Internally Managed Private Funds: A Cost-Efficient Alternative for Private Advisers

For years, internally managed private funds (IMFs) have remained an underutilized business model within the private funds industry. The introduction of Internally Managed Private Funds (IMFs) has emerged as a compelling alternative for private fund advisers seeking to streamline operations and navigate the regulatory terrain with greater agility. In this article, Arootah Advisor Irwin Latner delves into the intricacies of IMFs, offering a comprehensive overview of their structure, regulatory considerations, and strategic advantages in the current investment climate.

What is an Internally Managed Private Fund?

An Internally Managed Private Fund (IMF) generally refers to a private non-SEC registered investment fund that pursues a typical hedge, venture, real estate, private equity, or other common private fund investment strategy. Still, rather than being managed by a separate investment manager or general partner entity, it is managed internally by a board of directors if established as a corporation or (more commonly) by a board of managers as a limited liability company.^xiii

In our experience, an IMF is often best suited for scenarios in which one or a limited number of sophisticated institutional or family office investors engage a U.S.-based management team to manage investor assets. An IMF is internally governed and reflects highly negotiated terms including capital contribution requirements, permitted withdrawals of capital, investor consent to major decisions and distribution waterfalls. Lastly, an IMF carries participation rights for the management team, investor reporting, liquidation events, joint venture funds, club deals (collectively, a JV), and Single Investor Funds (SIF).

Rather than paying a separate asset-based management fee, however, an IMF typically entails an agreed-upon salary for management team members and an approved budget to cover annual operating expenses. Therefore, many aspects of an IMF are similar to a traditional private fund JV or SIF arrangement managed by a separate general partner or investment manager entity.

Though investors in an IMF typically have more governance and information rights than investors in a traditional private fund structure, the IMF management team can typically negotiate its majority or minority representation rights on the board and investment committee as well as its compensation, D&O insurance coverage and the other bespoke fund like terms described above. For regulatory reasons, the management team typically would not invest its capital alongside the investors in an IMF.

An IMF structure is often used by corporate venture arms of public and private operating companies seeking to make strategic technology investments utilizing the parent company’s capital and other resources, which investments are managed either by the parent’s employees or by an outside management team. In such circumstances, the parent company retains voting control and input into investment operations while entering negotiated compensation arrangements with the internal or external management team.

Understanding the Current Landscape

The current environment for private fund advisers is one of increasing regulation and supervision, primarily due to several recently adopted and proposed new rules by the Securities and Exchange Commission (SEC). Unlike advisers to registered investment funds, which are subject to enhanced regulation and compliance requirements under the Advisers Act and the Investment Company Act of 1940 (the 1940 Act), advisers to private unregistered investment funds have long enjoyed a less onerous regulatory regime under the Advisers Act, primarily due to the limited number and greater sophistication of the investors authorized to invest in such funds.ⁱ

However, the regulatory gap between advisers to registered funds and advisers to private funds appears to be narrowing. In particular, the SEC has recently taken the following actions specifically targeting and significantly impacting private fund advisers:

• Marketing Rule

Adopting a new marketing rule, effective Nov. 4, 2022, with specific standards and requirements for, among other things, performance advertising, use of placement agents, testimonials and endorsements, and new Form ADV disclosures;ⁱⁱ

• Investor Reporting

Adopting a broad new Private Funds Rule (PFR) on August 23, 2023, mandating new investor reporting and disclosure requirements for liquid and illiquid funds, including extensive quarterly reports detailing adviser compensation, fees and expenses, and fund performance data;ⁱⁱⁱ

• Conflicts of Interest

As part of the Private Funds Rule, prohibiting or restricting certain conflicts of interest transactions and other private fund adviser practices, including (i) reducing a general partner’s carried interest clawback obligation by the amount of any taxes owed; (ii) causing investment-related expenses to be allocated across funds on a non-pro-rata basis; (iii) borrowing from a private fund client; and (iv) causing a fund to bear expenses associated with a regulatory examination or investigation of the adviser;^iv

• Secondaries: Preferential Treatment

As part of the Private Funds Rule, requiring fairness or valuation opinions in GP-led secondary transactions and prohibiting or restricting certain preferential treatment of fund investors, specifically focusing on preferential information and redemption rights (notwithstanding existing side letter arrangements and disclosure practices);^v

• Form PF

Adopting amendments to Form PF reporting for private funds, including requiring (1) increased reporting from large private equity fund advisers and (2) event reporting from large hedge fund advisers (on a current basis) and all private equity fund advisers (every quarter) of the occurrence of any of several designated reportable events;^vi

