By Richard L Shamos (pictured), Sadis & Goldberg – As traditional investment fund strategies have run into increasing competition, investor appetite for boutique or alternative investment strategies in the United States (US) continues to grow.
Cross border allocations continue to offer a unique opportunity for both investors and managers alike, as such allocations enable investors to reach managers with an outlook that differs from local managers, and likewise enable managers outside the US to access the large institutional investors in the US and expand their product offerings. In this piece, we explore the primary legal considerations and strategies for European managers seeking to raise capital in the US.
I Regulatory Concerns
As a start-off point, it is important to highlight significant differences between the European and US regulatory regimes. Notably, European regulations include standardised regimes for the regulation of investment managers and investment funds in Europe, while national regulatory regimes on the marketing of investment products still remain in place. As a result, European managers approaching an offering in the US often come with the same question they would have if offering in another European country: how do I market? Marketing in the US, however, is actually quite straight-forward, and there is no notification procedure as exists under EU Directive 2011/61/EU (AIFMD). Instead, non-US managers will need to consider how US laws on the regulation of investment advisers and investment funds apply to their actions. These adviser and fund regulations pose the most significant regulatory risk to investment managers operating in the US.
As in most non-US financial jurisdictions, investment funds and investment advisers in the US are subject to regulation by the national regulatory authority (in this case, the US Securities and Exchange Commission (the “SEC)). The SEC oversees the regulation of securities, the regulation of investment funds, and the regulation of investment advisers and broker-dealers. All of these regulations are relevant to a non-US investment adviser marketing into the US.
Although an offering of securities in the US requires registration under the Securities Act of 1933 (Securities Act), Section 4(a)(2) of the Securities Act provides an exemption from registration for transactions “not involving a public offering.” As a result, non-US managers seeking to conduct private placements in the US will want to conduct their offering and sales activities so as to fit within the exemption. Fortunately, Rule 506 in Regulation D of the Securities Act provides standardised safe harbours for private offerings involving (i) a limited number of US persons, or (ii) US persons who meet minimum net worth requirements (Accredited Investors). These two provisions are commonly relied upon by managers during a private offering of securities and are designed to work together with the Investment Company Act of 1940 (the “Company Act), which applies directly to investment funds.
As with any other type of issuer of securities, an investment fund is required under the Company Act to register with the SEC unless it meets certain exemptions. There are several exemptions available to an investment fund, though the two most common include fund offerings, not involving a public offering, that are made to (i) a limited number of persons (less than 100) or (ii) limited types of investors who meet minimum net worth requirements (Qualified Purchasers) (but without a prescribed limit as to number of investors). It is important to note here that the minimum net worth requirements for Qualified Purchasers are higher than those applicable to Accredited Investors under the Securities Act, though most institutions should be able to meet both.
Non-US managers offering in the US will also be subject to regulation as an investment adviser. Historically, private fund managers did not commonly register with the SEC. However, after the passage of the Dodd-Frank Act, the SEC generally required all advisers to managed accounts and investment funds to register with the SEC, subject to limited exemptions. These exemptions include (i) a foreign private adviser exemption applicable to foreign managers who oversee less than USD25 million in assets (among other requirements), and (ii) a private fund adviser exemption, which exempts advisers to private funds if they manage less than USD150 million in assets. Such “exempt reporting advisers” (ERAs) are required to notify with the SEC and file periodic reports, much in the same way that US managers are required to notify under AIFMD private placement rules, though they are not subject to full SEC regulation of investment advisers. Fortunately for non-US managers, the SEC has taken the position that if a non-US manager has no place of business in the US and manages only private funds from outside the US, it can avail itself of the private fund exemption “without regard to…the amount of assets it manages outside of the United States.” In the event the non-US manager intends to hire a marketing agent to solicit investors in the US for its fund, then the manager should also explore the SEC’s requirements applicable to broker-dealers.
It is worth noting that there are ancillary regulators and other laws applicable to investment funds in the US Notably, the Commodity Exchange Act (CEA), in addition to regulating commodities and currencies, regulates most derivatives in the US As a result, investment funds will need to conduct analysis regarding the CEA and accompanying regulations, though again, many investment advisers are able to rely on recognised exemptions from full registration, or devise a structural solution to manage their compliance obligations, if the non-US manager is only trading a small amount of commodity interests.
