Over the last several years, there has been a significant uptick in the number of private investment funds that are registering their classes of limited partnership (LP) interests under the Securities Exchange Act of 1934 (the 1934 Act). To date, there are eleven of these so-called 1934 Act private funds. They all employ private equity or infrastructure investment strategies, including fund of funds strategies, however, the 1934 Act private fund structure is suitable for other alternative investment strategies as well, such as private credit.
Like traditional private funds, when offering LP interests to investors, 1934 Act private funds utilize the private placement safe harbor of Rule 506 of Regulation D under the Securities Act of 1933 (the 1933 Act) and only permit investment by “accredited investors” in order to avoid registering the sale of their LP interests under the 1933 Act. In addition, like most private funds, 1934 Act private funds rely on Section 3(c)(7) of the Investment Company Act of 1940 (the 1940 Act), only permitting investment by “accredited investors” who are also “qualified purchasers,” to avoid registration as an investment company under the 1940 Act. 1934 Act private funds are structured with an indefinite life and continuously offer their LP interests to investors, allowing for ongoing capital inflows. Subscriptions are typically funded in full at closing (rather than drawn down over time as with traditional private funds), so the asset classes in which these funds invest need to be conducive to deploying capital immediately to avoid cash drag. In addition, they offer redemptions through periodic LP interest repurchase programs at a price based on the fund’s net asset value. Finally, 1934 Act private funds operate so as to qualify as partnerships for federal income tax purposes, with Schedule K-1 annual tax reporting to investors.
Traditionally, private funds have sought to avoid registration under the 1934 Act given the associated public disclosure obligations and costs relating thereto (e.g., preparing and filing Form 10-Ks, Form 10-Qs and Form 8-Ks with the SEC). Because the 1934 Act requires private funds with more than $10 million in assets and a class of equity securities with more than 2,000 holders of record to register such class of equity securities under the 1934 Act, private funds have historically limited the number of holders owning any class of their LP interests to 2,000 or less to avoid becoming 1934 Act reporting companies.
However, the rising popularity of 1934 Act private funds is bucking the historical trend of private funds avoiding 1934 Act registration. Managers are increasingly finding 1934 Act private funds to be attractive products to offer to investors because of their perpetual nature and ability to take in an unlimited number of investors. This creates operational and administrative efficiencies compared to traditional private funds that have a finite life and are separately formed and offered periodically. In addition, both managers and investors have found 1934 Act private funds appealing because they marry the characteristics of both open-end and closed-end funds that managers and investors have been clamoring for over the years. In this regard, open-end funds have no end date and can accept investors’ contributions on a periodic basis with preset intervals for investors to withdraw capital. On the other hand, closed-end funds have a defined life span with no capital withdrawal rights in a capital commitment drawdown structure where the fundraising only occurs during a fixed window when a new fund is launched. The key to permitting the fusion of these two fund structures when dealing with illiquid asset classes, such as private equity and infrastructure, as mentioned above, is the ability of 1934 Act private funds to raise capital from an unlimited number of LPs, which allows them to better manage the dollars flowing into and, more importantly, out of the fund via their periodic LP interest repurchase programs. Given this, and the regulatory climate under the current administration and the increased focus on making alternative asset classes more available to high-net worth retail investors, we expect to see the number of 1934 Act private funds grow exponentially in the coming years.
