A company seeking to raise capital through a private placement generally looks to either debt or equity. Each has its respective advantages and disadvantages, both to the company and to the investor. An equity investment presents the investors with the possibility of a larger upside participation, but does not does not require the repayment of capital. A debt investments provides a periodic, fixed return to investors, but can put the company at risk if the company cannot timely meet its debt repayment obligations. If your company wants the benefits of debt without the risk of default, consider a hybrid approach: preferred equity.
Regulation D contains safe harbors that provide exemptions from federal registration. These include exemptions under Rules 504, Rule 505, and Rule 506. Rule 506 is the most commonly relied upon exemption in private offerings (accounting for more than 90% of offerings, according to SEC statistics).
Improper drafting of PPM disclosures often results in significant liability, even when the company did not overtly intend to deceive investors. The SEC and state securities commissions have developed a complex system of disclosure regulations, with which a company must comply for the securities to be deemed properly sold. In recent years, SEC regulations have undergone and continue to undergo major shifts, largely in response to the Dodd Frank Wall Street Reform and Consumer Protection Act (Dodd Frank) and the Jumpstart our Business Startups Act (JOBS Act). Failure to properly navigate the complex and continually changing regulations carries significant liability, including personal civil liability and criminal penalties in some cases.
A private placement offering’s basic structure involves either debt, equity, or some combination of debt and equity. Within the basic structure, an issuer has numerous options, from convertible securities (debts that convert to equity upon certain events), to priority distributions and resumptions. Not one structure fits every issuer. The offering structure is driven in large part by investor appetite for the particular investment.
A Private Placement Memorandum (“PPM”), also known as a private offering document and confidential offering memorandum, is a securities disclosure document used in a private offering of securities by a company or investment fund. From an investor’s point of view, the purpose of a PPM is to obtain needed information about the security and the company, both good and bad, to allow investors to make an informed decision about whether to purchase the security. From the company’s perspective, the purpose of a PPM is to provide the necessary disclosures about the company and its securities to protect the company against claims of misstatements or omissions.
As part of the hedge fund formation process, the attorney works closely with the fund sponsor to craft the terms to which the fund and its investors will be bound. When properly structured, hedge fund offering documents contain terms that adequately protect the fund sponsor and are attractive to investors. Hedge fund terms are driven by a combination of the market trends within the fund’s specific asset class and the particular needs and objectives of the fund.
In September 2103, the SEC adopted rules allowing private issuers of securities, including hedge funds, to engage in advertising and general solicitation under Regulation D. Until the recent CFTC announcement, hedge funds that include commodities or futures within their portfolios could not engage in general solicitation, since such instruments are regulated by the Commodities Futures Trading Commission (CFTC).
Hedge fund strategies encompass a broad range of risk tolerance and investment philosophies within a wide array of investments, including debt and equity securities, commodities, currencies, derivatives, real estate and other investment vehicles. The horizon of hedge fund investment strategies has seen unprecedented expansion in recent years. Below is a description of some of the more common hedge fund strategies. Note that hedge fund investment terms are driven in large part by the fund’s strategy and its level of liquidity. See our article: Brief Survey of Common Hedge Fund Terms.
Filing the ADV and other registration documents is only the beginning of an RIA’s regulatory obligations. Following registration, RIAs and their representatives become subject to a network of complex compliance obligations. This article touches briefly on a few of the many components of RIA compliance, including: annual license renewals, detailed record keeping, investor disclosure, compliance/ethics manual issues, and preparing for audits. RIAs should work closely with an experienced investment management attorney to maintain compliance with its obligations.
A prime broker is a central broker through whom the fund executes most or all of its trades and who typically acts as custodian to the fund’s assets. When the hedge fund executes trades through other brokers, the prime broker works with the executing brokers to settle and transfer all assets through the prime broker.
Your hedge fund attorney will prepare five core documents, which are necessary to launch the fund: (i) a private placement memorandum, (ii) a limited partnership agreement, (iii) a subscription agreement, (iv) an investment management agreement, and (v) a management company operating agreement.
There are two standards of investor suitability that may apply to investment fund investors, depending whether the fund manager is required to be registered as an investment adviser: the “accredited investor” standard or the significantly higher “qualified client” standard.
Hedge fund manager fees typically consist of (i) an annual management fee and (ii) a performance allocation, also referred to as incentive allocation, or carried interest. The latter is not technically a “fee,” but rather a capital allocation, as will be discussed below. This blog post describes the role of both compensation components.
Individuals and entities that provide securities investment advice for compensation are subject to state and federal investment advisor regulations. Anyone providing investment advice should consult an experienced investment management attorney to determine whether state or federal registration is required.