Alternative Funds 2024

1. General

1.1 General Overview of Jurisdiction

The United States is the world's largest and most predominant jurisdiction for the formation of alternative funds and boasts the largest number of alternative asset managers in the world. In recent U.S. Securities and Exchange Commission (SEC) filings, investment advisers have reported more than USD25 trillion in private fund gross asset value, amongst tens of thousands of funds.

Under the US federal securities laws, US investment advisers are governed by a robust regulatory framework, although certain exemptions may apply. In addition, the US federal securities laws cover many aspects of fund formation and the offerings of fund interests. Other US federal and state rules may apply depending on a number of factors, including the nature of the fund's investment activities and/or the advisory activities of an investment adviser.

1.2 Key Trends

The regulatory landscape for private funds continues to grow more complex, with new rules and regulations adopted and proposed by the SEC and other regulatory authorities. Significant new rules include those relating to beneficial ownership reporting, the protection of customer information and advertisements and marketing communications, and proposed rules include those addressing conflicts of interest in predictive data analytics, the safeguarding of customer assets, outsourcing and cybersecurity risk management.

2. Funds

2.1 Types of Alternative Funds and Structures

Alternative funds are formed to accommodate a variety of investment strategies. Generally, structures will be tailored to meet the business and legal needs of both the investment adviser and its investors. The strategies of "closed-end" private funds will typically be structured to target investments in one or more segments of a company's capital stack, such as:

• venture capital funds, which typically invest in early and development-stage companies;
• growth equity funds, which typically invest in later-stage, pre-IPO companies or in "PIPE" transactions with public companies;
• buyout funds, which typically acquire controlling interests in companies with an eye towards later selling those companies or taking them public;
• distressed funds, which typically invest in debt securities of financially distressed companies at a discount; and
• credit funds, which typically target debt securities in companies (focusing on a variety of senior, mezzanine or other types of credit).

Open-ended funds will generally permit investors to invest or redeem their fund securities periodically, often subject to restrictions such as redemption gates or lock-ups. Open-ended funds will typically pursue a more liquid portfolio, although these structures can also be designed to accommodate illiquid investments.

Both closed- and open-ended alternative funds formed in the USA will typically involve several key entities, including:

• The fund: This is generally a pool of capital with no direct operations. Funds targeting US investments will typically be formed as Delaware limited partnerships or limited liability companies. Depending on the tax needs of the investors, US and non-US investors may invest in these structures directly or indirectly via one or more feeder vehicles or in parallel funds or other alternative fund structures. In the USA, Delaware is widely known as the "go-to" jurisdiction for entity formation given, among other things, its wide recognition, well-developed body of case law, robust legal protections, freedom to contract, and low startup costs. Also, its state courts are highly experienced in resolving complex business disputes and generally known for respecting the freedom to contract. Other US states or non-US jurisdictions will be used where appropriate to accommodate particular tax, regulatory or other legal needs.
• A general partner or other managing entity (eg, managing member or manager): They have the legal power to act on behalf of the fund.
• A management company or investment adviser: They are appointed to provide investment advisory services to the fund, employ the investment team, provide management or investment advisory services and generally manage the day-to-day operations of the fund.
• Other related entities may be formed to accommodate the tax, regulatory and other legal needs of the investment adviser or the fund and its investors.

2.2 Regulatory Regime for Funds

Alternative funds and investment advisers are subject to a variety of regulations under US federal and state laws. The below outlines the basic US federal regulatory regime for alternative funds; depending on the facts and circumstances, other rules may apply.

U.S. Securities Act of 1933 (the "Securities Act")

Alternative funds are subject to the US rules concerning private placements when interests are offered to US persons, or US jurisdictional means are otherwise used in connection with an offering. Offers and sales of securities in the United States generally may only be made pursuant to a registration statement filed with, and declared effective by, the SEC, or in accordance with an exemption from these registration requirements. Alternative funds typically rely on the registration exemption provided by Section 4(a)(2) of the Securities Act, and the "safe harbour" provided by Rule 506 under Regulation D under the Securities Act ("Regulation D"). Section 4(a)(2) is a private placement exemption available to issuers for sales of their securities "not involving any public offering." Section 4(a) (2) does not expressly provide details of what constitutes a valid private placement, so most alternative funds rely on the safe harbour provisions set forth in Regulation D. Rule 506(b) of Regulation D generally requires:

