In the multi-trillion dollar world of private equity and hedge funds, what are the rules that apply to raising capital? Private funds attorney Jeff Tabak explains some of the common mistakes involved with PE fundraising and the risks that can follow.
Jeff Tabak is a longtime private funds lawyer and a regular lecturer on topics relating to private equity.
Regulation D: Rules Governing the Limited Offer and Sale of Securities Without Registration Under the Securities Act of 1933.
In today’s market, private equity fund and hedge fund managers are raising billions of dollars. What are the rules of the road for fundraising these days? And what are the consequences for violating those rules?
Hi, I’m Jeff Tabak. I’m going to talk to you a little bit about what it takes to fundraise in today’s market. So, if you want to engage in a private placement of your securities, which is what managers do when they raise money for private equity and hedge funds, there are certain rules you have to follow.https://www.ecfr.gov/cgi-bin/text-idx?SID=465dc4251925603a672a767b7916fc49&node=sg17.3.230_1498.sg11&rgn=div7
Number 1: you are subject to the private placement exemption that keeps you from registering with the securities exchange commission. The safe harbor for the private placement under the securities act is known as Regulation D. That requires fund managers to sell to accredited investors.
So, what are the criteria for accredited investors? Well, individuals have to have a net worth of at least 1 million dollars, or an income of $200,000 in any year, or $300,000 with their spouse for two years and a reasonable expectation of that same income for the current year. And entities have to have at least $5 million of net worth. If they satisfy that, they are going to be accredited investors.
It’s also possible to raise money from not more than 35 non-accredited investors. But most private equity funds and hedge funds don’t need to use the not more than 35 non-accredited investors, because they have such large minimums to invest to begin with; it’s just not worthwhile.
So now I’ve described who you can solicit, but there’s also the question of the manner in which you can solicit investors. The SEC has said that you cannot engage in a general solicitation or any kind of media advertising to raise money. That’s anathema to a private placement. So again, when clients call me up and ask what they can do, the first thing I tell them is they can’t go into central park and distribute private placement memoranda to anybody who walks by. They need to have a relationship of some type with the investors that they are going to solicit. No cold calls, no emails to people they don’t know. And this is especially true in the age of the internet, where anything you say might be accessible to anybody who turns on their computer and accesses a website.
And so, what has developed over the course of the last few years is a password-protected website, at least a portion of the website that gives information about the particular fund that’s being raised so that only current investors and prospective investors who have the financial sophistication and the ability to invest in the fund can have access to information about that fund raise.
So how do you avoid general solicitation? Well the first thing that we do is send a memo to our clients that tells them things they should not do. One of them, for example, is to go on CNBC and be interviewed about their fund raise. Or to be on any other media or other program or be in the newspaper talking about what they are doing. That’s not to say that you can’t go on TV and be interviewed; you can talk about your business in general. But if somebody were to ask you a question about your fund raise, the answer should be, "no comment."
Private equity fund managers, especially when they are successful, like to talk about their returns. So, one of the things that’s important for them to know when they’re raising a fund, is they need to be careful not to talk too much about their business or their potential fund raise. The consequence of doing that though are severe.
Number one, if you have violated the general solicitation rules, there is a possibility that you may have to have a cooling-off period of up to 6 months. One of the most difficult things to tell a client is they have to stop fund raising for at least 6 months. After the fund is closed, there is a possibility, if general solicitation was engaged in, that the investors would have a rescission right. They’d be able to ask for all of their money back and possibly disgorgement by the manager of any of its prophets.
It’s also difficult because the manager not only shouldn’t talk about the actual fundraise, but maybe restricting what he can say about his actual business, any other products that he has, because it may be seen as priming the market. In the private equity fund context, where the manager might have successor funds, what that also means is that they shouldn’t go on TV or anywhere else and talk about their returns from their prior funds. That may be seen as being of interest to prospective investors to invest in their future funds, and that also might be seen as a general solicitation. So, if a private fund manager is out raising fund 6, and has just had a very successful exit from fund 5, he needs to be very careful about how he describes that.
There is an exception to that. If the fund manager has a history of issuing press releases to announce the sale of a business, then that would be something that he would be entitled to do going forward. But you wouldn’t want to start that in the middle of the fundraise if you’ve never done that before.
So, raising a private equity or hedge fund, means raising money in a private manner without any general solicitation. That’s private equity rule making 101. I’m Jeff Tabak. Thanks for watching Talks on Law.