• Cybersecurity

Proposing new cybersecurity rules that would, among other things, require advisers to (1) disclose cybersecurity risks and significant incidents within the last two years on their Form ADV brochure, (2) report significant cybersecurity incidents to the SEC within 48 hours on a new Form ADV-C, and (3) develop enhanced and tailored cyber policies and procedures covering oversight of third-party service providers and other items;^vii

• ESG

Proposing new rules requiring advisers pursuing Environmental, Social, and Governance (ESG) related investment strategies to provide enhanced ESG-related disclosures to the SEC and investors;^viii

• Custody Rule

Proposing amendments to the SEC’s custody rule which would, among other things: (i) expand the rule to cover a broader array of client assets (e.g., crypto, real estate, and other physical assets in addition to securities); (ii) enhance the custodial protections for client assets (e.g., new written agreement required between adviser and custodian; and various written assurances required from custodian regarding the safeguarding of client assets); and (iii) expand the audit exemption from the surprise exam requirement to require the auditor to notify SEC of certain events;^ix

• Third-Party Service Providers

Proposing amendments that would require advisers to satisfy specified due diligence elements before retaining a service provider that will perform certain advisory services or other “covered functions” and to subsequently carry out periodic monitoring of the provider’s performance and reassess its retention;^x

• Exam Priorities

The SEC’s Division of Examinations released its 2024 examination priorities report (the SEC Report), highlighting multiple concerns in the private fund sector. These include portfolio management risks, advisory committee practices, conflicts of interest, fee calculation, due diligence, Form PF reporting, and custody rule compliance. The SEC Report also noted that the SEC will look closely at advisor compliance programs, marketing practices, compliance with the new marketing rule, valuation practices, safeguarding confidential client information, and use of third-party service providers.

The surge in new initiatives and the SEC’s heightened attention on private funds are attributed to Chairman Gensler’s vision for an activist and paternalistic SEC. This entails a shift towards a more detailed rules-based regulation for private fund advisers, departing from the traditional principles-based approach historically favored under the Advisers Act. Though there may be sound policy reasons for many of the SEC’s new rulemaking proposals and compliance initiatives,^xi there is no denying that the regulatory burden and related compliance costs and risks associated with being an SEC-registered private fund adviser are risky. Regardless of the outcome and final form of the proposed rules, registered private fund advisers will need to comply with a bevy of new rules and limitations on their activities and can expect the SEC to pursue an increasing number of enforcement actions as it assumes a more aggressive oversight role.^xii

Accordingly, existing exemptions to Advisers Act registration available for single family offices, foreign private advisers, venture capital fund advisers, and small private fund advisers have become more valuable in allowing emerging asset management firms to establish and structure their business in a more cost-efficient manner while still meeting investor expectations. Many advisor firms, however, cannot fit within any of the foregoing Advisers Act registration exemptions and may want to consider forming an IMF.

Advisers Act Analysis^xiv

Under the Advisers Act, an “investment adviser” is generally defined as someone who “advises others” regarding securities. The Advisers Act is silent on the treatment of internal directors, managers, officers, and employees (collectively, Internal Managers) of investment companies such as the IMF. Commentators have pointed out that the SEC and the industry have long understood that Internal Managers of investment companies are not advisers under the Advisers Act.^xv This is mainly due to both the history of the Advisers Act and the fact that Internal Managers typically do not bear the business risk of the enterprise, generally act as a group rather than as individuals, and are subject to the oversight of their superiors (in the case of officers and employees) and are subject to state law fiduciary duties (in the case of directors). As outlined in more detail below, other relevant factors include the exclusivity of the services, the lack of personal capital investment, the non-existence of any marketing or solicitation activities or holding oneself out to the public as providing advisory services, and the sophistication of IMF investors. Overall, the Advisers Act was intended to cover persons advising clients as part of conducting a separate investment advisory business and not to cover internal corporate relationships.^xvi

In the case of an IMF structured as a SIF, additional support exists for excluding Internal Managers from investment adviser status based on the analogous precedent of a wholly-owned corporate subsidiary exclusively advising the parent company and other wholly-owned direct or indirect subsidiaries. The SEC has confirmed the lack of investment adviser status for the wholly-owned adviser subsidiary and its management personnel in such circumstances.^xvii These precedents are substantively similar to a SIF structured as an IMF employing Internal Managers to manage its assets (i.e., the assets invested by the single investor and controlling equity owner) rather than employing a separate wholly-owned advisory subsidiary.

The Bottom Line

As the regulatory landscape for private fund advisers becomes increasingly complex, the internally managed private fund (IMF) model presents a strategic alternative for those seeking to operate outside the stringent requirements of the Advisers Act. With the SEC intensifying its scrutiny on private funds, it’s more important than ever for advisers to navigate these regulatory waters with precision and foresight. Book a call with us to explore how Arootah can assist in optimizing your private fund management strategy.

