RETAIL INVESTMENTS IN PRIVATE FUNDS

Regulatory Obstacles and Opportunities

INTRODUCTION

OVER THE PAST SEVERAL YEARS, regulators and market participants increasingly have called for the expansion of investment opportunities for retail investors and retirees. These calls for expanded opportunities have cited market structure changes, the looming retirement crisis and basic fairness to retail investors and retirees who do not meet existing regulatory proxies for investor "sophistication." SEC Chairman Jay Clayton, for example, observed that, in 2018, more capital was raised in the private markets than in the public markets, and that retail investors should (but currently do not) have access to those opportunities.1 Because retail investors are generally limited to investments in public companies, market trends suggest that the investment opportunities available to retail investors have decreased.2

SEC Chairman Jay Clayton, for example, observed that, in 2018, more capital was raised in the private markets than in the public markets, and that retail investors should (but currently do not) have access to those opportunities.

Calls for expansion of retail investment opportunities have also noted that lack of access to investments in private funds3 is contributing negatively to the retirement savings of many U.S. workers. Commenters have also noted the direct link between retail investors' access to investment opportunities, on one hand, and private companies' and small businesses' access to investment capital, on the other hand.

On June 18, 2019, the SEC published its Concept Release on Harmonization of Securities Offering Exemptions (the "Concept Release") to solicit public comment on exemptions from registration under the Securities Act of 1933 (the "Securities Act").4 Most of the Concept Release describes the requirements and limitations of Securities Act registration exemptions that make up the existing exempt offering framework and solicits responses to a wide range of questions.5 Commenters' responses are intended to help the SEC assess whether changes to applicable statutes and regulations are necessary or desirable to improve specific exemptions and, more generally, the existing exempt offering framework.

STATE OF THE MARKET

AT A HIGH LEVEL, the federal securities laws and ERISA essentially foreclose significant retail investment in private funds. As described below, direct investment in private funds is generally available only to investors who meet both the "qualified purchaser" and "accredited investor" standards under the 1940 Act and the Securities Act, respectively. While a handful of "registered funds of private funds" currently exist in the marketplace, an SEC staff position requires that these products be sold only to accredited investors, which drastically limits their availability in the marketplace. In addition, practical considerations and legal risks largely deter sponsors of defined contribution plans (including 401(k) sponsors) from offering exposure to private funds to plan participants.

FEDERAL SECURITIES LAWS

Private funds generally rely on an exclusion from the definition of "investment company" under Section 3(c)(7) of the 1940 Act to avoid registration as an investment company.6 To rely on the Section 3(c)(7) exclusion, a private fund's securities must be owned exclusively by persons who, at the time of acquisition of the securities, are "qualified purchasers."7 In our experience, most private funds of any significant size are Section 3(c)(7) funds that accept investments only from qualified purchasers. Approximately 98% of U.S. households are not qualified purchasers.8

The investor protection policies underlying the definitions of "qualified purchaser" and "accredited investor" have been a key feature of the federal securities laws. Investors who are neither accredited investors nor qualified purchasers—i.e., retail investors—are effectively blocked from investing directly in private funds.

ERISA

Defined benefit plans are significant investors in private funds, and there is evidence that exposure to private fund investments is contributing to the outperformance of defined benefit plans compared to defined contribution plans.9 Over the past few decades, however, employersponsored retirement accounts have migrated sharply away from defined benefit plans and toward defined contribution plans as the sole retirement plans for employees. This shift has resulted in increasing numbers of plan participants and their beneficiaries being deprived of the benefits of exposure to alternative asset classes in their retirement plans, despite sponsors and fiduciaries of defined contribution plans having shown interest in hedge funds and private equity investments.10

The DOL could facilitate investment in private funds by defined contribution retirement plans by providing formal guidance that (i) reaffirms the long-standing principle that a 401(k) fiduciary must consider the totality of factors related to investment options as opposed to just focusing on liquidity and fees and (ii) expands the safe harbor for plan fiduciaries who are making good faith efforts, well informed by expertise on long-term retirement investing, to provide participants with access to alternative asset classes that offer the potential for attractive gains and greater diversification to hedge risk.

