Private Equity

Private equity funds pursue a variety of investment strategies, including buyout, growth equity, and venture capital. A typical investment strategy undertaken by a private equity fund is to take a controlling interest in a portfolio company and engage actively in the management and direction of the business in order to increase its value. Some private equity funds may also specialize in making minority investments in fast-growing businesses or startups.

Reading the Words: Adviser, General Partner, Limited Partner and Portfolio Company

The adviser is the private equity firm that manages the fund. A general partner is an individual or an entity, typically affiliated with a venture capital firm, private equity firm, or other investment firm, that raises money from limited partners for a private fund organized as a limited partnership and that both invests in and manages the fund. A fund that is organized in a different structure, such as a limited liability company, has a managing member or other manager under applicable state law and governing documents of the fund instead of a general partner.

A limited partner is an investor who commits capital to a private fund. Unlike a general partner, a limited partner's participation in the fund's investment activities is restricted, and its personal liability for fund debt is limited to the amount of money that the limited partner contributed or committed to contribute. The relationship of a limited partner with the fund and the general partner is governed by a Limited Partnership Agreement. For a fund that is organized as a limited liability company, the investor is referred to as a member under applicable state law and governing documents of the fund.

A portfolio company is an operating company that has received an investment from a fund. A portfolio company generally represents one of several investments for a fund.

How a Private Equity Fund Works

An investor in a private equity fund usually receives offering documents detailing material information about the investment and enters into various agreements as a limited partner of the fund. These offering documents and agreements should disclose and govern the terms of the investor's investment throughout the fund's life, including the fees and expenses to be incurred by funds and their investors.

The initial investment amount for a private equity investment is often very high.

Advisers may be managing multiple funds that are jointly invested in multiple portfolio companies. The adviser has a legal obligation to act in the best interests of each of the funds it manages and must allocate expenses among itself, its funds and the funds' portfolio companies in accordance with this fiduciary duty.

How the SEC Classifies a Private Equity Fund

Investment advisers to private funds use Form ADV to register with the SEC and/or certain state securities authorities. For Question 10, Type of Private Fund, the instructions to Form ADV define a private equity fund as any private fund that is not a hedge fund, liquidity fund, real estate fund, securitized asset fund, or venture capital fund and does not provide investors with redemption rights in the ordinary course.

The same instructions define a venture capital fund as any private fund meeting the definition of venture capital fund in Rule 203(l)-1 under the Investment Advisers Act of 1940. Under that rule, a venture capital fund includes any private fund that meets five conditions. It represents to investors and potential investors that it pursues a venture capital strategy. Immediately after the acquisition of any asset, other than qualifying investments or short-term holdings, it holds no more than 20 percent of the amount of the fund's aggregate capital contributions and uncalled committed capital in assets, other than short-term holdings, that are not qualifying investments, valued at cost or fair value, consistently applied by the fund. It does not borrow, issue debt obligations, provide guarantees or otherwise incur leverage in excess of 15 percent of the private fund's aggregate capital contributions and uncalled committed capital, and any such borrowing, indebtedness, guarantee or leverage is for a non-renewable term of no longer than 120 calendar days, except that a guarantee by the private fund of a qualifying portfolio company's obligations up to the value of the fund's investment in that company is not subject to the 120 calendar day limit. It only issues securities the terms of which do not provide a holder with any right, except in extraordinary circumstances, to withdraw, redeem or require the repurchase of the securities, but which may entitle holders to receive distributions made to all holders pro rata. And it is not registered under Section 8 of the Investment Company Act and has not elected to be treated as a business development company.

A qualifying investment includes an equity security issued by a qualifying portfolio company that has been acquired directly by the private fund from that company. A qualifying portfolio company, among other requirements, is a company that at the time of any investment by the private fund is not reporting or foreign traded and does not control, is not controlled by or under common control with another company, directly or indirectly, that is reporting or foreign traded.

The SEC's glossary lists venture capital among the strategies pursued by private equity funds, while the Form ADV instruction treats a venture capital fund as separate from a private equity fund, because its definition of a private equity fund excludes any venture capital fund.

Private Equity Compared with Hedge Funds and Mutual Funds

A hedge fund is a private, unregistered investment fund. Hedge funds pool money from investors and invest in securities or other types of assets with the goal of getting positive returns. Hedge funds are generally limited to individuals and institutional investors who meet certain financial or sophistication criteria. Hedge funds generally pursue more flexible investments and strategies than registered investment companies, like mutual funds and exchange-traded funds, which may increase the risk of investment losses. These investment strategies can include using leverage, which means borrowing to increase investment exposure as well as risk, short-selling, and other speculative investment practices.

