Marketing Restrictions for Raising Capital as a Private Fund

23rd March, 2021

What You Need to Know

Many people probably assume that outperforming the market is the greatest challenge a hedge fund advisor faces. Not so, says investing expert Daniel Strachman, Managing Director of A & C Advisors and the author of nine books looking at managers and their strategies: “Raising money is the toughest thing in the hedge fund business. Period. End of story.”

One of the reasons it’s difficult to raise money is that an advisor must be aware of, and in adherence with, applicable SEC rules. A failure to be compliant can result in censure from the authorities and even private lawsuits from your investors.

What You Are Selling Are Securities

The interests that a hedge fund advisor offers to investors constitute securities. This is crucial, because generally speaking, securities must be registered with the SEC, per the Securities Act of 1933.

With securities registration comes serious reporting requirements. As the SEC underscores, significant information must be reported by a registered issuer, including:

  • A description of the company’s properties and business
  • A description of the securities to be offered for sale
  • Information about the management of the company, and
  • Financial statements certified by independent accountants

The above filings become public soon after they’ve been filed with the SEC. Understandably, hedge fund advisors seek to avoid both the expense and hassle of these filings. Perhaps more importantly, fund advisors are also keen, for competitive reasons, to not have their financial statements and activities available to the public.

SEC Exemptions from Registering Securities

To steer clear of registering their securities, hedge fund advisors can take advantage of two regulatory exemptions contained in SEC Regulation D (“Reg D”). These exemptions permit funds to issue an unlimited number of securities to investors. Advisors may choose one of two Reg D exemptions to avoid registering securities with the SEC: Rule 506 (B) and Rule 506 (C). They cannot, however, choose both routes.

Rule 506 (B), Explained

To satisfy the first possible exclusion, Rule 506 (B) a fund advisor must be in compliance with the following SEC rules:

  •  The company cannot use general solicitation or advertising to market the securities.
  •  The company may sell its securities to an unlimited number of “accredited investors” and up to 35 other purchasers. All non-accredited investors, either alone or with a purchaser representative, must be sophisticated—that is, they must have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment.
  •  Companies must decide what information to give to accredited investors, so long as it does not violate the antifraud prohibitions of the federal securities laws. This means that any information a company provides to investors must be free from false or misleading statements. 

Source: Securities and Exchange Commission

What Constitutes ‘General Solicitation’?

Arguably the greatest drawback to using the 506 (B) exemption is the rule prohibiting “General Solicitation”. The term is not defined per se, but rather understood to mean publicizing information about a fund or an offering of its securities. However, as law firm Morrison and Foerster notes, SEC rules do list specific instances that would qualify as General Solicitation. These include:

(1) “any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio” and (2) “any seminar or meetings whose attendees have been invited by any general solicitation or general advertising

Of course, in today’s world, the internet is often used for the purposes of advertising various products and services. But as Morrison & Foerster of Counsel Kelley Howes explains, a fund cannot provide much information about itself if it intends to rely on the private placement exemption in Rule 506(b).  “If I can go out on the web, put you into Google and what comes up isn’t just your name, location, and maybe key personnel”, you might have crossed the line into General Solicitation, she explains. 

Howes believes private fund advisors need to be aware of how broad the definitions of advertising and solicitation are, to avoid crossing the regulatory line. “If an adviser runs afoul of the rules, it can end up being a lot more expensive”, Howes cautions.

Using Pre-Existing Relationships to Raise Money Under 506 (B)

While you can’t advertise to the public, you can still raise money for a fund via a “pre-existing relationship.” There are two possible kinds of pre-existing relationships, observes Morrison and Foerster. First, it can be one that the issuer already has with a potential investor before an offering has commenced (this is where PitchBoard can help). Alternatively, such a relationship can exist between a potential investor and a broker-dealer or investment adviser, prior to either the dealer or adviser becoming involved with an offering.

Mind you, it’s not sufficient for a relationship simply to be “pre-existing” in order to raise money under 506 (B). Rather, it has to be a “substantive”, meaning that the offeror or its agent must know enough about the potential investor’s finances and investment acumen to determine whether they are an accredited or sophisticated investor.

Needing to have a substantive, pre-existing relationship with a potential investor might sound daunting. Some fund managers might think that the only way to satisfy this requirement is to advertise to close friends and business associates they’ve known for years. Fortunately, that’s not the case. As SEC regulations continue to evolve, new platforms like Pitchboard can facilitate these introductions while staying on the right side of the rules.  

506 (C): The General Solicitation Route

Reg D does provide a way for fund advisors to advertise to the public (i.e. solicit and advertise generally), and that’s via rule 506 (C). Advisors relying on this exemption must comply with two key regulations:

  • The investors in the offering are all accredited investors; and
  • The company takes reasonable steps to verify that the investors are accredited investors, which could include reviewing documentation, such as W-2s, tax returns, bank and brokerage statements, credit reports and the like.

Source: Securities and Exchange Commission

The latter part of this rule can be very onerous for a fund. Under 506 (B), a fund advisor must only have a “reasonable belief” that their investors are accredited. This test can be met through a questionnaire. But as the second key provision of 506 (C) shows, much more legwork is required to establish that an investor is truly accredited. You cannot simply take their word for it.

The Reg D Form

Even though an advisor is relying on one of the two exemptions, it still must file what’s known as a Reg D form with the SEC. This document lists basic information, such as the names of executive officers, and the size and date of the offering. It has to be filed no later than 15 days after the first issuance of securities.

Meet Potential Investors Through PitchBoard

As an emerging fund manager, raising capital could well be your biggest challenge. You’ll want to have as many pre-existing relationships with potential investors as possible. That’s where PitchBoard comes in. Our platform can connect you to the high net-worth investors you’re looking for, giving you the best chance to grow your fund.

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