As the US is the largest asset management market in the world by a number of metrics, it is understandable that many non-US private equity (PE) and venture capital (VC) managers wish to access this pool of capital. However, most are deterred by the perceived complexities of US securities and tax rules affecting the marketing of fund interests in the US This article explains how compliance with such rules is no more burdensome than with domestic securities and tax laws (which non-US managers are subject to), and can be made palatable with sound advice and planning.
Investment Advisers Act
The Investment Advisers Act of 1940 (the Advisers Act) is typically the US securities law that non-US managers consider to impose the most significant compliance costs. Under the Advisers Act, a fund manager that actively seeks US investors will be required to register as an “investment adviser” with the US Securities and Exchange Commission (the SEC) unless an exemption applies. These exemptions often provide an easier pathway to operate in the US, and several potential exemptions may be available to a non-US manager, including the Foreign Private Adviser Exemption, the Private Fund Adviser Exemption, and the Venture Capital Exemption.
Foreign Private Adviser Exemption
The most favorable outcome for a non-US manager would be to rely on the “Foreign Private Adviser Exemption” from registration since a non-US manager benefiting from this exemption does not need to make any filings or take any other affirmative actions in dealing with the SEC. The Foreign Private Adviser Exemption is available to a manager that:
(a) has no place of business in the United States;
(b) has, in total, fewer than 15 clients in the United States and investors in the US in private funds advised by the manager;
(c) has less than $25 million of aggregate capital commitments from US investors; and
(d) does not hold itself out generally to the public in the US as an investment adviser.
As the exemption counts both “clients” and “investors” in the United States, in certain cases (e.g., US investors investing through a non-US special purpose vehicle), the rules would require the manager to “look through” an investor that is a non-US entity and count its underlying US investors for the purposes of these tests.
Managers often will outgrow the Foreign Private Adviser Exemption as they begin to accept more US capital. In this case, a manager typically will rely on either the “Private Fund Adviser Exemption” or the “Venture Capital Exemption” (each summarized below). Managers relying on either of these two exemptions are referred to as “Exempt Reporting Advisers” (ERAs) because such managers are (a) exempt from registration under the Advisers Act, but (b) still need to make “Form ADV” filings with the SEC within 60 days of first relying on the exemption and annually thereafter (and upon certain other material events). The filings and other compliance costs for ERAs are lighter than for managers that are registered with the SEC, but the compliance costs are higher than those for managers relying on the Foreign Private Adviser Exemption (discussed above), which are not required to make any filings at all. Since an ERA is typically required to make its first Form ADV filing within 60 days after it begins to rely on the relevant ERA exemption, these filings and the related analysis can often be finalized after the fund’s initial closing.
Private Fund Adviser Exemption
The Private Fund Adviser Exemption requires that a manager (a) manage only private funds and (b) have less than $150 million in assets under management (AUM) attributable to US investors. Any assets managed by a non-US adviser outside the US (whether investment funds or managed accounts) do not count toward the $150 million limit. However, if the non-US adviser manages any assets from a US place of business for clients that are not qualifying private funds1, the non-US adviser will be unable to rely on this exemption.
Venture Capital Exemption
The Venture Capital Exemption exempts managers that only manage “venture capital funds.” In order to qualify as a venture capital fund, a fund is generally required (a) to represent to its actual and potential investors that it pursues a venture capital strategy; (b) to invest primarily in qualifying venture capital investments, except that the fund may invest up to 20% of the fund’s capital commitments in non-qualifying investments; (c) not to incur leverage in excess of 15% of its capital contributions and uncalled capital commitments; and (d) to provide no liquidity rights to its investors except in extraordinary circumstances (i.e., it must be a closed-end fund with no redemptions), among other technical requirements.
