Finders’ weepers: A risk for private funds

Tempting (and fraught) market beckons

Private fund advisers hoping to bank on wealthy families or other high-net-worth clients should take extra care with the Security and Exchange Commission’s finders’ rules.

Under Securities Act rule 3a4-1, affiliates of private funds generally can sell securities without registering as a broker-dealer so long as they aren’t “bad actors”; don’t collect commissions; aren’t already an affiliate of a registered B-D; only sell to registered B-Ds, investment companies, banks or insurers; are already exempted from registration under sections 3(a)(7), 3(a)(9) or 3(a)(10); are selling under a plan approved by a majority of the shareholders; or the securities are being offered under some kind of employee bonus, profit-sharing or pension plan.

The risks here aren’t hypothetical, said Ben Marzouk, a partner with Eversheds Sutherland in Washington, DC. “Everyone needs to be careful because at any moment the SEC could prioritize compliance,” he told Regulatory Compliance Watch in a Zoom interview. “It’s a gap that I think the industry should be aware of. They know it’s a place where if the SEC wanted to devote some serious enforcement efforts, it would seriously worry the industry.”

Investors by the numbers

Ben Marzouk

High-net-worth investors have at least $1 million in liquid assets. It’s easy to see why they’re an appealing market: they’re already accredited investors and they tend to be more sophisticated than retail investors. Some experts estimate the North American market covers about seven million people with more than $24 trillion in gross assets. The worldwide market may be up to 21 million people, with $80 trillion in assets.

It’s a largely untapped market for private funds. According to the SEC’s first quarter Form ADV data, a few dozen registered private fund advisers split nearly $580 billion in high-net-worth client assets among them.

Tempting as that market may be, it’s fraught, said Kerry Potter McCormick, a partner with Barnes & Thornburg in New York. “One question to ask in a closed-end drawdown fund is, ‘what’s the risk of default?’ Investors that are natural persons may have accumulated wealth, but they also have expenses,” she told RCW. “Even qualified investors who make a commitment to a private fund with a 10-year term may find themselves in a different financial position in the fund’s later years. In those circumstances, they may come to the adviser after receiving a capital call notice to discuss their funding ability, and the investment adviser will need to look to the fund documents to help determine next steps.”

Vulnerable to violations

It’s also a function of numbers, Marzouk said. “The private funds that are marketing their interests to high-net-worth retail investors, they’re probably more vulnerable simply because they’re talking to more people. The more you’re selling, the more likely you are to be in violation of those 3a4-1 rules.”

In the last days of the prior administration, the SEC proposed limited relief to some of the finder’s rules. They’ve laid dormant since. If your firm is thinking about using finders to help you sign up high-net-worth clients, Marzouk said you might consider the following steps:

  • Try getting a no-action letter from regulators. That’s admittedly a tougher sell under this administration, Marzouk said, but “it’s the traditional route.”
  • Document everything. If you’re going to rely on 3a4-1, explain carefully why your firm qualifies, how your firm meets the conditions of 3a4-, and the supporting evidence behind it, Marzouk said.
  • Revisit your compliance manual. “If they are relying on 3a4-1, they should have specific guard rails for what they can do,” Marzouk said. Make sure the policies get out firm-wide, and that you train staff on them regularly.