Sources:

1. See registration exemptions under sections 3(c)1) and 3(c)(7) of the 1940 Act, which are typically relied upon by most private funds and their advisers.
2. SEC Rule 206(4)-1.
3. SEC Release No. IA-6383 (August 23, 2023), 88 FR 63206.
4. SEC Release No. IA-6383 (August 23, 2023), 88 FR 63206.
5. SEC Release No. IA-6383 (August 23, 2023), 88 FR 63206.
6. SEC Release No. IA-6297 (May 3, 2023).
7. SEC Release Nos. 33-11038, 34-94382 and IC-34529 (March 23, 2022), 87 FR 16590.
8. SEC Release Nos. 33-11068, 34-94985, IA-6034 and IC-34594 (June 17, 2022), 87 FR 36654.
9. SEC Release No. IA-6240 (February 15, 2023), 88 FR 14672.
10. SEC Release No. IA-6176 (October 26, 2022), 87 FR 68816.
11. As stated the SEC’s Division of Examinations 2023 examination priorities report, the SEC’s enhanced focus on private funds stems, in part, from the fact that (i) registered private fund advisers manage approximately $21 trillion in private fund assets deployed in a variety of fund types, including hedge funds, private equity funds and real estate funds, (ii) there has been an 80% increase in private fund assets under management over the last five years, and (iii) the SEC is seeking to increase protections for investors in pension plans which, in turn, invest in private funds, including working family beneficiaries, charities and endowments, notwithstanding the fact that most pension plans have sophisticated institutional plan fiduciaries who manage their assets.
12. Consistent with its increasingly activist and aggressive approach to regulating private fund advisers, the SEC has brought several recent enforcement actions against private fund advisers, including sanctioning (i) a private equity fund adviser for failing to disclose that it had allocated a disproportionate share of deal expenses to its fund client instead of co-investors in the deal (In the Matter of Energy Capital Partners Management, LP, Advisers Act Release No. 6049 (June 14, 2022)); and (ii) a venture capital fund adviser for misleading investors about its fee practices and for engaging in improper inter-fund loans and cash transfers (In the Matter of Alumni Ventures Group, LLC and Michael Collins, Advisers Act Release No. 5975 (March 4, 2022)).
13. The use of corporate blockers and other tax considerations would apply in structuring an IMF to the same extent as in traditional private fund structuring.
14. This discussion only addresses federal investment adviser status and not state law investment adviser status, although many states adhere to the federal Advisers Act definition of “investment adviser.”
15. Regulation of Money Managers: Mutual Funds and Advisers – Frankel and Laby (3rd Edition, 2022-2 Supp.).
16. See note 15. Note that a general partner of a limited partnership, however, is not treated as an Internal Manager, and the SEC and the courts would normally consider a general partner to be an investment adviser to the limited partnership or its limited partners under the Advisers Act. See Abrahamson v. Fleschner, 568 F.2d 862, 869-71 (2d Cir. 1977), cert. denied, 436 U.S. 905, 913 (1978); and SEC Rule 203(b)(3)-1 under the Advisers Act.
17. See MEAG MUNICH ERGO AssetManagement GmbH, SEC Staff No-Action Letter (Feb. 14, 2014) (MEAG); and Zenkyoren Asset Management of America Inc., SEC Staff No-Action Letter (June 30, 2011) (ZAMA). Note that in MEAG and ZAMA, the SEC did not see any need to look through the wholly-owned advisory subsidiary to its Internal Managers, and treated the parent investor (and not its underlying insureds) as the ultimate beneficial owner of the managed assets for 1940 Act purposes. See also SEC Staff Report on Regulation of Investment Advisers (March 2013) at p. 4.
18. To the extent that an Internal Manager does not exercise investment discretion, there may be an argument that such person does not have “regulatory assets under management” (or RAUM) sufficient to trigger an ERA filing or full investment adviser registration (assuming such person is otherwise considered to be an investment adviser under the Advisers Act). See Form ADV Instructions, item 5(b)(3).
19. A properly structured JV or SIF where a sophisticated investor partners with a US management team and is actively involved in forming and managing the IMF vehicle (e.g., is actively involved in negotiating the terms of the IMF and has active or majority board representation) could avoid coming within the securities offering regime of the Securities Act of 1933, including the Form D filing and other requirements under Rule 506 of the Regulation D private offering exemption and related state blue sky filing requirements.
20. SEC Rule 202(a)(11)(G)-1.
21. See Advisers Act sections 203(l) (venture capital funds) and 203(m) (small private fund advisers), and SEC Rules 203(l)-1 and 203(m)-1. Note that the status of private funds investing in real estate, cryptocurrencies and/or other potential non-securities instruments which may offer similar exclusions from Advisers Act coverage while involving other types of restrictions or regulation, is beyond the scope of this discussion.