Securities Act and Investment Company Act
PE and VC managers typically need to structure their US offerings as “private placements” (i.e., non-public offerings to specifically identified investors) in order to avoid the requirement to register their fund interests under the US Securities Act of 1933 (the Securities Act) and register the fund itself as an investment company under the US Investment Company Act of 1940 (the Investment Company Act). For non-US managers, the key action items are (a) ensuring that there is no “general solicitation” (i.e., broad marketing of fund interests, including via social media or publicly available webpages) in the United States; and (b) confirming that each US investor (i.e., an investor resident/domiciled in the United States) is both (1) an “accredited investor” under the Securities Act, and (2) a “qualified purchaser” under the Investment Company Act. However, if the fund will admit fewer than 100 beneficial owners (in some cases, this will include indirect investors), then it is not necessary that investors be qualified purchasers. Notably, there is no “reverse solicitation” exemption under the US securities laws.
A fund’s GP typically will file a “Form D” with the SEC in order to affirm the availability of a private placement “safe harbor” provided in Regulation D under the Securities Act. Form D should be filed within 15 days following the earlier of the date that the first US investor is admitted to the fund and the date the GP receives an irrevocable subscription agreement from a US investor. However, for tactical reasons, a GP will often “pre-file” Form D prior to the fund’s closing (which allows the GP to avoid disclosing the size of the closing). Some GPs in the market may determine not to file a Form D or rely on Regulation D, and, instead, rely on the general private placement exemption available under Section 4(a)(2) of the Securities Act. Such a strategy can save costs but carries additional regulatory risk.
The SEC implemented new rules in 2013 (Rule 506(c)) permitting managers to offer interests in a fund by “general solicitation”—a departure from the traditional restrictions mentioned above—if the manager follows additional procedural and investor diligence requirements. However, the SEC has been strict in scrutinizing offerings under these more permissive rules, and relatively few managers have raised capital in this manner. Accordingly, where practicable, it is suggested that managers continue to avoid “general solicitations” and, instead, comply with the traditional private placement rules under the Securities Act as described above.
As AUM increases (e.g., $200 million-plus), many managers will begin to target US pension plan investors, which represent a significant source of capital for PE and VC funds globally. Unless an exemption is available, the US Employee Retirement Income Security Act of 1974 (ERISA) imposes onerous fiduciary and prohibited transaction requirements on a fund with investors that are subject to ERISA (generally US private pension plans and Individual Retirement Accounts (RAs).
Most managers avoid the application of ERISA by complying with the “25% Exception,” which is available if aggregate participation of benefit plan investors is less than 25% of each class of interests in the fund. Helpfully, the benefit plan investors, in this instance, do not include US state and local government pension plans, but they do include IRAs.
In other situations, managers of funds may instead seek to comply with an “Operating Company” exception, pursuant to which the fund would qualify as either a “Venture Capital Operating Company” or a “Real Estate Operating Company,” depending on its investment strategy. Under an Operating Company Exemption, a fund will not be subject to ERISA if, upon the fund’s initial investment and thereafter, at least 50% of its assets are invested in investments that meet certain requirements, and that the fund itself must hold and actually exercise significant rights in respect of the management/operations of the underlying portfolio company.
Even if the fund’s investment strategy is conducive to the Operating Company exception under ERISA, in many cases the 25% Exception may be preferred (unless the manager’s investor base is difficult to monitor or will have a substantial focus on ERISA investors.) Operating Company exceptions may require additional care in deal structuring with the attendant substantial legal compliance costs.
US Tax Considerations
From a US tax perspective, there are two main types of US investors—US taxable investors and US tax-exempts. US taxable investors generally include individuals who are US tax residents or who hold a Green Card, and US corporations. US tax-exempts, on the other hand, include pension plans, retirement funds, private foundations and charities. Similar tax considerations also apply to US investors who are investing through a fund-of-funds, though an investor that is investing in a fund‑of-funds might not raise any US tax‑related requests unless it has meaningful US ownership.
From a structuring perspective, a US taxable investor will often request that all fund entities it directly or indirectly invests through be structured as “pass-through entities” for US tax purposes. Typically, managers can accommodate this request by making certain US tax elections (called check-the-box elections) with respect to the fund entities without needing to actually reorganize the fund entities or create alternative investment vehicles.
