Legal Status of an IMF:
In this second article, in a series of three, we define what an IMF is and explain its status under the Investment Advisers Act of 1940 (Adviser Act).
What Is an Internally Managed Private Fund?
An IMF is generally understood to refer to a private non-U.S. Securities and Exchange Commission (SEC) registered investment fund that pursues a typical hedge, venture, real estate, private equity or other common private fund investment strategy, but rather than being managed by a separate investment manager or general partner entity, it is managed internally by a board of directors, if established as a corporation, or (more commonly) by a board of managers if established as a limited liability company. In our experience, an IMF is often best suited for a joint venture fund or club deal (collectively, JV) or a single investor fund (SIF) type scenario in which one or a limited number of sophisticated institutional or family office investors engages a U.S.-based management team to manage investor assets through an IMF that is internally governed and reflects highly negotiated terms, including capital contribution requirements, permitted withdrawals of capital, investor consent to major decisions, distribution waterfalls and carry participation rights for the management team, investor reporting, liquidation events and other fund-like terms. Rather than paying a separate asset-based management fee, however, an IMF typically entails an agreed-upon salary for management team members and an approved budget to cover annual operating expenses. Many aspects of an IMF are, therefore, similar to a traditional private fund JV or SIF arrangement that is managed by a separate general partner or investment manager entity.
Though investors in an IMF typically have more governance and information rights than investors in a traditional private fund structure, the IMF management team can typically negotiate its majority or minority representation rights on the board and/or investment committee as well as its compensation, D&O insurance coverage and the other bespoke fund-like terms described above. For regulatory reasons, the management team typically would not invest its own capital alongside the investors in an IMF.
An IMF structure is often used by corporate venture arms of public and private operating companies seeking to make strategic technology investments utilizing the parent company’s capital and other resources, which investments are managed either by the parent’s own employees or by an outside management team. In such circumstances, the parent company typically retains voting control and input into investment operations while entering into negotiated compensation arrangements with the internal or external management team.
Advisers Act Analysis
Under the Advisers Act, an “investment adviser” is generally defined as a person who “engages in the business of advising others” regarding securities. The Advisers Act is silent on the treatment of internal directors, managers, officers and employees (collectively, Internal Managers) of investment companies such as an IMF. Commentators have pointed out that the SEC and the industry have long understood that Internal Managers of investment companies are not advisers under the Advisers Act. This is mainly due to both the history of the Advisers Act and the fact that Internal Managers typically do not bear the business risk of the enterprise, generally act as a group rather than as individuals, are subject to the oversight of their superiors (in the case of officers and employees) and are subject to state law fiduciary duties (in the case of directors). As outlined in more detail below, other relevant factors include the exclusivity of the services, the lack of investment of personal capital, the non-existence of any marketing or solicitation activities (or holding oneself out to the public as providing advisory services) and the sophistication of IMF investors. Overall, the Advisers Act was intended to cover persons who advise clients as part of conducting a separate investment advisory business and was not intended to cover internal corporate relationships.
In the case of an IMF structured as a SIF, there is additional support for the exclusion of Internal Managers from investment adviser status based on the analogous precedent of a wholly owned corporate subsidiary exclusively advising the parent company and/or other wholly owned direct or indirect subsidiaries of the parent. In such circumstances, the SEC has confirmed the lack of investment adviser status for the wholly owned adviser subsidiary and its management personnel. These precedents are substantively similar to a SIF structured as an IMF employing Internal Managers to manage its own assets (i.e., the assets invested by the single investor and controlling equity owner) rather than employing a separate wholly owned advisory subsidiary for such purpose.
Relevant Considerations for an Exempt IMF
In view of the foregoing, a U.S. management team seeking to partner with one or a limited number of sophisticated institutional or family office investors to form an IMF should consider the following factors, among others, in structuring its business and negotiating the venture’s governing documents in order to assess whether the Internal Managers of the IMF are subject to Advisers Act registration:
- The ability and willingness of the Internal Managers to provide advisory services exclusively to the IMF and not to any outside persons and otherwise forgo conducting any advisory business apart from the IMF.
- Whether the Internal Managers conduct any marketing or solicitation activities or otherwise hold themselves out to the public as providing advisory services.
- The willingness of Internal Managers not to invest their own capital in the IMF and otherwise not to assume any downside business risk.
- The ability to limit investment discretion to the board or investment committee acting as a group and not to any individual director or committee member.
- Whether the board, the investment committee or both will exercise investment discretion.
- The sophistication of IMF investors and their willingness to play an active role in the venture, including negotiating terms and having board representation, an oversight role and consent rights.
- Which investor or group of investors are the ultimate beneficial owners and funders of the IMF for regulatory purposes?
- The appropriate compensation structure for the Internal Managers.
- Whether the IMF is a collaboration between the Internal Managers and investors or involves a more passive relationship.
- Whether the Internal Managers provide periodic reports or advice on whether IMF investors should redeem their interests.
- Whether the IMF investors need the protections of the Advisers Act and SEC regulation.
In the next and final article in this three-part series, we explain the pros and cons of forming an IMF and how an IMF structure may be an attractive option for those investment management groups seeking to avoid Advisers Act registration and related SEC regulation and examination but whose business model may not fit within any of the traditional Advisers Act registration exemptions.
 The use of corporate blockers and other tax considerations would apply in structuring an IMF to the same extent as in traditional private fund structuring.
 This discussion only addresses federal investment adviser status and not state law investment adviser status, although many states adhere to the Federal Advisers Act definition of “investment adviser.”
 Regulation of Money Managers: Mutual Funds and Advisers – Frankel and Laby (3rd Edition, 2022-2 Supp.).
 See note 13. Note that a general partner of a limited partnership, however, is not treated as an Internal Manager, and the SEC and the courts would normally consider a general partner to be an investment adviser to the limited partnership or its limited partners under the Advisers Act. See Abrahamson v. Fleschner, 568 F.2d 862, 869-71 (2d Cir. 1977), cert. denied, 436 U.S. 905, 913 (1978); and SEC Rule 203(b)(3)-1 under the Advisers Act.
 See MEAG MUNICH ERGO Asset Management GmbH, SEC Staff No-Action Letter (Feb. 14, 2014) (MEAG); and Zenkyoren Asset Management of America Inc., SEC Staff No-Action Letter (June 30, 2011) (ZAMA). Note that in MEAG and ZAMA, the SEC did not see any need to look through the wholly owned advisory subsidiary to its Internal Managers and treated the parent investor (and not its underlying insureds) as the ultimate beneficial owner of the managed assets for the Advisers Act purposes. See also SEC Staff Report on Regulation of Investment Advisers (March 2013) at p. 4.
 To the extent that an Internal Manager does not exercise investment discretion, there may be an argument that such a person does not have “regulatory assets under management” sufficient to trigger an ERA filing or full investment adviser registration (assuming such a person is otherwise considered to be an adviser under the Advisers Act). See Form ADV Instructions, item 5(b)(3).