Exploring the Pros and Cons of an IMF Business Model:
In this final article of this three-part series, we explain the pros and cons of certain investment advisers utilizing an internally managed private fund (IMF) business model as a means for avoiding increasingly burdensome U.S. Securities and Exchange Commission (SEC) regulation of private fund advisers.
Pros and Cons of Forming an IMF
With an increasingly active SEC that has significantly expanded the scope of its regulation and oversight of private fund advisers in recent years (and provides all indications that it plans to continue this trend into the future), investment groups employing a joint venture fund or club deal (collectively, JV) or single investor fund (SIF)-type structure with the proper alignment of investors’ and managers’ interests, may wish to form an appropriately structured IMF with internal directors, managers, officers and employees (collectively, Internal Managers) who are not subject to Investment Advisers Act of 1940 (Advisers Act) registration requirements and related SEC regulation and examination.
Despite its potential regulatory advantages, an IMF normally entails some limitations and restrictions. For example, an IMF typically cannot manage capital outside of the IMF or provide investment advice to third parties. Its only source of income is attributable to the proceeds of its own investment portfolio. Accordingly, one disadvantage would be its limited investor base and restrictions on its ability to advise outside clients. Also, due to an IMF’s internalized governance structure, increased investor participation and lack of a separate management fee, an IMF’s management team may have less autonomy over the scope of permitted activities, hiring practices, annual budgets, use of outside service providers, etc. than it would in a traditional hedge fund or private equity fund structure. Similarly, IMF investors should be sufficiently sophisticated and comfortable with overseeing the fund’s management activities and/or participating in the investment process, negotiating customized arms-length terms, understanding the regulatory and compliance risks and generally being an active partner in the venture.
As noted in prior articles in this series, given the JV or SIF-type circumstances in which an IMF is typically utilized, other exemptions from SEC investment adviser registration may not be available. For example, the family office exclusion is available only for advisers to single family office clients, and the more limited exempt reporting adviser (ERA) exemption is available only for small private fund advisers (i.e., those with less than $150 million in private fund assets under management and no non-private fund clients) and venture capital fund advisers. Like family office advisers but unlike ERAs, Internal Managers of an IMF who are not investment advisers under the Advisers Act are not subject to the antifraud rules, fiduciary obligations or any other provisions of the Advisers Act and related SEC rules (including certain rules that are applicable to ERAs and other unregistered advisers).
While utilizing an IMF may be advantageous for avoiding burdensome SEC investment adviser regulation in circumstances in which other exemptions may not be available, an IMF should not be utilized to avoid properly addressing relevant conflicts of interest, fiduciary obligations, disclosure and consent issues, cybersecurity risks and other applicable risk management and compliance issues that would otherwise be required to be addressed by a registered investment adviser. Rather, an investment group that is considering forming an IMF should seek to develop an internal legal and operational framework that allows them to achieve their business goals while enacting appropriately tailored risk management and compliance programs suitable for the IMF and its limited and sophisticated investor base, despite the lack of SEC oversight.
Although the inapplicability of the Advisers Act to Internal Managers of an IMF is not incontrovertible, there is a sound basis for concluding that the Advisers Act was not intended to cover the types of properly structured SIF and JV arrangements described in the articles in this three-part series. In view of the current regulatory environment for private fund advisers, for a SIF or JV business model, an IMF may be an attractive business structure option for management teams and investors seeking to minimize regulatory compliance costs and related risks. This is especially true for emerging managers and spinout management teams who may be more willing and sufficiently flexible to embrace an IMF business model than more institutional asset managers already operating through a traditional registered investment adviser business model.
 SEC Rule 202(a)(11)(G)-1.
 See Advisers Act sections 203(l) (venture capital funds) and 203(m) (small private fund advisers), and SEC Rules 203(l)-1 and 203(m)-1. Note that the status of private funds investing in real estate, cryptocurrencies and/or other potential non-securities instruments, which may offer similar exclusions from Advisers Act coverage while involving other types of restrictions or regulation, is beyond the scope of this discussion.