• Limitation on manner of offering: There should be no general advertising or "general solicitation".
• Limitations on resale:
  1. Offering materials should include special legends regarding US selling and transfer restrictions.
  2. Each purchaser should represent in the fund's subscription agreement that it is acquiring the interests for its own account and not with a view to resale or distribution thereof, and each purchaser should further undertake that it will only resell the interests in accordance with the Securities Act and the fund's transfer restrictions.
• Nature of and limitation on number of purchasers: Offers and sales of interests should only be made to institutions and individuals that qualify as "accredited investors" ("accredited investors"), as defined in Regulation D. Rule 506(b) does allow for offers and sales to up to 35 financially sophisticated investors so long as those non-accredited investors are provided with disclosures that are similar to what would be required in a public/registered offering.
• "Bad actor" disqualification: The fund, the general partner or the management company can be subject to disqualification if they have committed "bad acts". The fund itself can be disqualified if more than 20% of its securities are owned by investors who are "bad actors".
• SEC Filing: Form D must be filed with the SEC within 15 days of the fund's first sale of securities, and any annual amendments thereto must be filed while the offering is ongoing.

Rule 506(c) is a separate safe harbour that has no restrictions on the use of general advertising or general solicitation, but all investors must be "verified" as accredited investors. The overwhelming majority of alternative funds rely on Rule 506(b).

Offerings by US domiciled funds to non-US investors will generally be made in accordance with Regulation D. Offerings by non-US domiciled funds to non-US investors will generally be made in accordance with Regulation S under the Securities Act, which provides that registration under the Securities Act is not required when the offer and sale of a security occurs outside the United States in an offshore transaction and there are no directed selling efforts in the United States with respect to such sale.

U.S. Investment Company Act of 1940 (the "Investment Company Act")

The Investment Company Act regulates "investment companies", which are broadly defined as companies that engage primarily in "investing, reinvesting, owning, holding or trading in securities". To avoid being subject to the onerous requirements of operating as a registered investment company under the Investment Company Act, many alternative funds are structured to rely on certain exclusions from the definition of investment company. Most common are Section 3(c)(7) and Section 3(c)(1) of the Investment Company Act.

• Section 3(c)(7) provides an exclusion for a privately-offered fund whose interests are beneficially owned by "qualified purchasers". "Qualified purchasers" generally include (i) individuals, family-owned businesses, and trusts for family members that own USD5 million or more in "investments"; (ii) a trust (not addressed in (i)) that is not formed for the specific purpose of acquiring securities, as to which the trustee or other person authorised to make decisions with respect to the trust, and each settlor or other person who has contributed assets to the trust, is a qualified purchaser; (iii) entities that own and invest at least USD25,000,000 in investments; and (iv) entities exclusively owned by qualified purchasers.
• Section 3(c)(1) provides an exclusion where an issuer's securities are held by less than 100 beneficial owners. A fund structured under Section 3(c)(1) must adhere to various "anti-pyramiding" rules that are designed to prevent circumventing the 100 investor limit. Where a fund forms two parallel funds, one a 3(c)(1) private investment fund with 100 or fewer non-qualified purchasers and the other a 3(c)(7) qualified purchaser fund with an unlimited number of qualified purchasers, the two funds are not integrated for purposes of determining whether the first qualifies under the applicable exemption.

U.S. Investment Advisers Act of 1940 ("Advisers Act")

See 3.3 Regulatory Regime for Managers.

U.S. Commodity Exchange Act (CEA)

The CEA generally governs the futures and derivatives markets. In the United States, securities and futures are subject to separate regulatory regimes. The U.S. Commodity Futures Trading Commission (CFTC) and U.S. National Futures Association (NFA) serve as the derivative industry's regulatory and self-regulatory authorities. If a fund will trade any amount of exchange-traded futures contracts, options on futures contracts or swaps (collectively, "commodity interests") as part of its investment strategy, for all practical purposes, the fund will fall within the definition of a "commodity pool". The operator (ie, sponsor or general partner) of a commodity pool must register with the CFTC as a commodity pool operator (CPO) and must become a member of the NFA unless it can avail itself of an exemption. The investment manager to a commodity pool generally must register with the CFTC as a commodity trading adviser (CTA) and become an NFA member unless it can avail itself of an exemption. These registration requirements are generally subject to narrowly drawn exceptions or exclusions. See 2.3 Disclosure/Reporting Requirements and 3.3 Regulatory Regime for Managers for further information regarding CFTC registration.

