United States: The SEC Expands The Types Of Employees Of Fund Managers Who Can Invest In Private Funds

The SEC has issued an interpretive letter to the Managed Funds Association (MFA) providing favorable interpretations of the concept of a knowledgeable employee. Knowledgeable employees can invest in qualified purchaser (QP) funds without meeting the QP financial requirements (generally $5 million in investments). In addition, knowledgeable employees do not count against the 100-holder limit in a C1 fund.

The MFA letter expands the number of situations where employees of private fund managers will be considered to be knowledgeable employees.

Executive Summary

Knowledgeable employee status generally depends on

  • being an executive officer of a principal business unit;
  • performing policymaking functions; or
  • participating in the investment activities of the fund.

Executive Officers of a Principal Business Unit

The SEC’s usual definition of “executive officer” has created uncertainty when applied to fund managers because that definition is based on an operating company concept.

The MFA letter expands the concept of a principal business unit to include departments not traditionally considered principal business units (such as information technology and investor relations) under certain circumstances discussed in more detail below.

Employees Who Perform Policymaking Functions

These types of employees generally are considered to be knowledgeable employees. The MFA letter confirms that this status does not depend on any particular title and that this status can result from participation in a group (typically a committee) that performs policymaking functions.

Participation in Investment Activities

Employees who participate in investment activities are generally considered to be knowledgeable employees. The MFA letter discusses several situations which have created uncertainty under current interpretations of the concept, including research analysts, risk analysts, tax professionals and lawyers.

Separate Accounts

The MFA letter confirms that the knowledgeable employee status of persons involved in managing separate accounts will be analyzed in a manner similar to that of employees involved in managing private funds.

Affiliated Funds

The MFA letter confirms that employees who are knowledgeable employees for a fund which is part of a controlled fund complex using the ABA letter dated Jan. 18, 2012, combined IA registration format would generally be considered to be knowledgeable employees for all funds in the controlled fund complex.


Private fund managers should document the basis for any decision to treat an employee as a knowledgeable employee and should retain that documentation in their books and records.

Qualified Clients

Rule 205-3 of the Advisers Act also contains provisions which are intended to permit knowledgeable employees to invest in funds which involve “performance fees,” such as the typical carried interest. The language in the applicable Investment Company Act rule, Rule 205-3, is slightly different from the language in Rule 3c-5. The MFA letter does not state whether the interpretations in the MFA letter also apply to Rule 205-3. However, the logic behind the interpretations in the MFA letter should also apply to 205-3, or else the MFA letters would have little practical effect, because so many funds have performance fees. The SEC staff has confirmed by phone that the analysis in the MFA letter should also apply in determining qualified client status in Rule 205-3.

Accredited Investor Issue Not Resolved

The MFA letter does not resolve a second issue that the MFA has also advocated: whether knowledgeable employees should automatically be treated as accredited investors or have to meet the financial tests in Regulation D. So far, the SEC has not taken this position, and the MFA letter does not deal with this issue.

Detailed Analysis

Executive Officers and Policymaking Employees

“Knowledgeable employee” includes any natural person who is an executive officer of a private fund or an affiliated manager of a private fund (“Affiliated Management Person”). The term “executive officer” means

  • the president, any vice president in charge of a principal business unit, division or function (such as sales, administration or finance);
  • any other officer who performs a policymaking function; or
  • any other person who performs similar policymaking functions for a private fund or for an Affiliated Management Person.

The application of these concepts to investment managers has generated uncertainty in a number of situations. One of these uncertainties has been whether various functions associated with private investment vehicles would be considered to be principal business units for the purpose of this definition.

Principal Business Unit

The MFA letter confirms that

  • the principal business unit status of a division or function depends on the relevant facts and circumstances of a particular investment manager’s business operations;
  • whether a business unit, division or function qualifies as a principal business unit, division or function should be determined through an analysis by the investment manager of the relevant facts and circumstances regarding the investment manager’s business operations;
  • several business units, divisions or functions within an investment manager’s business operations may each be considered a principal unit, division or function;
  • while not all business units, divisions or functions are necessarily principal, it is possible that several business units, divisions or functions could each be principal units, divisions or functions, depending on the facts and circumstances;
  • the unit, division or function need not be part of the investment activities of a prviate fund to be considered a principal unit, division or function; and
  • the size of a particular department is not determinative as to whether a function should be considered principal.

The IT Department Can Be a Principal Business Unit

The MFA letter confirms that an information technology (IT) department may be considered to be a principal business unit where

  • an investment manager employs one or more technologically driven trading models, and the IT professionals are charged with building the models and systems that translate certain quantitative signals into trade orders; and
  • an investment manager employs technology professionals to build performance and risk monitoring systems that interact with the investment program.

The Investor Relations Department Can Be a Principal Business Unit

The MFA letter also confirms that the investor relations department could be considered to be a principal business unit where an investment manager relies on investor relations personnel to

  • conduct substantive portfolio reviews with investors, and
  • respond to substantive due-diligence inquiries from institutional investors and consultants.

However, an investor relations function would not have principal business unit status where the department merely assists in arranging meetings between an investment manager’s investment staff and prospective investors, disseminates investor communications written by senior executives outside of the investor relations department, or performs administrative tasks.