Unlike mutual funds, exchange-traded funds, and other types of open-end funds, hedge funds are not marketed to retail investors. They are not subject to the numerous regulations that apply to mutual funds and exchange-traded funds for the protection of investors, including requiring that mutual fund shares be redeemable on a daily basis based on the net asset value; protecting against conflicts of interest; ensuring fairness in the pricing of fund shares; requiring disclosure; limiting the use of leverage; and more. Hedge funds, however, are subject to the same prohibitions against fraud as are other market participants, and their managers owe a fiduciary duty to the funds that they manage.

Hedge funds typically limit opportunities to redeem, or cash in, shares to four times a year or fewer. They also often impose a lock-up period of one year or more, during which an investor cannot cash in shares. Private equity funds typically impose limitations on investors' ability to withdraw their investment, and the Form ADV definition of a private equity fund turns on whether the fund provides investors with redemption rights in the ordinary course.

Why a Private Fund Is Not a Registered Investment Company

A private fund is excluded from the definition of investment company by one of two provisions of the Investment Company Act. Section 3(c)(1) applies to any issuer whose outstanding securities (other than short-term paper) are beneficially owned by not more than one hundred persons (or, in the case of a qualifying venture capital fund, 250 persons) and which is not making and does not presently propose to make a public offering of its securities. Section 3(c)(7) applies to any issuer, the outstanding securities of which are owned exclusively by persons who, at the time of acquisition of such securities, are qualified purchasers, and which is not making and does not at that time propose to make a public offering of such securities.

A qualified purchaser is an investor that meets certain financial and sophistication standards, as defined in the Investment Company Act and its rules. Under the Act, the term includes any natural person who owns not less than five million dollars in investments, as defined by the SEC, and any person, acting for its own account or the accounts of other qualified purchasers, who in the aggregate owns and invests on a discretionary basis not less than twenty-five million dollars in investments.

Who May Invest

A private equity fund is typically open only to accredited investors and qualified clients. Accredited investors and qualified clients include institutional investors, such as insurance companies, university endowments and pension funds, and high income and net worth individuals. An institutional investor is an entity that invests capital.

An investor that meets certain standards outlined in Rule 501(a) of Regulation D qualifies as an accredited investor. Under the federal securities laws, only persons who are accredited investors may participate in certain securities offerings. One reason these offerings are limited to accredited investors is to ensure that all participating investors are financially sophisticated and able to fend for themselves or sustain the risk of loss, thus rendering less necessary the protections that come from a registered offering.

An individual is an accredited investor if the individual earned income that exceeded two hundred thousand dollars, or three hundred thousand dollars together with a spouse or spousal equivalent, in each of the prior two years and reasonably expects the same for the current year; or has a net worth over one million dollars, either alone or together with a spouse or spousal equivalent, excluding the value of the person's primary residence and any loans secured by the residence up to the value of the residence; or is a broker or other financial professional holding certain certifications, designations or credentials in good standing, including a Series 7, 65 or 82 license. A spousal equivalent means a cohabitant occupying a relationship generally equivalent to that of a spouse. Directors, executive officers, or general partners of the company selling the securities, or of a general partner of that company, are also accredited investors, and so, for investments in a private fund, are knowledgeable employees of the fund. Entities that qualify include a bank, savings and loan association, insurance company, registered investment company, business development company, small business investment company or rural business investment company; investment advisers that are SEC-registered, state-registered or exempt reporting advisers; SEC-registered broker-dealers; and entities where all equity owners are accredited investors.

Rule 205-3 under the Investment Advisers Act of 1940 addresses the compensation of advisers. It provides that Section 205(a)(1) of that Act will not be deemed to prohibit an investment adviser from entering into an advisory contract that provides for compensation on the basis of a share of the capital gains upon, or the capital appreciation of, the funds of a client, provided that the client is a qualified client. A qualified client is a natural person or a company that, immediately after entering into the contract, has under the management of the investment adviser at least the applicable dollar amount specified in the most recent SEC order. A qualified client is also a natural person or a company that the adviser reasonably believes, immediately before entering into the contract, either has a net worth of more than the applicable dollar amount specified in the most recent order or is a qualified purchaser. Certain executive officers, directors, trustees, general partners, and employees of the adviser are qualified clients as well.

