Regulation D for Private Equity and hedge funds operate in similar ways. In both cases, the businesses raise money from institutional and individual investors. These investors provide their capital in exchange for some form of interest into the entity the hedge fund or private equity form oversees.
Furthermore, both hedge funds and private equity are considered non-public investment options. In the case of private equity, this is considered an alternative form of investment, meaning it is not listed publicly. For hedge funds, restrictions surrounding advertising of the fund mean that practically all of them are operated privately, often involving a tight-knit network of investors.
While this privacy offers both types of funds some advantages, it can also make raising capital for future investments complicated. Thankfully, the document known as a Reg D private placement memorandum (PPM) can allow both hedge funds and private equity firms to raise money without having to go public or break any regulations.
In this article, we begin by examining some basic advice for raising capital that applies to these types of businesses. We dig into the concept of securities and explain why you should seek the help of a syndication lawyer when raising capital. Finally, we explain what private placement memorandums are, what you should expect to see in them, and the two key exemption rules you must follow as detailed by Regulation D of the Securities Act and how Reg D can apply to nearly every industry.
Raising Capital as a Hedge Fund or Private Equity Firm
As mentioned, the key challenge both private equity firms and hedge funds face is that they cannot make public appeals for capital. Neither can be listed on a public stock exchange, meaning neither can raise capital through the public sale of shares.
Thankfully, raising capital is not impossible for either type of business. We’ll explain how you can use a PPM to do this later in the article. For now, these are some general tips to follow when preparing to raise capital for a hedge fund or private equity firm.
Tip No. 1 – Keep it Simple
Both of these types of businesses can get complex, especially for investors who have never taken part in a hedge fund or private equity venture. As such, you can never assume that your potential investor understands the technical terms you use in day-to-day business.
Keep your funding presentation as simple as possible by avoiding complex terminology. If you’re not sure if your presentation fits the bill, ask a trusted friend or professional acquaintance to listen to it. If they can understand your offer, it’s likely that others will too.
Tip No. 2 – Don’t Try and Do it All Yourself
We’ll discuss why it is so crucial that you work with a syndication attorney later in the article. However, this avoidance of the do-it-yourself approach doesn’t only extend to the legal aspects of raising capital.
Understand that investors expect you to be completely focused on making them money. If you’re spending all of your time trying to create capital proposals, you’re not spending time running your fund or private equity firm.
Tip No. 3 – Always be Honest
Trust is a key component for both private equity and hedge funds. The lack of public advertisement means you’ll be working within a network of investors. If you develop a reputation as somebody who investors can’t trust, that reputation won’t just mean that you don’t receive capital from the investor you upset. It may also mean that other investors won’t even consider any offers you make.
Be honest about your experience and any work you’ve done with previous funds. Discuss why any funds you’ve worked on ended and aim to demonstrate your experience while showing potential investors that you’ve learned from any mistakes you made in the past.
Tip No. 4 – Address the Risk Factors
Your potential investors aren’t stupid people. They know that they’ll have to deal with risks if they invest in your fund. What they don’t know, until you tell them, is how much risk they’ll assume.
Again, transparency is key here, both from ethical and legal perspectives. Ethically, trying to hide risk essentially means that you’re misleading your investors, which can come back to bite you in the same way that being dishonest can. Legally, you’re obligated to present the full facts to your investors. Failure to do so can lead to civil and criminal prosecution under both SEC and state anti-fraud regulations.
Tip No. 5 – Prepare to Explain Your Returns
If you’re already running a successful hedge fund or private equity firm, you may be seeking investment to take the business to the next level. Of course, being able to demonstrate a track record of success is not a bad thing. Being successful raises investor confidence and makes it more likely that somebody will commit their money to your fund or firm.
However, success also leads to pessimism. Many investors have either heard of or been directly affected by Ponzi schemes and similarly fraudulent investment “opportunities”. Seeing an exceptionally successful investment opportunity may set off some alarms in the head of a more cautious investor. As such, you need to be prepared to explain exactly what led to every success you’ve already experienced. With appropriate explanations, you show your potential investors that everything you’ve achieved is legitimate.
