Private funds

What is a private fund?

Private funds, also called private investment funds, are a type of pooled investment vehicle (PIV) run by professional fund managers. Examples of private funds include hedge funds, private equity funds, real estate funds, and venture capital funds. Each type of private fund has a distinct investment strategy and risk profile.

Managed investment funds are considered investment companies under the Investment Company Act of 1940, a law that regulates the activities of investment companies in the United States. Unless they qualify for an exemption, investment companies must register with the U.S. Securities and Exchange Commission (SEC). 

Private funds are able to remain exempt from registration as investment companies if they follow the restrictions outlined in either Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act. Qualifying for exemption under one of these sections is what distinguishes a “private” fund from a “public” fund, or registered investment company.

Who can invest in private funds?

The registration exemptions under Section 3(c)(1) and Section 3(c)(7) restrict investment in the fund to either accredited investors or qualified purchasers, depending on the exemption the fund pursues. Investors from the general public, also called retail investors, aren’t allowed to invest in private funds.

Private funds also are limited to a certain number of beneficial owners, depending on whether they seek exemption under Section 3(c)(1) or Section 3(c)(7). 

Advantages and risks of private funds

Regulators restrict investment in private funds because they’re generally regarded as riskier investments than public funds. The higher risks, however, come with unique advantages.

Advantages of private funds

Investors contribute to private funds for several reasons:

• Potential for higher returns: Private funds aspire to beat public market averages, and the top quartile of private funds typically do. 

• Portfolio diversification: Private assets have longer investment horizons that don’t correlate directly to cyclical trends in public equities markets, which means they can be used to create a more balanced investment portfolio. 

• Access to specialized opportunities: Venture capital funds in particular offer opportunities for investors to gain exposure to equity in companies they wouldn’t otherwise know about, let alone be able to access as investors. 

Risks of private funds

Despite the potential for outsized returns, private funds present a number of risks, including:

• Limited liquidity: Private funds typically limit redemption opportunities, which means investors can’t cash out of the fund except in certain circumstances. 

• Longer return timelines: Depending on the fund’s investment strategy, it can sometimes take years before investors begin to receive distributions from the fund. 

• Limited transparency: Private funds often provide quarterly financial reports to investors, but they’re not required to make the same extensive disclosures as public funds.

• Limited regulatory oversight: Although the SEC regulates private funds, they don’t apply the same regulatory controls or scrutiny to private funds as they do for public funds, because it’s assumed that accredited investors and qualified purchasers have the sophistication and financial resilience to support higher risk and lower regulation. 

How are private funds structured?

Private investment funds, including most venture funds, are generally structured as limited partnerships, a legal entity made up of at least one general partner (GP) and at least one limited partner (LP). The GPs and LPs of a limited partnership can be individual people or legal entities. A limited partnership agreement (LPA) spells out the roles and responsibilities of the general partners and limited partners.

→ Learn more about private fund structures

How are private funds managed?

Like other types of PIVs, investment management for private funds is handled by professional fund managers. The legal term for these managers is “fund adviser.”A fund adviser can be an individual or management company. In the private funds industry, most advisers are investment firms, such as a venture capital firm, private equity firm, or hedge fund adviser. 

The fund adviser’s role

Fund advisers formulate the fund’s investment strategy, pitch investors, and close investors into the fund. They’re also responsible for conducting due diligence on potential investments, negotiating and closing those investments, and managing the day-to-day operations of the fund, including financial reporting, tax and audit responsibilities, and investor relations. Fund advisers employ staff and contractors, such as a fund administrator, to help them carry out these tasks. 

The SEC and state securities agencies regulate the activities of fund advisers. Depending on the amount of assets and types of funds they manage, a fund adviser may either be an exempt reporting adviser (ERA) or a registered investment adviser (RIA). 

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Private fund regulations

Private funds are regulated by the SEC and by state securities agencies. Regulations control how the fund raises money and how private fund advisers interact with investors. The SEC and state securities agencies also have authority over all investment advisers, including all private equity and venture capital fund advisers. 

Understanding private fund laws and regulations is crucial to maintaining compliance, building investor confidence, and avoiding potential regulatory enforcement actions (and related penalties) that could cause your firm reputational or financial harm.

Types of investment strategies within private equity

Private equity is an alternative asset class that encompasses a few distinct varieties of private funds. In general, PE investment advisers raise funds from institutional investors and then use that capital to purchase equity in private companies with the hope of selling the equity or the whole company at a profit years later. There are five main private equity investment categories: VC, fund of funds, leveraged buyouts (LBO), growth equity, and secondaries.

Venture capital

A VC fund pools money to invest in high-growth private companies (commonly called startups). VC funds can be generalist, or can pursue a venture capital investment strategy based on industry, stage, geography, or another type of specialty . The fund eventually liquidates its positions in these high-growth companies and distributes the returns to investors. Although many startups fail, the high-risk, high-reward nature of VC investments means that a few successful investments can yield a multiple return on the fund’s total invested capital—even if a majority of the investments yield a loss.

Fund of funds (FoF)

A fund of funds (FoF) uses its capital to purchase stakes in other private funds. A FoF earns a return for its investors by receiving a slice of the profits generated by each of the funds in which it invests. Compared to a direct venture capital fund, a VC fund of funds usually indirectly owns much smaller stakes in a much longer list of companies.

Leveraged buyout (LBO)

Leveraged buyouts have historically been the most common private equity investment strategy. In an LBO, the PE firm acquires a majority stake in the company, using cash and a large amount of debt that goes onto the company’s balance sheet. The portfolio company is then responsible for paying back that debt with cash generated through operational improvements resulting from the PE firm’s majority ownership and influence over the company’s management. 

Growth equity

PE firms that specialize in growth equity investments do not necessarily acquire a majority stake in the company. Instead, they purchase minority stakes in mature private companies that are growing revenue but are perhaps not yet profitable. Growth equity and late-stage venture capital (VC) are often used interchangeably, but they have several key differences. Growth equity and VC deals differ by investment sizes, revenue goals, target industries, and investment geographies.

Secondaries

Secondary investments come in many forms, but their basic purpose is to purchase a stake in a private company from another private investor. Secondary sales provide liquidity for the selling investor and earlier returns for the investor’s limited partners (LPs). They also offer opportunities for investors to purchase stakes in portfolio companies that are theoretically closer to realizing an exit. 

Hedge funds

Hedge funds are a type of private fund with an investment strategy distinct from the LBO and VC strategies that characterize PE and VC funds, respectively. Hedge funds pursue a variety of high-risk strategies that together “hedge” against the failure of individual high-risk bets.

Depending on a hedge fund’s strategy, it might trade wide variety of assets, including: 

• Public securities, such as stocks and bonds

• Private equities (such as stakes in private companies)

• Private credit

• Financial instruments like options, futures, and other derivatives

• Foreign currencies

• Cryptoassets 

• So-called “SWAG” assets: silver, wine, art, and gold

Hedge funds often use aggressive trading methods, including leveraged trades, market arbitrage, and trading based on quantitative analysis. 

Carta for private funds

Carta offers fund administration services for venture capital and private equity funds. To learn more, book a call with a member of our team: