A remarkable phenomenon in the global ﬁnancial markets is the headlong growth of marketplace lending, sometimes referred to as peer-to-peer or online direct lending. These terms denote a mode of non-bank ﬁnance conducted via online platforms, through which prospective borrowers (typically individuals or small businesses) seeking modest loans are matched with investors who are willing to fund them. In 2013, LendingClub and Prosper, the two largest U.S. marketplace lending platforms, originated $2.4 billion of loans, a 180% increase over 2012. This growth is hardly conﬁned to the United States. The United Kingdom boasts a sophisticated online direct lending market, and entrepreneurs are creating thriving platforms in continental Europe, Latin America and elsewhere.
For borrowers, the appeal of marketplace lending is easy to understand. It offers individuals and small businesses access to small-scale debt ﬁnancing that in the past might have been available from a local bank but now is not. For investors, the returns available on platform loans are often signiﬁcantly higher than those available on other savings or investment products.
Institutional Investors: Emerging Interest and Unmet Demand
In the earlier days of online direct lending, borrower loans were funded almost exclusively by individual (“retail”) investors. More recently, however, platform-funded loans are attracting increasing attention from yield-hungry institutional investors.
Institutions can gain platform loan exposure via the traditional “back-to-back note” model, in which several investors purchase portions of a borrower loan indirectly by acquiring a platform-issued note corresponding to, and dependent for payment on, the underlying loan held by the platform. But for many institutional investors, this traditional model—resulting as it does in the investor holding indirect pieces of numerous underlying loans—is too piecemeal to be practical. A more recent variation on marketplace lending, geared to institutional investors, therefore has begun to emerge. Under this newer approach, a platform operator agrees with an institutional investor to set aside for the investor’s direct purchase an agreed volume of whole loans originated through the platform. The investor thereby acquires and becomes the lender of record for a portfolio of whole loans. Even with the advent of the whole- loan investment option, however, it appears that U.S. institutional investor demand for marketplace lending product is not being met.
An Opportunity for Platform Operators Outside the United States
Unsatisﬁed demand on the part of U.S. institutional investors presents an opportunity for operators of foreign marketplace lending platforms to connect home- country borrowers with American capital. If that can be done: (i) U.S. institutional investors will be able to put more money to work in the marketplace lending space, often at interest rates surpassing those available on American platforms; (ii) creditworthy foreign borrowers, who remain underserved by local banks, will gain access to funding; and (iii) non-U.S. platform operators will enhance their loan volume, thereby boosting their origination and servicing revenues.
The regulatory, currency and tax implications for investments by U.S. institutions in loans made by non-
U.S. platforms will vary, depending on factors such as the platform’s structure, borrower base and home- country legal environment. A non-U.S. platform interested in working with U.S. institutions therefore will need to think carefully about the details of building that relationship. The challenges may be signiﬁcant in any particular case but, at this stage of marketplace lending’s evolution—with growing U.S. institutional investor demand and substantial unmet funding needs among many non-U.S. platforms—there are signiﬁcant incentives to work through the relevant legal and practical issues.
Jumpstarting the Process
We understand that certain non-U.S. lending platforms are in discussions with U.S. institutional investors on an individual basis. However, a non-U.S. operator that wished to access the U.S. institutional community efﬁciently and broadly could take a more proactive step. This would be to create a U.S. private investment fund, capitalized by multiple U.S. institutional investors and devoted to purchasing borrower-dependent notes or whole loans on the operator’s home-country platform.
The operator could organize such a fund on its own or in collaboration with an established U.S. asset manager. In either case, the point would be to offer U.S. investors an opportunity to acquire interests in a single, U.S.- organized vehicle dedicated solely to purchasing exposure to the operator’s home-country platform loans. To our knowledge, no such U.S.-capitalized investment vehicle focused on a foreign marketplace lending platform has been established. But with sufﬁcient planning, forming such a vehicle certainly should be possible, and the rewards for a ﬁrst mover could be quite compelling.
The remainder of this white paper explains in basic terms how such a platform-focused investment fund might be structured, and highlights the key U.S. securities law issues to be considered in that regard. We refer to the private investment fund as the “Fund,” and to the U.S. institutional investors who capitalize it as the “Investors.”1
FUND STRUCTURE AND ECONOMICS
We assume the Fund will be a limited partnership organized under Delaware law, that choice of entity and jurisdiction being a common one for U.S. private funds. The Fund’s operations therefore will be governed by a limited partnership agreement (the “Partnership Agreement”). The Partnership Agreement will set forth the Investors’ rights as limited partners, including as to capital accounts, withdrawals and distributions.