What is a Security?
Following the above tips may help you to attract investment when you offer your private placement memorandum. However, before focusing on creating your PPM, you need to know more about securities and the role they play for hedge funds and private equity firms seeking investment.
At the basic level, a security is any financial instrument or asset that your company can sell, buy, or trade. Shares, stocks, and mutual funds are all examples of securities that investors can focus on. All securities fall under the jurisdiction of the Securities and Exchange Commission (SEC), which is responsible for creating the rules and regulations you must follow when trading securities.
Securities are fungible and can be traded easily for money or other assets. When you create a PPM, you’re essentially offering a form of security to investors into your fund or private equity firm.
There are four types of security:
Type No. 1 – Debt Securities
Debt securities work similarly to loans. Think of them as an “IOU” from a government or company that is addressed to the person who holds the security.
With a debt security, an investor gives your fund or firm an agreed-upon amount of money. In return, that investor receives interest based on how much they’ve loaned to your firm and the interest rate you agreed with the investor. Eventually, this security matures, at which point you have to repay the full principal of the security.
Those who invest in debt securities make their returns on the interest payments they receive while being safe in the knowledge that they’ll also get their original investment back at a later date. The borrower gains immediate access to capital that can be used to grow their fund or private equity firm.
Type No. 2 – Equity Securities
With an equity security, the security owner trades their capital for an ownership stake in the fund or firm. For example, those who buy stocks in a publicly-listed company gain a level of ownership commensurate with the number of stocks bought. Somebody who buys 51% of the available stock in a business gains a controlling interest in that company.
Equity securities differ from debt securities in that the investor tends to focus on long-term gains when investing for equity. They believe that the eventual sale of an asset will result in them receiving a large return on the original investment.
To achieve that return, they may need to sacrifice ongoing returns from periodic payments. However, this is not the case for all equity securities. For example, equity securities related to property may allow the investor to collect a percentage of rental returns in addition to taking a percentage of the capital gains generated upon the sale of the property. Another example is the dividends provided to company shareholders, which are typically paid either quarterly or annually.
Equity securities may also give the security owner voting rights in the company, allowing them to influence future direction.
Type No. 3 – Derivative Securities
The value of a derivative security is, as the name implies, derived from the value of a specific group of assets. An example of a derivative may be an agreement between two individuals that relates to a pool of assets that includes property and shares. The value of the entire pool depends on the collective values of the various assets contained within.
Many investors use derivative securities to mitigate riskier investments. However, it is possible to generate substantial returns via this type of security.
Futures contracts are good examples of derivative securities.
Imagine you agreed to buy a patch of land for $100,000 at a date set two years into the future. During those two years, the value of the land increases to $120,000. Due to your agreement, you will still receive that land for $100,000, meaning you’ve generated a gain via a derivative security. Of course, the opposite occurs if the land loses value between the date you sign the agreement and the date of purchase.
Type No. 4 – Hybrid Securities
As the name suggests, a hybrid security is something of a combination of equity and debt securities.
Take convertible bonds as an example.
A convertible bond acts similarly to a regular bond. This means the security owner invests money with the organization offering the bond. They then receive interest payments based on the agreement they make.
However, the investor also has the option of converting that bond into equity in the organization that provided the security at any point. As such, the security owner has a choice of whether they benefit from the consistent returns the bond generates or from the large capital gain that may occur upon the sale of the connected asset.
Hybrid securities provide more flexibility to investors. However, your fund or firm may be wary of the idea of offering a type of security that can change based on the investor’s needs.
Why Hire a Syndication Lawyer?
When you create a private product memorandum, you essentially offer a security to your potential investors. We will dig into what this involves shortly. Before we do, it’s important to recognize that creating a PPM, and soliciting any sort of investment for a hedge fund or private equity firm, is subject to both state and SEC regulations.