A person who is not invested in a private equity fund directly may still be indirectly invested in one. A person may be indirectly invested in a private equity fund by participating in a pension plan or owning an insurance policy, among other ways. Pension plans and insurance companies may invest some portion of their large portfolios in private equity funds.

How Private Equity Funds Are Offered

Under the federal securities laws, a company may not offer or sell securities unless the offering has been registered with the SEC or an exemption from registration is available. Offerings exempt from the SEC's registration requirements pursuant to Section 4(a)(2) of the Securities Act of 1933 or its safe harbor under Regulation D of that Act are often referred to as private placements. Hedge funds and other private funds also engage in private placements. The Financial Industry Regulatory Authority, known as FINRA, describes a private placement as an offering of unregistered securities to a limited pool of investors.

Regulation D includes two SEC rules, Rules 504 and 506, that issuers often rely on to sell securities in unregistered offerings. Most private placements are conducted pursuant to Rule 506. Issuers may raise an unlimited amount of money in offerings relying on one of two possible Rule 506 exemptions, Rules 506(b) and 506(c). An issuer relying on Rule 506(b) may sell to an unlimited number of accredited investors, but to no more than 35 non-accredited investors in any 90-calendar-day period. Any non-accredited investors in the offering must be financially sophisticated or, in other words, have sufficient knowledge and experience in financial and business matters to evaluate the investment.

Issuers relying on the Rule 506(b) exemption may not generally solicit their offerings. However, the Rule 506(c) exemption permits the issuer to generally solicit or advertise for potential investors. Only accredited investors, however, are allowed to purchase in generally solicited offerings under Rule 506(c), and the issuer will have to take reasonable steps to verify the investor's accredited investor status.

If the issuer offers securities to non-accredited investors, the issuer must disclose certain information about itself, including its financial statements. If selling only to accredited investors, the issuer has discretion as to what to disclose to investors. Any information provided to accredited investors also must be provided to non-accredited investors.

Issuers may provide a document called a private placement memorandum or offering memorandum that introduces the investment and discloses information about the securities offering and the issuer. This document is not required. Moreover, private placement memoranda and other offering documents typically are not reviewed by any regulator and may not present the investment and related risks in a balanced light.

All issuers relying on a Regulation D exemption are required to file a document called a Form D no later than 15 days after they first sell the securities in the offering. The Form D will include brief information about the issuer, its management and promoters, and the offering itself. Form D does not represent SEC approval or registration. The SEC does not approve any offering.

Despite not being subject to the same disclosure obligations as registered offerings, private placements are subject to the antifraud provisions of the federal securities laws. Even though the offering may be exempt from SEC registration, the offering may have to comply separately with state securities laws, including state registration requirements or a state exemption from registration.

Fees and Expenses

Management fees are fees generally paid out of fund assets to its adviser in exchange for managing the fund. A private equity fund manager typically charges a fee based on a percentage of capital invested in the fund or committed to the fund, in addition to a performance fee. Performance fees are compensation provided to an adviser based on the performance of a client's portfolio. A common way to calculate such fees is based on a percentage of investment profits.

A private equity fund manager typically uses a fee structure that includes a yearly management fee based on committed capital or invested capital and a performance fee based on the profits made above a certain benchmark. The latter is often referred to as carried interest. Carried interest is a type of performance fee, in the form of a portion of profits from an investment or investments, paid to private fund managers in venture capital and private equity firms. These arrangements are often referred to by their percentages, and a 2 percent management fee and 20 percent performance fee is referred to as 2 and 20.

Investors should be vigilant about the fees and expenses incurred in connection with their investment. The SEC has brought enforcement actions involving fees and expenses that were incurred by funds and their investors without being adequately consented to or disclosed, and several enforcement actions related to shifting and allocation of expenses.

Illiquidity and Resale Restrictions

Liquidity refers to how easily or quickly a security can be bought or sold in a secondary market without significantly impacting its trading price. Securities of private companies are generally illiquid assets because there are typically fewer buyers and sellers, and resale restrictions pursuant to Securities Act Rule 144 may apply to securities acquired in an exempt offering.

Because of their long-term investment horizon, an investment in a private equity fund is often illiquid, and it may be necessary to hold an investment in a private equity fund for several years before any return is realized. Private equity funds typically impose limitations on investors' ability to withdraw their investment. Investors in private equity funds should be able to wait the requisite time period before realizing their return. For an institutional investor, a private equity investment may represent only a small portion of its diversified investment portfolio.