The General Partner
As a limited partnership, the Fund will have a general partner (the “General Partner”). The General Partner typically is a limited liability company, organized in the same state as the Fund (Delaware in our example). The member(s) of the General Partner will be the platform’s principal(s). The Partnership Agreement will vest with the General Partner substantially all control over the Fund’s affairs, including authority to delegate portfolio
- This white paper is a general summary. Applying the U.S. securities laws to any particular private investment fund or marketplace lending platform requires a variety of speciﬁc legal determinations, which are beyond the scope of this discussion. Nor does this white paper address potentially applicable home-country laws relating to the platform or the Fund.
management functions to an afﬁliated investment manager as discussed below.
The Investment Manager
The Fund’s investment activities could be managed directly by the General Partner. More typically, though, a separate afﬁliated entity (the “Manager”) serves as a
U.S. private fund’s investment manager and we assume that will be the case for the Fund. The Manager is often a Delaware limited liability company and likely will have the same member(s) as the General Partner. The Manager will enter into an investment management agreement with the Fund, pursuant to which the Fund engages and delegates authority to the Manager to acquire and run the Fund’s investment portfolio. The Fund thus will be the Manager’s investment advisory client.
Economics for the Principals
The classic economic arrangements to compensate a private fund’s principals – i.e., the member(s) of the General Partner and the Manager – involve a quarterly management fee payable by Investors to the Manager and an annual incentive allocation to the General Partner.
The management fee typically is calculated as a percentage (often 1-2% annually) of the value of the Fund’s portfolio. The incentive allocation, sometimes called a performance allocation or a carried interest, typically ranges from 10-20% of the Fund’s positive return each year. The incentive allocation involves increasing the General Partner’s capital account in the Fund annually by the agreed percentage, assuming the Fund has experienced a positive return for the year in question; this allocation to the General Partner’s capital account thus reduces the extent to which performance gains are allocated to the Investors’ own respective capital accounts.
A Fund formed by a non-U.S. platform operator with a mandate to invest only in that platform’s loans could conceivably provide Investors with a better fee arrangement than is typically offered by U.S. private investment funds, since the operator would gain signiﬁcant economics through the sale of platform loans to the Fund.
The above organizational and economic structure may be depicted as follows:
Investment Mgmt. Agt.
Delaware Limited Partnership
Platform Loan Assets
As a limited partnership, the Fund will be a pass-through entity for U.S. federal income tax purposes. This means that the Fund itself pays no tax; rather, each Investor must take into account its distributive share of items of Fund income, gain, loss and deduction substantially as though those items had been realized directly by the Investor (whether or not the Fund makes cash distributions).2
MARKETING THE FUND TO U.S. INSTITUTIONAL INVESTORS
Once the structure of the Fund and related entities has been established, the next order of business is marketing limited partnership interests in the Fund (“Interests”) to prospective investors in the United States. The process of offering and selling Interests raises two main concerns under the U.S. federal securities laws. These are ensuring that: (i) the offer of Interests is exempt from registration under the Securities Act of 1933 (the “Securities Act”); and (ii) the Fund’s offering memorandum or similar private placement document contains accurate and complete disclosure, such that the Fund can avoid potential liability to Investors under the Securities Exchange Act of 1934 (the “Exchange Act”).
Exempting the Offer and Sale of Interests from Securities Act Registration
The Securities Act requires that every offer and sale of securities—such as the Interests—either be registered with the SEC or speciﬁcally exempt from such registration. SEC registration is costly, time-consuming and otherwise burdensome. Accordingly, private investment funds such as the Fund typically structure offerings of their interests in the United States to comply with Section 4(a)(2) of the Securities Act, which exempts from registration private placements of securities. More
speciﬁcally, private investment funds usually attempt to comply with Rule 506(b) under the Securities Act, which is a safe harbor under Section 4(a)(2)—that is, compliance with Rule 506(b) ensures that an offering is a valid private placement and hence exempt from registration.
An issuer of securities relying on Rule 506(b) generally will offer its securities only to “accredited investors.” That term includes, among other types of investors, an entity with total assets of at least $5 million, not formed for the speciﬁc purpose of investing in the Fund.