In short, you need to work with a syndication attorney to ensure your PPM offering is legitimate and legal. This attorney will help you to create the various syndication documents needed for each stage of the process. However, this is far from the only reason a hedge fund or private equity firm should retain a syndication attorney. There are several more for you to consider.
Reason No. 1 – Receive Ongoing Legal Support
It’s not simply the creation of a valid private placement memorandum that your firm or fund may need help with. In both types of business, there are various legal requirements to meet just to stay in operation. For example, hedge funds may not directly advertise their companies to the public. By ensuring you have a good syndication lawyer, you provide your organization with access to ongoing legal counsel that ensures you don’t do anything that could make it difficult for you to raise capital.
Your attorney will ideally be able to help you do the following:
- Determine the legality of any marketing or promotional materials your firm creates.
- Suggest and implement amendments or conditions that need to be added to any offering documents, such as a PPM, that you create.
- Chase up information from potential investors, particularly when it comes to determining if you’re working with an accredited investor. Validating accreditation is important to ensure you abide by certain rules in Regulation D of the Securities Act.
- Offer legally succinct answers that you can provide for questions that your investors ask. A good syndication lawyer ensures you’re able to answer questions transparently while protecting yourself.
- Assist with any modifications you need to make to your fund’s structure.
The investment you make into ongoing legal counsel may seem large. However, it is far outweighed by the legal fees and penalties you may face if you break SEC regulations.
Reason No. 2 – Proper Fund Structuring
When creating a hedge fund, you must meet certain regulatory obligations. These obligations include filings, registrations, and exams. Failing to meet these regulations may result in your fund operating illegally. Additionally, some funds are ‘trickier’ than others, for example raising capital for crypto funds can be more complicated.
A good attorney can ensure you meet all of the obligations placed on you.
What’s more, your syndication lawyer will help you to define your organization’s structure while helping you to prepare your syndication documents. These documents extend beyond your private placement memorandum to include subscription agreements, partnership agreements, and other regulatory filings.
Reason No. 3 – Negotiating on Your Behalf
A potential investor may disagree with the figures in your PPM. For example, an investor may want a larger equity share in your firm or fund in return for their money. Or, they may wish to implement a higher interest rate if you have gone down the private placement debt offering route.
In many cases, you may choose to no longer work with the investor, especially if they would only contribute a small amount of capital to the fund. However, cutting ties may not be the best solution if the investor can offer a substantial amount of capital to your organization.
If you have a syndication lawyer, you can have them handle the negotiation process on your behalf. Doing so provides several benefits. You save time on dealing with individual investors, allowing you to dedicate more focus on your fund’s investment activity. Furthermore, attorneys are experienced negotiators, meaning they can form strong arguments that may sway your prospective investor. Finally, you will have worked with your attorney to structure your fund or private equity firm, meaning they have an in-depth understanding of what is best for the firm.
Reason No. 4 – Performing Due Diligence
No hedge fund or private equity firm should enter into any sort of financial agreement with a potential investor without conducting due diligence first. In addition to ensuring the investor has all of the credentials they claim to have, due diligence allows the fund or firm to protect itself from regulatory issues that may come as a result of working with inappropriate people.
Again, due diligence takes up a lot of time, especially when you need to conduct it on dozens, or even hundreds, of investors into a fund. A syndication attorney can handle the due diligence burden on your behalf, allowing you to focus on your fund’s activities while feeling secure in the knowledge that you’re attracting good investors.
Are You Liable for Getting Your Private Placement Memorandum Wrong?
As a private placement memorandum is essentially an offering of securities in your hedge fund or private equity firm, you face a large amount of liability if you get the document wrong. The key here is that any attempt to deceive investors, willfully or otherwise, can result in sanctions from both the SEC and your state.
In terms of the SEC, you must operate within Section 10(b) of the Securities Exchange Act, which makes the seller of securities liable should an investor discover an omission or misrepresentation of facts.
If this occurs, the minimum penalty imposed is called the recission of the investor’s contract, which essentially means the contract the investor signed to purchase securities from you is voided. This leaves you, as the syndicator offering the securities, holding the bag for the payment of the investor’s share and any related fees the investor paid while attempting to do business with you.
More seriously, purposeful omission or misrepresentation of the facts in a PPM can lead to up to 20 years of jail time, combined with a fine of a maximum of $5 million. These numbers vary depending on the court’s judgment.
On top of the SEC issues, you also have to consider potential state punishments for misrepresentation or omission. Many states impose civil liability on the PPM’s syndicator, in addition to the criminal liability imposed by the SEC. This civil liability can lead to you having to pay extensive fines.
Moving away from the adequate disclosure of facts, you must also consider your liability in terms of preparing the ancillary syndication documentation that goes along with your PPM. A properly-drafted PPM will reference several other documents, such as security agreements, promissory notes, subscription agreements, and relevant bylaws.
You must work with a licensed syndication attorney to prepare any ancillary agreements or documentation.
Failure to do so could lead to prosecution for practicing law without a license.
What is a Private Placement Memorandum?
Also referred to as an offering memorandum or an offering document, a private placement memorandum is a financial document that private companies use to attract investment. The document is a little like a business plan for the private company, as it offers information about what the organization does in addition to informing the investor about the securities the company is offering.
The information provided in a PPM should help an investor conduct due diligence on any opportunity a business offers to them.
There are several reasons why your hedge fund or private equity firm should consider using a PPM to raise capital:
- A PPM costs less than preparing a full prospectus.
- You gain quick access to capital, assuming you’ve created an adequate PPM.
- You can use a PPM to appeal to a larger pool of investors.
Organizations tend to use PPMs when they’re trying to raise large amounts of money from institutional investors. For example, a hedge fund may use a PPM to raise capital for future investments. The same goes for a private equity firm, only, in this case, the PPM may serve as a means of exposing the firm to other investors.
Types of Private Placement Memorandum
As a PPM is a document that essentially offers securities to a potential investor, the actual offers you can make via a PPM match up with the types of securities mentioned earlier in the article.
For example, you can use a PPM to offer equity in your enterprise through an LLC promissory note or a corporation common stock sale. This is essentially the same thing as selling shares in your company via the stock market. Only here, you conduct the transaction privately. The investor still receives an ownership share commensurate with the amount of money they invest into the business.
Alternatively, you can conduct a private placement debt offering, which means issuing a bond. The investor then receives interest based on the terms of the bond. They’ll also receive the full principal of the bond back after an agreed-upon period.
What is Included in a Private Placement Memorandum?
Regardless of the specific way you intend to raise money via a private placement, you must create a private placement memorandum that complies with current state and SEC regulations. As a formal document, your PPM is one part business plan and several parts statement of the facts that an investor needs to know in order to determine whether they want to commit their money to your enterprise.
There is no hard and fast structure for a PPM. However, the following are the sections that a good PPM tends to contain.
An Investor’s Notice
This is a basic outline of all of the important information that an investor would expect to see in the document. For example, an investor would expect to see a notice about how the opportunity carries a high degree of risk if the level of risk is an issue. They’ll also expect to see information about company rights and any restrictions that apply to the investment.
If it’s something that the SEC’s regulations require you to disclose, it should likely be in the investor’s notice.
An Executive Summary
Where the investor’s notice is a summary of the regulatory information an investor needs to know about, the executive summary focuses more on the opportunity presented in the PPM. This is your chance to entice an investor into becoming a part of your enterprise. A typical tactic is to highlight the top three things you want the investor to take away from the PPM.
Purpose and Overview
This is where you can dig a little more into what your organization does and what it intends to do with the money the investor would commit to it if they sign the PPM. It’s here that you share information about your experience, market acumen, and the plans you have for the hedge fund or private equity firm. If you have completed a SWOT analysis, you can use that here too. The goal of this section is to give your prospective investor a better idea of who you are and what your company is all about.
Terms and Conditions
In the terms and conditions section, you talk about the deal’s structure. You may include information about dividends, dilutions, and interest payments, assuming they’re relevant to your offer. You will also highlight the rights the investor has. For example, their investment may grant them rights to liquidation, voting, and information, all of which you must outline here.
It’s here a good syndication lawyer comes in especially handy. Your attorney can provide you with a checklist of all of the things that might go into the terms and conditions of your PPM, thus ensuring you don’t miss anything critical. Again, having a syndication attorney available when drafting your PPM lowers the chances of you experiencing the liability issues discussed above.
What’s the first thing that an investor wants to know about any opportunity presented to them?
Many investors will skip ahead to this section of your private placement memorandum. What you say here can make or break your deal. However, this is not an excuse for you to cover up or otherwise misrepresent the risk involved in the deal you’re offering. Again, doing so would leave you liable under both state and SEC law.
When discussing risk factors, make your statements short, clear, simple, and as easy to understand as possible. Leave no room for interpretation. It may be a good idea to have an independent person read through your risk factors and explain each one to you to ensure your list is as clear as possible.
In terms of what you should discuss here, focus on risks that are specific to the offer you’re making. You don’t need to talk about any general company risks or the general risks that come with being involved in a hedge fund or private equity firm. These are all risks that you can reasonably assume the investor has uncovered in their due diligence. Instead, stay focused on specific risks that affect the deal you’re putting forth.
You can use this section of your PPM to share some of your fund’s past successes. Include financial statements that show how you’ve taken investments and turned them into further profit and returns in the past. Furthermore, be open about any gaps or bad periods. Talk about the mistakes you’ve made and what you’ve learned from them.
The purpose of this section of the PPM is to show your investors that you’re financially savvy enough to deliver on the promises you’re making. A track record of success, coupled with transparency about mistakes, helps investors see that you’re the real deal. Speak to your accountant to access the financial statements necessary for this section.
The Use of the Proceeds
How is your hedge fund or private equity firm going to use the capital it raises?
It’s a pretty important question that your investors are going to expect you to answer in great detail. Provide a complete breakdown that outlines how much capital you expect to raise through the PPM and exactly how you’re going to spend it. Outline everything, from the specific investment opportunities you’re considering to any expenses you will incur in making those investments.
Ideally, the categories you discuss in this section should match those found inside your pro forma documents. In fact, cohesion between your PPM and this set of documents can help to show investors that you’re presenting a legitimate opportunity.
Final Quick Private Placement Memorandum Tips
It’s important to note that the SEC is often quick to warn investors away from any opportunities that feel illegitimate to them.
To ensure your PPM isn’t something an investor feels wary about, ensure you do the following:
- Don’t allow any sloppiness in terms of writing quality or formatting errors. If your PPM doesn’t look professional, an investor may assume that you’ve taken a slapdash approach to preparing it. If you’re so lackadaisical about such an important document, what does that tell an investor about how careful you’ll be with their money?
- Don’t try to draft your PPM alone. While there are some elements, particularly those related to how your hedge fund or private equity firm functions, that are best handled by you, there are other elements of a PPM that need a syndication attorney’s attention.
- While a PPM allows you to avoid some of the regulatory requirements associated with more public securities offerings, that does not mean you face no regulatory requirements. Accuracy is critical in every aspect of a PPM. Misrepresentation and omission carry serious penalties.
Choosing an Exemption – SEC Regulation D
When offering a PPM, you’re eligible for some private placement exemptions under Regulation D.
What is Regulation D?
Regulation D is essentially a set of rules and exemptions that the SEC applies to your offering. It’s the regulation that allows you to see debt or equity securities without having to register those sales with the SEC. Thanks to Regulation D, you can conduct your business faster and with fewer regulatory hurdles. While many people immediately think of the real estate industry as the exclusive lord of the Reg D manor, it actually spans across nearly every industry.