Restricted securities are securities that were acquired from the company or an affiliate of the company in certain types of exempt offerings. The holder of restricted securities cannot resell them unless the resale is exempt from the SEC's registration requirements. Generally, most securities acquired in a private placement will be restricted securities. An investor should not expect to be able to easily and quickly resell restricted securities and should be prepared to hold the securities indefinitely.

One rule investors commonly rely on to resell restricted securities requires the investor to hold the restricted securities for at least a year if the company does not file periodic reports, such as annual and quarterly reports, with the SEC, and six months if the company does file periodic reports with the SEC. Most private companies that issue private placements do not file these periodic reports.

Information about a private company is not typically available to the public, and a private company may not provide information to the investor or the investor's buyer. Any restricted status of the securities may also transfer to the buyer. For these reasons, it will generally be more difficult to find buyers compared to selling stock of a public company on a stock exchange. An investor may also be required to enter into one or more contracts or agreements that may contain provisions that restrict or prevent the investor from freely transferring the securities.

Conflicts of Interest

Private equity firms often have interests that are in conflict with the funds they manage and, by extension, the limited partners invested in the funds. Private equity firms may be managing multiple private equity funds as well as a number of portfolio companies. The funds typically pay the private equity firm for advisory services. In addition, the portfolio companies may also pay the private equity firm for services such as managing and monitoring the portfolio company. Affiliates of the private equity firm may also play a role as service providers to the funds or the portfolio companies.

As fiduciaries, advisers must make full disclosure of all conflicts of interest between themselves and the funds they manage in order to get informed consent. Through its various relationships, including with affiliates and portfolio companies, there exists opportunity for advisers to benefit themselves at the expense of the funds they manage and their investors.

Risks

Companies engaging in private placements may be early stage and high risk. An investor should be able to afford the increased risk of loss with such investments, including the potential of a total loss. Companies engaging in private placements are not required to provide the disclosure that would be required in a registered offering. An investor may have less information to make an informed investment decision than with stock purchased on a stock exchange, including information that may help determine whether the price asked for the investment is a fair price.

FINRA lists private placements among its alternative and emerging products. FINRA's guidance on those products observes that with the promise of higher returns comes higher risk. It adds that it is important to stay diversified, not only across and within the major asset classes, but also across a variety of investment products, and that alternative and emerging products are generally used to supplement traditional investments.

Regulation of Private Fund Advisers

Historically, many of the investment advisers to private funds had been exempt from registration. The Dodd-Frank Act replaced the old private adviser exemption with narrower exemptions for advisers that advise exclusively venture capital funds and advisers solely to private funds with less than one hundred fifty million dollars in assets under management in the United States. Many previously unregistered advisers to private funds were required to register with the SEC or the states.

SEC-registered investment advisers with at least one hundred fifty million dollars in private funds assets under management use Form PF to report, on a non-public basis, information about the private funds that they manage. Most advisers file Form PF annually to report general information such as the types of private funds advised, each fund's size, leverage, liquidity and types of investors. Certain larger advisers provide more information on a more frequent basis.

The Broker-Dealer's Role

FINRA reminds broker-dealers of their obligation to conduct a reasonable investigation of the issuer and the securities they recommend in offerings made under Regulation D, also known as private placements. A broker-dealer has a duty, enforceable under federal securities laws and FINRA rules, to conduct a reasonable investigation of securities that it recommends, including those sold in a Regulation D offering. In order to ensure that it has fulfilled its suitability responsibilities, a broker-dealer in a Regulation D offering should, at a minimum, conduct a reasonable investigation concerning the issuer and its management; the business prospects of the issuer; the assets held by or to be acquired by the issuer; the claims being made; and the intended use of proceeds of the offering. A broker-dealer must conduct a reasonable investigation in connection with each offering, notwithstanding that a subsequent offering may be for the same issuer.

In the course of a reasonable investigation, a broker-dealer must note any information that it encounters that could be considered a red flag that would alert a prudent person to conduct further inquiry. When presented with red flags, the broker-dealer must do more than simply rely upon representations by the issuer's management, the disclosure in an offering document or even a due diligence report of the issuer's counsel. An issuer's refusal to provide a broker-dealer with information that is necessary for the broker-dealer to meet its duty to investigate could itself constitute a red flag.