However, certain US tax-exempts sensitive to “unrelated business taxable income” (generally, any business income unrelated to such entity’s exempt purposes) might insist on investing through a “blocker” that is treated as a corporation for US tax purposes, rather than directly incurring such taxable income. This requirement would often necessitate establishing a “feeder fund” above the fund or a “parallel fund” alongside the fund to accommodate these US tax-exempts.
In most cases, US investors will expressly require the fund to provide certain US informational returns (called Schedules K-1) or equivalent information statements annually that the US investors require to prepare their own US tax returns. These Schedules K-1 or equivalent information statements generally can be prepared by US accounting firms based on the fund’s financial statements. US investors might also request that the fund’s governing documents incorporate certain provisions specifically addressing US partnership tax rules, such as the allocation of income for US tax purposes and the handling of US tax audits. Often, US investors request that the fund provide specific information about the fund investments that may be required to mitigate the impact of certain US anti-deferral rules applicable to ownership of non-US corporations. Other common requests made by US investors are intended to address the extensive United States tax reporting requirements.
Tax structuring (including the need for blockers and/or parallel vehicles) can add substantial costs to a fund offering, particularly when new investors with different needs join the fund over time. However, these costs can be substantially lower if the fund is set up from the beginning with a structure and governing agreements that allow flexibility to accommodate any future investor issues that may arise. In addition, it is common for costs associated with structuring accommodations to be borne by the investors that require the structure for legal, tax or regulatory reasons.
Additional US Regulatory Issues
The summary above addresses the key US regulatory and tax rules that most commonly arise for an offering of fund interests by a non-US fund manager to US investors. Other US-specific issues that may arise include the following:
1. CFIUS—The Committee on Foreign Investment in the United States (CFIUS) has authority to review transactions for risks to US national security. The Foreign Investment Risk Review Modernization Act of 2018 (FIRRMA) expanded the scope of transactions subject to review by CFIUS, and the US Department of Treasury (the Treasury) published new regulations to implement FIRRMA with effect from February 13, 2020. The new regulations expand CFIUS review to certain non-passive investments in US businesses with critical technology, critical infrastructure, and sensitive personal data, and also certain real estate transactions that are in proximity to sensitive US governmental facilities. In addition, the regulations incorporate FIRRMA provisions requiring a mandatory CFIUS filing for any investment involving critical technology or a foreign government owned investor. Failure to make a mandatory filing could result in the imposition of a civil penalty, potentially up to the value of the transaction. As a general matter, an investment in a US business by a fund the GP of which is not (and is not controlled by) a foreign person and the non-US LPs of which do not have any control rights over the GP would not be within CFIUS’s jurisdiction, even if the fund itself is domiciled outside the US. In addition, the regulations provide more liberal treatment for countries that have been designated as “excepted foreign states” and their nationals. The countries currently designated as excepted foreign states are Australia, Canada, New Zealand, and the United Kingdom.
2. Sanctions (OFAC)—The US Treasury’s Office of Foreign Assets Control (OFAC) administers and enforces most economic and trade sanctions in the United States. Generally, all US persons are required to comply with OFAC sanctions, including the prohibition on engaging in or facilitating any transaction with a designated party on OFAC’s List of Specifically Designated Nationals and Blocked Persons (SDNs) or any entity in which one or more SDNs have a 50% or greater interest. Non-US persons are subject to US sanctions if the transaction involves a US nexus (e.g., the transaction involves a US person or US goods or services, including the use of the US financial system). Certain OFAC programs, such as those in effect against Iran, North Korea, Russia, and cyber and proliferation activities, also include “secondary sanctions” whereby OFAC can sanction non-US persons even where there is no US nexus to the transaction. Fund managers should be aware of their OFAC-related compliance obligations as their funds make investments outside the United States that may be subject to the increasingly complex and dynamic US sanctions regime.