POTENTIAL BENEFITS OF PRIVATE FUNDS

The policy argument for expanding opportunities for retail investors to obtain exposure to private funds is that most such investors are missing out on an increasingly important set of investment opportunities. Some commenters claim that the federal securities laws, by foreclosing most investors from access to private offerings, facilitate wealth inequality in the U.S.11 Separately, the significant number of households that are not prepared for retirement also supports expanding retail access to private funds.12

Footnotes

1. Interview with Jay Clayton, SEC Chairman, in Washington (April 9, 2019), The David Rubenstein Show (Bloomberg May 8, 2019) available at https://www.bloomberg.com/news/ videos/2019-05-08/the-david-rubenstein-show-sec-chairmanjay-clayton-video?srnd=peer-to-peer. In August 2019, Chairman Clayton stated that "[p]rivate capital raising is now outpacing capital raising in our public markets, yet our Main Street investors have no effective access to investments in private capital offerings." Remarks at SEC's Small Business Capital Formation Advisory Committee Meeting (Aug. 13, 2019) available at https://www.sec.gov/news/public-statement/ statement-clayton-081319.

2. Although retail investors can, to a certain extent, invest in private companies indirectly through registered investment funds such as mutual funds and closed-end funds, as Part II of this article discusses, such access is limited.

3. This article uses the term "private fund" to refer broadly to funds that are sold in exempt offerings, including private equity buyout funds, private credit funds, hedge funds and venture capital funds.

4. Rel. No. 33-10649 (June 18, 2019) available at https://www. sec.gov/rules/concept/2019/33-10649.pdf.

5. The Concept Release discusses and solicits comments on the conditions and requirements for the following exempt offerings: Regulation D offerings pursuant to Rules 504, 506(b), and 506(c); Regulation A offerings by Tier 1 and Tier 2 issuers; intrastate offerings pursuant to Section 3(a)(11) and Rules 147 and 147A; and certain crowdfunding transactions under Section 4(a)(6). Comments on the Concept Release must be submitted to the SEC no later than September 24, 2019.

6. Although a private fund seeking investments from non-qualified purchasers can instead rely on the exclusion from the definition of investment company under Section 3(c)(1) of the 1940 Act, such funds are limited to no more than 100 beneficial owners. We believe that this limitation would be a substantial impediment to widespread access by retail investors.

7. Section 2(a)(51)(A) of the 1940 Act generally defines the term "qualified purchaser" to include (i) a natural person who owns at least $5 million in investments, (ii) a family-owned company that owns at least $5 million in investments, (iii) a person, acting for its own account or the accounts of other qualified purchasers, who, in the aggregate, owns and invests, on a discretionary basis, at least $25 million in investments, and (iv) a trust with respect to which the trustee and each person who has contributed assets to the trust is a person described in (i), (ii) or (iii).

8. See CCMR Report at 26.

9. See CCMR Report at 49-52 (noting that studies examining the performance of defined benefit plans and defined contribution plans show that defined benefit plans outperform defined contribution plans).

10. See Advisory Council Report on Employee Welfare and Pension Benefit Plans, Report to the U.S. Secretary of Labor: Hedge Funds and Private Equity Investments (Nov. 2011) available at https://www.dol.gov/sites/dolgov/files/ebsa/about-ebsa/about-us/ erisa-advisory-council/2011-hedge-funds-and-private-equityinvestments.pdf ("DOL Advisory Council Report").

11. See, e.g., Kevin G. Bender, Giving the Average Investor the Keys to the Kingdom: How the Federal Securities Laws Facilitate Wealth Inequality, 15 J. BUS. & SEC. L. 1, 2 (2016); Usha Rodrigues, Securities Law's Dirty Little Secret, 81 FORDHAM L. REV. 3389 (2013).

12. See, generally, James M. Poterba, Saver Heterogeneity and the Challenge of Assessing Retirement Saving Adequacy, 68 NAT. TAX J. 377 (2015).

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