FINRA Rule 5123 requires each member that sells a security in a non-public offering in reliance on an available exemption from registration under the Securities Act to submit to FINRA, or have submitted on its behalf, a copy of any private placement memorandum, term sheet or other offering document, and any retail communication that promotes or recommends the private placement, within 15 calendar days of the date of first sale, or to notify FINRA that no such offering documents or retail communications were used. The rule exempts private placements sold solely to categories that include institutional accounts, qualified purchasers, qualified institutional buyers, and certain accredited investors.

Regulation Best Interest provides that a broker, dealer, or natural person who is an associated person of a broker or dealer, when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer, shall act in the best interest of the retail customer at the time the recommendation is made, without placing the financial or other interest of the broker, dealer, or natural person making the recommendation ahead of the interest of the retail customer.

Under FINRA Rule 1220(b)(9), a representative may register as a Private Securities Offerings Representative if the representative's activities are limited to effecting sales as part of a primary offering of securities not involving a public offering, pursuant to Sections 3(b), 4(2) or 4(6) of the Securities Act and the Securities Act rules and regulations. Such a person shall not effect sales of municipal or government securities, or equity interests in or the debt of direct participation programs. All other individuals registering as Private Securities Offerings Representatives after October 1, 2018 must, prior to or concurrent with that registration, pass the Securities Industry Essentials examination and the Private Securities Offerings Representative qualification examination.

Private Equity on the Examination

The content outline for the Securities Industry Essentials examination lists private equity under Topic 2.1.8, Hedge Funds, in Section 2, Understanding Products and Their Risks. Under that topic the outline also lists minimum investment, partnership structure and generally illiquid. Topic 1.4, Offerings, lists public vs. private securities offering. Candidates should check the current outline before the examination.

Common Misunderstandings

A private equity fund is registered with the SEC like a mutual fund. Private equity funds themselves are not registered with the SEC, although a private equity fund may be advised by an adviser that is registered with the SEC.

Filing a Form D means the SEC has approved the offering. Form D does not represent SEC approval or registration, and the SEC does not approve any offering.

Any investor can buy into a private equity fund. A private equity fund is typically open only to accredited investors and qualified clients.

A private equity investor can cash in the investment at any time, as a mutual fund shareholder can. Private equity funds typically impose limitations on investors' ability to withdraw their investment, while mutual fund shares are required to be redeemable on a daily basis based on the net asset value.

Private equity funds and hedge funds are the same thing. Both are private funds, but the Form ADV instruction defines a private equity fund as a private fund that is not a hedge fund and does not provide investors with redemption rights in the ordinary course.

Private equity always means buying control of a company. A typical strategy is to take a controlling interest in a portfolio company, but some private equity funds specialize in making minority investments in fast-growing businesses or startups.

A limited partner manages the fund and is liable without limit. A general partner both invests in and manages the fund, while a limited partner's participation in the fund's investment activities is restricted and its personal liability for fund debt is limited to the amount of money that the limited partner contributed or committed to contribute.

Only wealthy individuals and institutions hold private equity. A person may be indirectly invested in a private equity fund by participating in a pension plan or owning an insurance policy, among other ways.

A private placement is not covered by the securities laws. Private placements are subject to the antifraud provisions of the federal securities laws, may have to comply separately with state securities laws, and require a broker-dealer that recommends them to conduct a reasonable investigation.

The Securities Industry Essentials examination by itself registers a person to sell private placements. Under Rule 1220(b)(9)(B), all other individuals registering as Private Securities Offerings Representatives after October 1, 2018 must, prior to or concurrent with that registration, pass the Securities Industry Essentials examination and the Private Securities Offerings Representative qualification examination.

Key Points

A private equity fund is a type of private fund, managed by a private equity firm, that pools investor money and uses it to make investments on behalf of the fund, typically with an investment time horizon of 10 or more years.

Private equity funds themselves are not registered with the SEC and are not subject to regular public disclosure requirements, even when the adviser is registered.

A private equity fund is typically open only to accredited investors and qualified clients. Private funds, including private equity funds, engage in private placements, which are offerings exempt from registration under Section 4(a)(2) of the Securities Act of 1933 or its safe harbor under Regulation D.

A general partner invests in and manages the fund, and a limited partner commits capital with participation restricted and personal liability for fund debt limited to the amount contributed or committed.

An investment in a private equity fund is often illiquid, and securities acquired in a private placement are generally restricted securities.

The adviser typically charges a management fee and a performance fee, and conflicts of interest between the private equity firm and the funds it manages must be fully disclosed.