3. Volcker Rule—Non-US managers that are affiliated with US banks (or non-US banks that have US banking operations) should be aware of the implications of section 13 of the Bank Holding Company Act of 1956 (the BHCA) (also known as the Volcker Rule). The Volcker Rule generally prohibits a banking entity (which is defined to include, among other things, entities affiliated with US banks and non-US banks with US banking operations) from investing in and sponsoring any covered fund. This is relevant if the manager is affiliated with a US bank or a non-US bank with a US branch. However, over the course of last year, US federal regulators relaxed certain restrictions in the implementing regulations of the Volcker Rule, making it easier for banks (especially non-US banks) to make large investments in PE and VC funds.
4. BHC Investors—Bank holding companies (BHCs) and their affiliates are subject to restrictions under the BHCA (in addition to the restrictions under the Volcker Rule discussed above). A BHC that has not elected to be treated as a financial holding company is generally prohibited from acquiring or controlling “voting securities” or assets of a non-banking company, subject to certain exemptions. A fund that may admit BHC investors should therefore ensure that the fund’s governing documents have in place provisions that provide that BHC investors will hold non-voting equity interests in the fund to the extent necessary to avoid application of the BHCA.
5. Broker-Dealer Rules (Placement Agents)—Under the Securities Exchange Act of 1934 (the Exchange Act), placement agents, finders, and similar service providers that are compensated for raising capital generally are required to be registered as “broker‑dealers” with the SEC. The broker-dealer requirements apply both to the individuals who engage in capital raising as well as the firms that employ them. However, PE and VC fund GPs and sponsors (and, subject to additional rules and increasing SEC scrutiny, certain of their employees) generally do not need to register as broker-dealers, relying on the SEC’s interpretation that issuers of securities are not acting as broker‑dealers when selling their own securities.
6. New Issues under FINRA—The Financial Industry Regulatory Authority (FINRA) has issued Rule 5130 and Rule 5131 to safeguard the integrity of the IPO process. Under these rules, broker-dealers who are FINRA members and their affiliates are generally prohibited from selling or allocating shares in all IPOs of equity securities (New Issues) to funds in which certain restricted persons (e.g., broker-dealers, portfolio managers, banks and similar persons, as well as executive officers and directors of the relevant portfolio company, and their related persons) have a significant interest. Helpfully, FINRA amended Rules 5130 and 5131 with effect from January 2020 to provide that the allocation restrictions do not apply to a non-US broker-dealer who allocates New Issues to non-US persons, provided that the allocation decisions are not made at the direction or request of a US broker-dealer. Generally, a fund that is domiciled, and managed by a non‑US manager, outside the United States is treated as a non-US person and, on that basis, may participate in New Issues through a non-US broker-dealer without concern for the requirements of Rules 5130 and 5131 irrespective of the nationality of the fund’s underlying investors.
7. FOIA—Under the Freedom of Information Act of 1966 (FOIA) and similar US state and local government rules, certain government investors may be required to disclose confidential information about the fund publicly. Some non-US governmental entities are subject to similar rules (which are collectively referred to as “FOIA laws” in the funds industry). A fund manager typically will obtain representations from each investor to determine if any FOIA laws apply and, if so, many agree to withhold certain information from investors who are subject to FOIA laws or provide such information only in a format that would not be subject to retention and public disclosure.
8. CFTC—A private fund that engages in commodity interest transactions generally will be subject to regulation by the Commodity Futures Trading Commission (CFTC) through the Commodities Exchange Act (CEA) unless the fund is structured or operated in a manner that does not trigger CFTC regulation. Typically, CFTC issues are more relevant for hedge funds than PE or VC funds given that hedge funds are more likely to trade in commodity interests. PE and VC funds that have some exposure to commodity interest (e.g., through certain hedging transactions) typically are able to rely on the “de minimis” exemption from registration with CFTC as a commodity pool operator if certain limits on the fund’s commodity interest positions are met.
When offering PE or VC fund interests to US investors, it is important to consider the foregoing issues and structure the fund in a manner that will be attractive to US investors from a regulatory and tax perspective. These rules can be complex and nuanced but can often be addressed in a simple, straightforward, and cost-effective manner with the support of experienced and solutions‑focused professional advisors. For non-US managers seeking substantial AUM growth, the extraordinary capital raising potential often justifies an increasing willingness to navigate these issues and begin fundraising in the United States.