Rule 506(b) prohibits “general solicitation” and “general advertising” in connection with the securities offering being made in reliance on the rule. This means not offering Interests by means of advertisements, media, the Internet or other publicity. Compliance with Rule 506(b) also requires keeping very tight control over how and to whom the Fund’s offering memorandum or other marketing materials are distributed.3
To protect the valid private placement status of the offering of Interests, the Fund must take steps to conﬁrm that Investors will not subsequently resell their Interests in a way that amounts to a “distribution” (i.e., a public offering) in violation of Securities Act registration requirements. Accordingly, the Fund will obtain from each Investor a representation that it is purchasing its Interest for investment, and will include resale restrictions in the Partnership Agreement.
High-Quality Offering Materials: Avoiding Liability for Misleading Disclosure
The Fund’s key marketing document likely will be an offering memorandum, sometimes referred to as a private placement memorandum. It is critical that this document contain accurate and complete information
- For simplicity, this white paper assumes that all Investors are U.S. taxable investors. If the Fund expects to have U.S. tax-exempt or non-U.S. Investors, the structure depicted above likely would change. Speciﬁcally, the Fund might be a “master fund” organized as an offshore corporate entity (e.g., a Cayman Islands limited company); an onshore “feeder fund” (usually a Delaware limited partnership) would be the vehicle in which U.S. taxable Investors and possibly U.S. tax-exempt investors held interests; and an offshore feeder fund (again, a corporate entity like a Cayman Islands limited company) would be the vehicle in which non-U.S. and possibly U.S. tax-exempt Investors held interests.
- In September 2013, new Rule 506(c) took effect, as mandated by the U.S. JOBS Act of 2012. Rule 506(c) allows an issuer to engage in general solicitation and general advertising when making a private placement, so long as all purchasers in the offering are accredited investors and the issuer takes reasonable steps to verify that such is the case. Due to several practical risks and uncertainties associated with Rule 506(c), it has not yet come into widespread use by issuers. For that reason—and because general publicity should not in any case be necessary to market a vehicle like the Fund—we assume that the Fund will offer Interests under traditional Rule 506(b) rather than new Rule 506(c).
about the Fund. An offering memorandum that skimps on necessary disclosure may expose the Fund and its principals to liability under Section 10(b) of the Exchange Act and related Rule 10b-5, which are general anti-fraud provisions relating to the offer and sale of securities (such as the Interests).
The purpose of the offering memorandum is to provide prospective Investors with all the information that a reasonable person needs to make an informed decision whether or not to invest in the Fund. Accordingly, the offering memorandum can be expected to address at least the following topics: (i) the Fund’s structure and the terms of the Partnership Agreement; (ii) the Fund’s proposed investment program; (iii) the nature and operations of the marketplace lending platform through which the Fund will acquire portfolio assets; (iv) the identity and experience of the individual Manager professionals who will be responsible for managing the Fund’s portfolio; (v) compensation arrangements for the Manager and the General Partner; (vi) any potential conﬂicts of interest that the Manager or the General Partner may face in advising or operating the Fund; (vii) certain tax and other regulatory considerations; and (viii) investor eligibility and other matters.
Equally important, the offering memorandum will include a discussion of risk factors relating to an investment in the Fund, including risks attributable to the nature of the Fund’s strategy and management, the restrictive nature of the investment itself (e.g., the illiquidity of the Interests), platform and market risks, legal and regulatory risks, etc. These risk factors will focus to a signiﬁcant degree on operational and investment risks associated with the platform and the quality of the borrower loans to which the Fund will purchase exposure, including legal and operational risks speciﬁc to the platform’s structure and home-country regulation. One would expect the platform’s home- country counsel to be signiﬁcantly involved in preparing the description of the business, the risk factors and other sections of the offering memorandum to which local law
and risks are relevant.
MAKING SURE THE FUND IS NOT AN “INVESTMENT COMPANY”
Another important U.S. securities law concern is making sure that the Fund is exempt from registration with the SEC as an “investment company” under the Investment Company Act of 1940 (the “1940 Act”). Sections 3(c)(1) and 3(c)(7) of the 1940 Act provide exclusions to the deﬁnition of “investment company.” The Fund will avoid the need to register with the SEC by satisfying either of these exclusions.4
Section 3(c)(1) excludes from investment company status any issuer (e.g., a private investment fund) whose outstanding securities (e.g., limited partnership interests) are beneﬁcially owned by not more than 100 persons. Counting a fund’s beneﬁcial owners for purposes of the 100-person limit can be a complicated exercise, as the rules require “looking through” certain types of investors.
Section 3(c)(7) of the 1940 Act excludes from investment company status any issuer whose outstanding securities are owned exclusively by “qualiﬁed purchasers.“ Qualiﬁed purchasers generally include institutions with
$25 million in investments.
