With lower barriers to fund formation, more accessible technology, and a growing pool of sophisticated investors, the number of first-time fund managers has grown substantially. Generally speaking, this new wave of operators, executives, and investors is good for the market. However, many emerging managers are excellent at identifying deals but less experienced navigating the legal and structural requirements of running a fund. Below are common mistakes we see and how you can avoid them:
1. Confusing 506(b) and 506(c) and Choosing the Wrong Exemption
Regulation D under the Securities Act provides two primary exemptions for private funds: Rule 506(b) and Rule 506(c). They are meaningfully different and choosing the wrong one can have serious consequences.
Under 506(b), you can raise capital from up to 35 non-accredited but sophisticated investors alongside an unlimited number of accredited investors. However, you cannot generally advertise or solicit the offering and you must have a substantive preexisting relationship with all investors. This means you cannot accept investments from those outside your personal network and there cannot be any social media posts, podcast appearances, or website language that constitutes a general solicitation. This limitation is broader than most new fund managers realize and all relationships with investors must predate the offering.
Under 506(c), you can generally advertise and solicit, but every investor must be a verified accredited investor. Recently, the SEC simplified the verification requirements significantly, making 506(c) a more attractive option than in the past.
The exemption you choose depends primarily on your marketing strategy, investment plan, and investor base. If you’re raising capital from a close network of people you have preexisting relationships with, 506(b) is often the cleaner choice. However, if you’re building awareness broadly, wanting to advertise, and understand you can only accept verified accredited investors, then 506(c) may be the better option.
2. Treating the PPM as a Checkbox or a Form of Marketing Materials
The private placement memorandum (“PPM”) is substantive disclosure document with the purpose of providing investors all information needed to make an informed investment decision, as well as protect the fund manager from securities fraud claims if something goes wrong. Regularly, we see first time fund managers try to cut corners by either using a generic template, having AI create their PPM, copying from another fund’s PPM, minimizing the risk factors to avoid “scaring off” investors, or thinking of it as a sales pitch. This is a huge mistake on every level. A properly drafted PPM should reflect your actual strategy, disclose all risks, and disclose all conflicts of interest. Furthermore, the PPM should be accurate, complete, and updated when material information changes. The PPM is also one of the first things the SEC will look at if your fund is ever examined.
3. Getting the Fund Structure Wrong From the Start
Most funds are structured as limited partnerships or limited liability companies with investors as limited partners or members, and the management team as the manager or general partner. However, the details within that structure matter tremendously as correcting those details later are much more complicated to fix once the fund is launched. Key decisions that must be made upfront include management fees, distribution waterfalls and carried interest, key person provisions, investment period and fund term, fees, and structure (deal by deal versus blind pool). These terms set the economic architecture of your relationship with investors and having the right terms matters for both the fund’s success and its ability to attract investors.
4. Underestimating Ongoing Compliance Obligations
Launching the fund is only the first step while operating the fund in compliance with applicable laws and regulations is an ongoing obligation. Depending on your fund size, strategy, and investor base, you may need to qualify as an exempt reporting adviser (“ERA”) or register as a registered investment adviser (“RIA”). Whether you are classified as an ERA or RIA can also have a significant impact on the fees you are able to charge. In addition, for most private funds, you will need to qualify for an exemption under the Investment Company Act. The three most common exemptions are: (i) 3(c)(5) for real estate funds, (ii) 3(c)(1) where the fund is limited to only 100 beneficial owners, and (iii) 3(c)(7) where the fund may only accept “Qualified Purchasers.” Each of these Investment Company Act exemptions requires managing the fund’s portfolio allocation or investor base over the entire life of the fund.
5. Skipping Investor Onboarding
While largely administrative, subscription agreements, accreditation verification, AML/KYC procedures, and investor communications are important and legally required. Before you accept your first subscription, you must establish a clear process for how investors subscribe, how you verify their accreditation status, and how you communicate with them through the fund’s term.
The Current Environment
The regulatory climate for private fund managers is more favorable today than it was in prior years with the SEC’s recent guidance. For aspiring fund managers who have been waiting for more clarity, this may be a good time to move forward. That said, the fundamentals of securities law compliance have not changed and the consequences of getting it wrong can be detrimental to not only the current raise, but also the ability to raise capital in the future. Furthermore, with the current state of the market, it is imperative that you establish a solid track record of deal experience and have investors within your personal network that trust you. To establish a track record, many fund managers start out with syndications or single asset offerings to build experience and gain investor trust.
If you are a first time fund manager, we’re to help guide you through the process. Please feel free to reach out if you have any questions.