It is important to note that Regulation D does not free you from any regulatory requirement. Even if a Reg D transaction involves two individuals and a small investment, it must still have the proper framework and documentation, such as a PPM.
The other crucial point to make about Regulation D is that this is the regulation that allows you to choose which exemption applies to your private placement memorandum. Rule 506 of Regulation D covers this aspect of your offering. This rule is broken down into two choices: Rule 506(b) and Rule 506(c).
So, it’s Reg D 506(b) vs 506(c).
Which one should you choose?
If you opt for 506(b) syndication, you’re able to accept an unlimited number of accredited investors into your hedge fund or private equity offering. Furthermore, you can accept up to 35 non-accredited investors, though these investors must meet the requirements to be considered “sophisticated”. The “sophisticated” designation denotes that the individual has the financial resources needed to engage in the transaction, along with the experience to contribute valuable experience to the syndicate you’re creating around your company’s opportunity.
Under Rule 506(b), you can rely on self-certification by your accredited investors, meaning you don’t have to go out of your way to verify the investor’s credentials as long as you believe they are who they say they are. However, you do face advertising restrictions. Under Rule 506(b), you cannot directly advertise your opportunity. Moreover, you can only present the offering directly to investors with whom you have a substantial and provable pre-existing relationship.
There is no limit on the amount of capital you can raise under this rule. But the syndicator or securities issuer does need to complete a Form D filing.
Under Rule 506(c), you can also have an unlimited number of accredited investors. However, you are not allowed to invite any other investors to your offering. That means no sophisticated investors, no matter what your prior relationship may be with them.
Under this rule, you also commit to verifying the credentials of every accredited investor who wishes to purchase one of your securities. Verification is an arduous and time-consuming process. As a syndicator or security offeror, you may choose to have a third party carry out the verification process for you. This saves time and ensures you’re not liable if the investor turns out to be unaccredited at a later date.
You may advertise your PPM in any way that you want and you do not need to have any sort of relationship with your investors to sell securities to them. As with Rule 506(b), there is no limit on the amount of capital you can raise or the amount of money you can accept from an individual investor.
Again, you must complete a Form D filing to ensure your PPM is legitimate. You’re also obligated to share all relevant information with your investors, as discussed above.
Draft Your Private Placement Memorandum
As you can see, creating a PPM offers several benefits to your hedge fund or private equity fund. You’re able to raise capital without meeting many of the complex regulations the SEC applies to public capital raising efforts. What’s more, a PPM can serve as a way for you to promote your fund to investors without violating any rules around advertising.
However, you do have to consider the issue of liability. When you issue a PPM, you’re offering securities to private investors. As such, you have a duty to accurately and fully represent the facts about your opportunity to your investors. Failure to do so can lead to fines, fees, and even prison time.
So, how do you ensure your PPM meets all SEC regulations while making your opportunity as attractive as possible to investors?
Work with the professionals.
At Moschetti Law Group, we specialize in creating private placement memorandums that are customized to meet the needs of your fund or firm. We provide the highest degree of protection for your deal, backed by many years of experience in helping others achieve what you’re trying to achieve. What’s more, our advisory services extend far beyond the drafting of your PPM. As your syndication attorney, we can also provide access to investors, help with deal structuring, and ensure you’re receiving qualified leads.
Simply put, we help hedge funds and private equity firms avoid the mistakes that many make when drafting PPMs.
And we’d like to help you too.
To find out more about how Moschetti Law Group can help you to create a private placement memorandum that follows all of the rules and regulations put forth by Regulation D, schedule a free consultation with our team today.
Tilden Moschetti, Esq., is a highly sought-after syndication attorney with nearly two decades of experience. His clientele ranges from real estate developers and startups to established businesses and private equity funds. Tilden’s expertise in syndication law comes not only from his knowledge of syndication and securities law but from real, hands-on experience as an active syndicator himself in every real estate product type and nearly all markets in the US. His knowledge and experience set him apart and established him as the Reg D legal services leader.