U.S. Securities Exchange Act of 1934 ("Exchange Act")

The Exchange Act generally governs the issuers of registered securities and regulates brokerdealers. In general, under the Exchange Act, all sales of interests in a fund must either be made by the "issuer" (ie, the fund) or a registered broker-dealer. If there will be no independent selling agents and the fund will be making all sales, the broker-dealer registration requirement generally is not implicated, unless the issuer hires or otherwise employs marketing personnel whose compensation is tied to the sales made by them. See 4.5 Compensation and Placement Agents.

ERISA

Under the Employee Retirement Income Security Act's (ERISA) Plan Asset Regulation, when "Benefit Plan Investors" acquire 25% or more of the equity interests in a fund, the Benefit Plan Investors are deemed to have an interest in the underlying assets of that investment, unless the investment meets one of the exceptions. These funds are typically referred to as "plan asset funds". Individuals responsible for the investment and management of plan asset funds are subject to ERISA's fiduciary responsibility provisions and certain prohibited transaction provisions under both ERISA and the U.S. Internal Revenue Code ("Code"). If these obligations are breached, the fund's sponsor and/or investment adviser can incur substantial liabilities and penalties. A Benefit Plan Investor is an (i) employee benefit plan subject to title I of ERISA; (ii) individual retirement accounts, Keogh Plans and other employee benefit plans that are not subject to ERISA but are subject to the prohibited transaction rules of Code §4975; and (iii) other entities the assets of which are deemed to be plan assets based on investment from entities listed in (i) and/or (ii) above.

State Regulation

Alternative funds and investment advisers will be required to comply with state securities laws (socalled blue sky laws) and related regulations, the application of which may (in part) be preempted by certain of the federal securities laws mentioned above.

2.3 Disclosure/Reporting Requirements

An investment adviser or management company that falls within the definition of "investment adviser" under the Advisers Act must register with the SEC, unless it (i) is prohibited from registering under the Advisers Act because it has less than USD25 million of regulatory assets under management and is regulated by state law or (ii) qualifies for an exception from the Advisers Act's registration requirement (see 3.3 Regulatory Regime for Managers). A sponsor that registers with the SEC as an investment adviser will be required to, among other things:

• file a Form ADV with the SEC and keep it current by filing periodic amendments, including an annual amendment;
• comply with the "brochure rule", which requires most advisers to provide clients and prospective clients with information about the adviser's business practices and its principals' educational and business backgrounds;
• maintain accurate and current books and records and be subject to inspection and examination by the SEC staff;
• complete Form PF filings, which contain more detailed information on the funds it manages or advises, and which are required to be filed on an annual or quarterly basis or more frequently with respect to certain events;
• adopt and maintain written policies and procedures that are reasonably designed to prevent violations of the Advisers Act and related regulations and have a code of ethics governing employee behaviour (including personal trading reporting, and restrictions and enforcement of certain insider trading procedures);
• comply with the Marketing Rule (see 3.3 Regulatory Regime for Managers); and
• only charge performance-based fees (ie, carried interest) to investors that are "qualified clients" as defined in Rule 205-3 under the Advisers Act.

CPOs and CTAs have specific filing and reporting requirements under the CEA, the CFTC's rules and the rules of the NFA.

Managers registered as CPOs must generally:

• distribute monthly or quarterly account statements to pool participants within 30 days of month-end or quarter-end;
• distribute an annual report to pool participants within 90 days of the pool's fiscal yearend; and
• file Form PQR with the NFA on a quarterly basis, providing specific information about the manager and the commodity pools that it operates.

Managers registered as CTAs must generally:

• file Form PR with the NFA within 45 days after the quarters ended March, June and September; and
• file a year-end report within 45 days of the calendar year end.

2.4 Tax Regime for Funds

No Entity-Level Income Tax on Flow-Through Funds

Typically, US-based funds are established as pass-through entities, such as partnerships or limited liability companies. Generally, a pass- through entity does not pay any entity-level income tax; instead, the beneficial owners of such pass-through entity report their share of the pass-through entity's income, which itself is reported by the pass-through entity to its beneficial owners on an Internal Revenue Service Schedule K-1 (and to the extent the fund has foreign income, on an Internal Revenue Service Schedule K-3), and pay applicable federal income taxes at rates specific to such beneficial owners. However, in certain circumstances, a fund could be deemed to be a "publicly traded partnership", subjecting it to federal income tax at the corporate income tax rate unless the fund satisfies an annual 90% "annual income" test.

