Private Funds

Private funds are not registered under the Investment Company Act of 1940 (ICA); they rely on exemptions. They offer less regulatory disclosure than registered investment companies, have limited liquidity, and are generally available only to accredited investors or qualified purchasers.

Private Fund Exemptions

Private funds avoid registration under the ICA by using one of two exemptions:

Section 3(c)(1) exception: Qualifying venture capital funds may have up to 250 investors if the fund has $12 million or less in assets under management (AUM).

Think of it this way: Private funds use these exemptions to avoid SEC registration. The logic is: if you only have sophisticated wealthy investors who can do their own due diligence, you do not need the same consumer protections required for everyday retail investors.

Accredited Investor vs Qualified Purchaser

Memory Aid: 1-2-3 (Accredited Investor)

• 1 = $1 million net worth (excluding primary residence)
• 2 = $200,000 individual income (each of the last 2 years)
• 3 = $300,000 joint income with spouse (each of the last 2 years)

Qualified purchaser is a higher standard than accredited investor. All qualified purchasers are accredited, but not all accredited investors are qualified purchasers.

Automatic accredited investor status by license:

• Holders of Series 7, Series 65, or Series 82 licenses in good standing also qualify as accredited investors.

Exam Tip: Gotchas

• Accredited investor is based on NET WORTH or INCOME. Qualified purchaser is based on INVESTMENTS owned. A person with a $6 million house and $2 million in investments is NOT a qualified purchaser despite having high net worth.
• 3(c)(1) = 100 investors max, typically accredited. 3(c)(7) = 2,000 investors max, qualified purchasers only.

Hedge Funds

Hedge funds are actively managed private funds using aggressive strategies to seek returns in any market condition.

Key characteristics:

• Typically organized as limited partnerships (general partner (GP) manages, limited partners (LPs) invest)
• Strategies include: long/short equity, leverage, short selling, derivatives, arbitrage, global macro
• Management fee (commonly 2%) + performance/incentive fee (commonly 20%), known as the "2 and 20" structure
• Lock-up periods restrict redemptions (often 1-2 years)
• Redemption typically only at specified intervals (quarterly, annually) with advance notice
• Less transparent; not required to disclose holdings publicly
• Higher risk profile due to leverage and concentrated strategies
• Exempt from ICA registration via Section 3(c)(1) or 3(c)(7)
• Fund manager may register as an investment adviser with the SEC under the Investment Advisers Act of 1940

Exam Tip: Gotchas

• Lock-up periods add liquidity risk but allow the manager to use illiquid strategies without being forced to sell.
• Long/short equity is the most common hedge fund strategy.

Private Equity

Private equity funds invest in private companies (or take public companies private). They have a long investment horizon, typically 7-10+ years for fund life.

Key characteristics:

• Capital is called (drawn down) from investors over time as deals are found
• Returns realized through exits: IPO, sale to another company, or recapitalization
• Buyout funds: acquire controlling stakes in mature companies
• Growth equity: minority stakes in growing companies
• Very illiquid; investors commit capital for the life of the fund
• Typically structured as limited partnerships

Venture Capital

Venture capital is a subset of private equity focused on early-stage and startup companies.

Key characteristics:

• Higher risk/higher potential return than traditional private equity (PE)
• Invest in companies with limited or no revenue history
• Fund life typically 10+ years
• Capital called over time as investments are made
• Most portfolio companies will fail; returns driven by a few big winners
• SEC-registered venture capital (VC) fund advisers may qualify as exempt reporting advisers (ERA) if they manage only VC funds

Hedge Fund vs Private Equity vs Venture Capital

Exam Tip: Gotchas

• Hedge funds = liquid strategies in public markets. Private equity = buying established private/public companies. Venture capital = funding startups. All three are private funds exempt from ICA registration.
• Private funds have limited liquidity. Lock-up periods and redemption restrictions are common.