Strings Attached to Hedge Fund Ad Rule

By Stephen Bornstein, of Wall Street Counsel

Getting ready to advertise your hedge fund or private equity fund when the new SEC ad rule goes into effect in a few months?  Here are a couple of things you should know.

First, you may not be able to charge performance fees to investors who merely satisfy the ‘accredited investor’ test underpinning the new rule.  That standard, as you may know, requires an investor to have (i) an income of at least $200,000 for the past two years and expected for the current year or (ii) a net worth of at least $1 million (exclusive of principal residence).

If you’re already registered with the SEC as an investment adviser, you unfortunately cannot charge a performance fee to any investor – whether in a fund vehicle or managed account — who does not meet the higher standard of a ‘qualified client’.  A ‘qualified client’ must have at least $1 million under your management or a net worth of at least $2 million (exclusive of principal residence).

If you don’t have sufficient AuM to register with the SEC (see Uncle Sam Wants You!), you are then at the mercy of the performance fee regulations of your home states, most (if not all) of which have by now adopted the SEC’s ‘qualified client’ standard.

You should also be aware that mere ‘accredited investors’ can only invest in so-called 3(c)(1) funds which are limited to 100 investors.  Private funds open to more than 100 investors are restricted to ‘qualified purchasers’ who, if natural persons, must have investment portfolios of at least $5 million (net of debt).  ‘Qualified purchasers’ can be charged performance fees both by SEC registrants and under all state laws.

Secondly, what may also take the wind out of some sales campaigns is the SEC’s proposed extension of its anti-fraud guidance on mutual fund sales literature (Rule 156) to private fund advertisements.  Rule 156 is designed to achieve balance in fund promotional materials and fleshes out the informational pitfalls that could constitute securities fraud.

Under Rule 156, fund managers are cautioned not to make public claims regarding past investment performance or asset growth without describing qualifications or limitations (such as particular economic or financial circumstances) relevant to the achievement of the claimed results.  This general guidance is in addition to the specific prohibitions the SEC has enunciated in regard to performance presentations by investment advisers, whether or not in connection with general solicitations under the new ad rule (see Performance Presentations).

Also, if an ad claims particular benefits associated with an investment strategy — such as preserving capital in down markets or protecting against tail risk – it must give equal weight to any risks inherent in that strategy.  Similarly, comparisons between the performance of a fund and other investment vehicles or market indices must also be appropriate and supportable.

To educate itself on how private funds choose to advertise themselves, the SEC has also proposed that, for the first two years following the effectiveness of the new ad rule, funds engaging in general solicitations must submit their written ads to the SEC simultaneously with their first public use.  Though the SEC is not expected to comment on the submitted ads, the filing requirement alone should serve the additional public purpose of detering would-be fraudsters from assuming their private fund promotions will never be picked up on the SEC’s surveillance radar.