Corporate Income Tax

In the unusual circumstance where a US fund is established as a corporation, such fund is subject to US federal income tax (currently 21%) and may be subject to state income tax. Additionally, some funds may elect to use a structure involving a below-the-fund or above-the-fund "blocker corporation" that would pay US federal income tax but may help tax-exempt and nonUS investors avoid incurring unrelated business taxable income (UBTI) or effectively connected income (ECI), respectively (see 4.6 Tax Regime for Investors).

2.5 Loan Origination

Permissible, Subject to State Lending Laws

Alternative funds are permitted to originate loans, but a state-by-state analysis should be considered to evaluate licensing risk.

State Licensing Laws

Certain states regulate both commercial and consumer lending. Because licensing requirements vary from state to state, alternative funds must consider their licensing risk on a state-bystate basis. Although there is no one-size-fits-all  analysis, some relevant factors that are typically considered to determine whether licensing is required include:

• the purpose/type of loan;
• the amount of the loan;
• the frequency of the lender's lending activity (eg, the number of loans made in a 12-month period);
• the amount of interest charged on the loan;
• the location of the borrower;
• the location of the lender/location from where lender solicits loans; and
• the location of the collateral.

If licensing is required, a state regulator will generally require the fund to meet certain financial conditions and to submit a licensing application that includes the disclosure of certain minimum information. Although state requirements vary, licensing applications may require disclosure of information regarding the fund's business plan, financial information, and the fund's owners, parents, subsidiaries and affiliates.

State Usury Laws

States generally impose statutory limitations regarding the permissible amount of interest that a lender may charge on a loan. State statutes vary, but the type/purpose of the loan and the amount of the loan generally are two key factors considered in this analysis.

Tax Considerations

A fund that originates loans may be treated as being engaged in a US trade or business for US federal income tax purposes. In that case, nonUS investors would be deemed to be engaged in a US trade or business as well, and would have to file US income and possibly state income tax returns and pay US federal and state tax.

2.6 Non-traditional Assets

There are no special limitations regarding the types of assets in which a fund may invest, although special US federal and/or state rules may apply, depending on the nature of the fund's assets. For example:

• Digital asset or cryptocurrency funds are typically structured utilising open-ended hedge fund structures. The SEC has clarified in guidance over the years that it will view these types of assets as "securities" and hence subject to US federal securities laws.
• Cannabis funds are typically structured utilising private equity fund structures. However, in determining the fund's domicile within the USA, fund sponsors should give due consideration to the various state-by-state differences in US state cannabis regulations, as well as the risks inherent in this strategy given that cannabis remains illegal under US federal law.
• Private credit funds that originate loans may be subject to applicable state regulations. See 2.5. Loan Origination.

2.7 Use of Subsidiaries for Investment Purposes

Alternative fund structures can be utilised to accommodate the tax, regulatory and other legal needs of the investment adviser and the fund and its investors. For example, non-US investors who seek to avoid certain US tax filing obligations or other adverse tax consequences may invest in a fund via feeder funds that are treated as corporations for US federal income tax purposes or by investing directly or indirectly in parallel funds or alternative investment funds that utilise blocker corporations. See 2.4 Tax Regime and 4.6 Tax Regime for Investors.

2.8 Local/Presence Requirements for Funds

Generally, US states (including Delaware) do not require managers to have a local presence (or appoint local directors) to form an entity. Delaware, for example, only requires the entity to maintain a registered agent and registered office in Delaware (amongst other limited requirements). Depending on the scope of their intra-state activities (eg, opening an office, hiring employees, etc), entities may be required to register to do business in one or more US states.

2.9 Rules Concerning Service Providers

Broad Discretion to Appoint Service Providers

Under relevant federal law, alternative funds and their managers have discretion to appoint service providers.

Custodians – SEC Custody Rule

Under the Advisers Act, where a SEC-registered investment adviser (RIA) is deemed to have "custody" of a fund's assets, the adviser becomes subject to Rule 206(4)-2 of the Advisers Act, more commonly known as the custody rule (the "Custody Rule"), which, among other things, requires the adviser to place the fund's securities with custodians who meet the definition of "qualified custodian" unless it delivers audited annual financial statements of the fund to its investors.

2.10 Anticipated Changes

On 26 October 2022, the SEC proposed Rule 206(4)-11 under the Advisers Act that would prohibit RIAs from outsourcing certain "covered functions" without meeting the requirements set forth in the rule. If adopted, the proposed rule would introduce four main requirements for RIAs: due diligence and monitoring; books and records; oversight of service providers serving as recordkeepers; and changes to Form ADV.

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Originally published by Chambers and Partners Global Practice Guide.

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.