may be required to register as such under Federal and state law and may be required to become a member of the National Association of Securities Dealers, Inc. Additionally, the solicitor may be deemed to fall within the definition of an investment adviser and thereby, may be required to register as an investment adviser. Hedge funds and solicitors alike, should discuss with counsel the possible need for the solicitor to register as either an investment adviser or broker-dealer. There are certain “safe harbors” under the 1934 Act pursuant to which persons associated with an issuer of a security (such as an employee of the general partner of a hedge fund) can engage in sales related activities without being deemed brokers, provided, however, that those persons are not compensated with commissions or other form of remuneration based on transactions in securities. 34 D. Registered Advisers; Requirements for Engaging a Solicitor Registered investment advisers must comply with certain provisions of the Advisers Act which severely restrict an adviser’s ability to pay referral fees to a solicitor. At the very least, a registered adviser is required to comply with certain disclosure requirements when engaging a solicitor. 35 Persons excluded from the definition of “investment adviser” or persons exempt from the registration requirements of the Advisers Act, are generally not subject to any restrictions 33 34 35 Hellmold Associates, Inc., pub. avail. June 4, 1993. Rule 3a4-1 of the 1934 Act. Rule 206(4)-3 of the Advisers Act. SADIS & GOLDBERG LLC JANUARY 2000 imposed by the Advisers Act in connection with the retention of a solicitor. Any solicitation fees paid to a solicitor by a registered investment adviser may only be paid pursuant to a written agreement between the adviser and solicitor and the agreement must be disclosed to each prospective investor introduced by the solicitor. The written agreement between the adviser and the solicitor must disclose, at least, the following information: $ $ $ $ A description of the services provided by the solicitor; A description of the compensation to be paid to the solicitor; A representation by the solicitor to perform its services in compliance with the Advisers Act and pursuant to the terms of the referral fee agreement; and A representation that the solicitor will provide the prospective investor a copy of the registered adviser’s Form ADV, Part II (or its equivalent) at the time of consultation and a separate written disclosure document containing: · · · · · the name of the solicitor; the name of the investment adviser; a nature of the solicitor’s and investment adviser’s relationship; a statement that the solicitor will be compensated by the investment adviser and the terms of such compensation; and the amount, if any, of any additional cost that the investor will be charged in addition to the investment adviser’s customary fee, and the differential, if any, among investors with respect to the amount or level of advisory fees charged by the investment adviser if such differential is attributable to the existence of any referral fee agreement. A registered investment adviser must receive from each prospective investor introduced by a solicitor, prior to or at the time of entering into any investment advisory agreement with the investor, whether written or oral, a signed and dated acknowledgment of receipt of the investment adviser's written disclosure statement and the solicitor's written document. A registered investment adviser may engage a person who is an officer, director or employee of the adviser or an officer, director or employee of an affiliate of the adviser as a solicitor, provided they enter into a written agreement. This written agreement, however, need not be disclosed to any prospective investor introduced by su ch officer, director or employee of the adviser or advisory affiliate. Registered investment advisers may not retain any person or entity to solicit who has been subject to a statutory disqualification, such as a conviction within the last 10 years of a felony or misdemeanor involving, in part, the purchase or sale of a security, bribery, perjury or fraud or have been found by the SEC to have made or caused to be made in SADIS & GOLDBERG LLC JANUARY 2000 connection with the filing of an application or report with the SEC, a false or misleading statement. Although this guide is believed to be accurate, it is general in nature and does not purport to be complete. Prior to acting on any specific course of action in reliance on this desktop reference, we suggest that you contact your counsel or speak to Ron S. Geffner or Jeffrey C. Goldberg at (212) 947-3793 SADIS & GOLDBERG LLC JANUARY 2000 23 SADIS & GOLDBERG LLC JANUARY 2000 24