“INVESTMENT ADVISER” CONSIDERATIONS
A further issue under U.S. securities law is whether the Manager will be required to register as an “investment adviser,” either with the SEC under the Investment Advisers Act of 1940 (the “Advisers Act”) or with one or more state authorities.
SEC Registration as an Investment Adviser
The Advisers Act deﬁnes an “investment adviser” to include any person who, for compensation, engages in the business of advising others as to the value of securities or as to the advisability of investing in, purchasing, or selling securities. The Advisers Act treats
- Exclusion from “investment company” status is crucial because registration under the 1940 Act—a statute designed to regulate mutual funds—would subject the Fund to a number of detailed operational rules that would be practically impossible to satisfy.
loans as “securities.” Therefore, since the Manager will be advising the Fund on investments in loans and will be compensated for doing so, the Manager will be an investment adviser for purposes of the Advisers Act.
Whether the Manager must register as an investment adviser with the SEC will depend primarily on the Manager’s assets under management (“AUM”) (i.e., the value of the Fund’s loan portfolio and the assets of any other client being advised by the Manager). Subject to exemptions including those noted below, the Advisers Act generally requires SEC registration by any investment adviser with AUM of $100 million or more. Registration with the SEC entails ﬁling Form ADV (a detailed disclosure document), complying with numerous substantive rules under the Advisers Act, and becoming subject to periodic examination by the SEC staff.
Notwithstanding the general rule that AUM of $100 million entails SEC registration, the Manager may be eligible for an Advisers Act registration exemption described below.
Foreign Private Adviser Exemption
Section 203(b)(3) of the Advisers Act provides a registration exemption for “foreign private advisers.” This exemption is available for an investment adviser that has no place of business in the United States; has in total fewer than 15 clients in the United States and U.S. investors in private funds (such as the Fund) managed by the adviser5; and has less than $25 million of AUM attributable to such U.S. clients and investors. This exemption could be useful, for example, if the Manager was clearly based outside the United States and had
$100 million or more of AUM (due to foreign Investors participating in the Fund and/or to having clients other than the Fund). In that situation, as long as U.S. Investors numbered less than 15 and accounted for less than $25 million of the Manager’s AUM, registration with the SEC would not be necessary.
Private Fund Adviser Exemption
A second potential Advisers Act registration exemption appears under Section 203(m) of the Advisers Act and is known as the “private fund adviser” exemption. An investment adviser with its principal ofﬁce and place of business in the United States may claim the exemption if it acts solely as an investment adviser to one or more private funds (such as the Fund) and has AUM of less than $150 million. For an investment adviser whose principal ofﬁce and place of business is outside the United States, the exemption is available if the adviser’s only U.S. clients are one or more private funds (such as the Fund) and the only AUM managed from a U.S. place of business (if any) are private fund assets totaling less than $150 million. An adviser that foregoes SEC registration in reliance on the private fund adviser exemption must ﬁle with the SEC a modiﬁed version of the Form ADV disclosure document referred to above.
Qualiﬁed Client Requirements if Manager Registers with SEC
If the Manager does register as an investment adviser with the SEC, it is important to note that all of the Investors must be “qualiﬁed clients” in order for the Fund to pay performance-based compensation (e.g., an annual incentive allocation as described above). A “qualiﬁed client” includes an investor with net worth exceeding $2 million or assets of at least $1 million under the adviser’s management.6
Possible Investment Adviser Registration at the State Level
If the Manager is not required to register as an investment adviser with the SEC, the Manager will need to consider whether registration is required in one or more states. While state investment adviser laws differ, they generally base their registration requirements on the number and type of clients an adviser has within the state. Many states have registration exemptions that might be available for the Fund structure described above.
- The term “private fund” essentially means a fund excluded from “investment company” status under Section 3(c)(1) or 3(c)(7) of the 1940 Act. As discussed above, the Fund will be structured to satisfy one of those exclusions.
- Note that qualiﬁed purchasers under Section 3(c)(7) of the 1940 Act are deemed qualiﬁed clients under the Advisers Act.
We believe that non-U.S. platform operators have an opportunity to capitalize on the conﬂuence of U.S. institutional demand for marketplace lending product and unmet home-country borrowing needs. One way to act on this opportunity would be to form a platform- dedicated Fund as discussed above. The ﬁrst platform operator to connect American institutional capital with local borrowers in that way may become an important mover in the rapid evolution of marketplace lending.