Policymaking Employees

The concept of a knowledgeable employee includes any officer who performs a policymaking function and any other person who performs similar policymaking functions on behalf of an investment manager. A policymaking individual does not need to have a specific title, and the concept of a knowledgeable employee includes all employees who have the power to make and do make policy on behalf of the investment manager, the private fund or an Affiliated Management Person.

The MFA letter confirms that an employee who does not have a senior manager title, depending on the facts and circumstances, may still be considered an executive officer under the rule if he or she makes policy through day-to-day involvement in the development and adoption of an investment manager’s policies.

Significantly, the MFA letter also confirms that the policymaking function need not be concentrated in one individual and that employees serving as active members of a group or committee who develop and adopt an investment manager’s policies, such as the valuation committee, could be executive officers under the rule.

However, individuals who merely observe committee meetings or simply provide information or analysis to the decision makers of a committee or group would not be engaged in making policy and therefore generally would not be executive officers.

Employees Who Participate in the Investment Activities of a Private Fund

The concept of a knowledgeable employee includes any employee of a private fund or an Affiliated Management Person who, in connection with his or her regular function or duties, participates in the investment activities of the private fund, other private funds or investment companies whose investment activities are managed by the Affiliated Management Person, provided that such employee has been performing such functions and duties for or on behalf of the private fund or the Affiliated Management Person of the private fund, or substantially similar functions or duties for or on behalf of another company for at least 12 months (“Participating Employee”).

Previously, while stating that certain types of nonexecutive employees would not generally be knowledgeable employees because they were not participating in investment activities, the SEC staff stated that some research analysts (e.g., a research analyst who researches all potential portfolio investments and provides recommendations to the portfolio manager) would be knowledgeable employees.

The MFA letter confirms that a research analyst who researches only a portion of the portfolio of a private fund and provides analysis or advice to the portfolio manager with respect to that portion of the private fund’s portfolio is participating in the investment activities of the private fund and could be a knowledgeable employee.

The MFA letter also confirms that individuals in the following factual scenarios could be considered Participating Employees because they participate in investment activities (provided they regularly perform those functions or duties and have been doing so for at least 12 months):

  • a member of the analytical or risk team who regularly develops models and systems to implement the private fund’s trading strategies by translating quantitative signals into trade orders or providing analysis or advice that is material to the investment decisions of a portfolio manager (in contrast to someone who merely writes the code to a program used by the portfolio manager);
  • a trader who regularly is consulted for analysis or advice by a portfolio manager during the investment process and whose analysis or advice is material to the portfolio manager’s investment decisions based on the trader’s market knowledge and expertise (in contrast to a trader who simply executes investment decisions made by the portfolio manager);
  • a tax professional who is regularly consulted for analysis or advice by a portfolio manager, typically before the portfolio manager makes investment decisions, and whose analysis or advice is material to the portfolio manager’s investment decisions, such as when a tax professional’s analysis of whether income from an offshore fund’s investment may be considered “effectively connected income” and is material to a portfolio manager’s decision to invest in certain debt instruments (in contrast to a tax professional who merely prepares tax filings); and
  • an attorney who regularly analyzes legal terms and provisions of investments and whose analysis or advice is material to the portfolio manager’s investment decisions, such as where the attorney’s legal analysis of tranches of a distressed debt investment is material to a portfolio manager’s decision to invest in the loan (in contrast to an attorney who negotiates agreements that effectuate transactions evidencing the investment decisions of the portfolio manager or an attorney or compliance officer who evaluates whether an investment is permitted under the fund’s governing documents).

Treatment of Separate Accounts

In some cases, employees of an Affiliated Management Person also participate in the investment activities of separate accounts (or a portfolio, or a part of a portfolio, of a separate account) for clients that are “qualified clients” and are otherwise eligible to invest in private funds advised by the Affiliated Management Person and whose accounts pursue investment objectives and strategies that are substantially similar to those pursued by one or more of those private funds (“Covered Separate Accounts”).

The MFA letter confirms that an employee of an Affiliated Management Person who participates in the activities of Covered Separate Accounts (or a portfolio, or a part of a portfolio, of a Covered Separate Account) can also be treated as a knowledgeable employee.

Employees of Related Advisers in Control Relationships

In a letter to the American Bar Association Section of Business Law dated Jan. 18, 2012 (“ABA letter”), the SEC permitted the managers of affiliated private fund complexes to file a single Form ADV to register all affiliated managers under specified circumstances which involve a single advisory business.

The MFA letter applies the same analysis to the concept of knowledgeable employee.

The ABA letter procedure involves the filing of an ADV by one of the fund managers in the complex, and the other fund managers in the fund complex are described in the ADV. The fund manager who files the ADV is known as the filing adviser, and the other managers included in the ADV are known as relying advisers. This procedure eliminates the need for all fund managers in a controlled fund complex to file separate ADVs.

Accordingly, the MFA letter confirms that if a filing adviser and its relying adviser(s) collectively conduct a single advisory business as described in the ABA letter, then the filing adviser and each of the relying adviser(s) may be an Affiliated Management Person of a private fund.

As a result, knowledgeable employees of a filing adviser or any of its relying advisers may be treated as knowledgeable employees with respect to any private fund managed by the filing adviser or its relying advisers, provided that the employees meet the other conditions of the rule.

To view the SEC's letter, please click here.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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