Section 3(c)(1) of the United States Investment Company Act of 1940 established the terms under which what we know as “hedge funds” are allowed to be exempt from SEC registration. Much like private placements of operating companies, hedge funds must issue a private placement memorandum (PPM) as a prospectus to potential investors when raising capital either to launch or expand.
The investors a hedge fund may seek include those with whom it has a pre-existing relationship. To legally solicit an individual investor, the hedge fund must establish this relationship before sending the PPM on for consideration. Another avenue is for a hedge fund to work with a solicitor or broker-dealer, who must be registered with the SEC as such. This broker-dealer can bring its own databases of pre-existing relationships to the table.
All investors must meet the suitability requirement for hedge funds, which is that they must be accredited investors or qualified clients. The definition of qualified clients is more selective than that of accredited investors. One way is for these individuals to have a net worth of over $1.5 million. If the hedge fund intends to charge a performance fee as a bonus for its management, it must use only qualified clients and not just accredited investors.
A Section 3(c)(1) hedge fund cannot have more than 100 investors and must not make, or propose to make, a public offering.
In the PPM, the hedge fund must make careful disclaimers when making statements about the past performance of the fund or of other funds its managers have previously led. For example, the PPM must discuss how the market and economic situation affected past performance, explain the fees and expenses which investors would have to pay out of financial results, and discuss the possibility that the fund could lose its entire value. It must be extremely clear that past performance does not guarantee future success of the fund.
Whether starting a hedge fund or engaging in an additional round of funding, legal counsel should review the PPM and insure that legal liability has been reduced as much as possible through the use of disclaimers.
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