II Tax Concerns
In addition to the regulatory concerns above, it is vital for non-US managers marketing an investment fund in the US to understand how the tax status of US investors affects their investment preferences. US tax status is a primary factor determining investor suitability when marketing a fund (in contrast to Europe, where investor suitability involves a number of prescribed factors). An investor’s US tax status is materially important to the economic viability of an investment product, as unintended tax liabilities can diminish investment returns or create liability for the boards and decision-makers of institutional investors. This can in turn result in significant liability for fund managers, and inadequate tax disclosure can result in an investor’s right to cancel the investment contract ab initio. As a result, understanding tax is a pre-requisite for managers seeking to successfully market into the US investor. Notably, private investment funds in the US have generally evolved to accommodate two principal categories of investors: US tax-exempt institutions like pension funds and foundations, and US taxable (generally “high net worth) individual investors.
US tax-exempt institutions generally prefer to invest through a non-US corporation, because offshore companies block potential US taxes that might flow through to the investor due to debt-financed income or in the event the fund were to conduct a non-investment business in the US (so-called unrelated business taxable income or “UBTI” – one of the main taxes that still affects tax-exempt US institutions’ investment activities). Taxable US investors, on the other hand, face a steep uphill climb in foreign corporate vehicles, and as a result generally avoid them altogether due to the punitive US tax regime on investments in a passive foreign investment company (PFIC). Gains from an investment in a PFIC are generally subject to taxation in the US at ordinary income rates at the maximum tax rate (39.6%), rather than the reduced 20% rate applicable to long term capital gains. Additional interest charges may apply as well.
There are, however, a number of ways to mitigate this tax liability in the event a taxable US investor seeks to invest in a PFIC, including by making a qualified electing fund (QEF) election. Investors in a QEF would include in their taxable income their share of the PFIC’s net realised capital gain or net ordinary income, whether or not actually distributed. In order to make a QEF election, a taxable US investor must receive a statement from the offshore fund (kept in accordance with US federal tax accounting), that enables it to identify the investor’s share of the fund’s capital gain income and net ordinary income and meet its tax obligations.
A mark-to-market election is also available to a taxable US investor’s investment in certain PFICs if the PFIC’s shares are publicly traded or otherwise treated as “marketable stock,” though this regime is generally not as favourable, since the mark-to-market income is taxed as ordinary income. Given this tax backdrop, non-US advisers managing an corporate entity formed outside the US may find a marketing opportunity with tax exempt US investors, as the funds they manage may provide similar tax benefits to those provided by standard non-US blockers (e.g., Cayman exempt companies), while enabling such managers to pitch to the biggest pools of assets in the US In the event managers find opportunities with taxable US investors, there may be viable paths to address the tax liability and risk arising from such investors’ investment in a PFIC.
While marketing in new jurisdictions may involve new areas of regulatory and investment risk, such offerings provide an opportunity for managers to diversify their products and investor base in the long-run. By working with experienced fund counsel to navigate the relevant US tax and regulatory concerns, non-US managers seeking to market investment funds in the US can reduce their regulatory burden and financial risk, while successfully charting a path through the tax and regulatory landscape in the US
Richard L. Shamos is Counsel in the Firm’s Financial Services Group. He advises financial services companies on the formation and distribution of investment funds, including hedge funds, private equity funds, fund of funds and registered funds. Mr. Shamos has counselled investment advisers and financial services companies on a variety of transactions, including complex cross-border fund mergers, corporate acquisitions, fund restructurings and asset-backed securitisations. In addition, he has advised companies in connection with international regulatory issues, including the conversion of alternative funds to AIFs, the structuring of multi-manager and multi-strategy products, cross-border regulatory compliance and tax planning. Richard can be reached at 212.573.8027 or [email protected].
About Sadis & Goldberg LLP
Sadis & Goldberg is a leading New York based law firm with practices in hedge, private equity, venture capital, commodity fund formation, family office, real estate, transactional counselling, compliance services, regulatory defence, litigation, derivatives, tax, ERISA and estate planning. For additional information: www.sglawyers.com.
