Private Placements for Total Strangers

JOBS Act should eliminate the need for a “pre-existing substantive relationship”

Tucked into the ban on general solicitations in U.S. private placements is the “pre-existing substantive relationship” requirement (PSR). For decades, the PSR has served as an unavoidable speed bump in the marketing of hedge funds and other private investment vehicles. It is now almost certain to disappear after the JOBS Act is signed into law by President Obama in the next few days.

The PSR requires marketers of unregistered funds – both fund managers and third-party placement agents — to know their prospective investors personally before offering them interests in their funds. The rule was adopted by the SEC as a way of enforcing the ban on general solicitations in private offerings by precluding the use of impersonal marketing techniques such as cold-calling, public seminars and advertising.

What the SEC had in mind by the “substantive” element of PSR is requiring marketers of private investment funds to make certain that their offerees had the financial sophistication to appreciate the risks of their fund investments. The “preexisting” element requires fund managers and marketers (1) to have established personal or business relationships with their offerees prior to the initiation of their fund offerings and (2) to make no offers to would-be investors until at least 30 days after those personal or business relationships have been formed.

The PSR has always been treated mechanically by the hedge fund industry. Fund managers typically comply with the rule by having prospective investors complete detailed questionnaires regarding their financial situations and investment experience and represent that they are either accredited investors (for 3(c)(1) funds) or qualified purchasers (for 3(c)(7) funds). The funds then wait at least 30 days before sending offerees their private placement memoranda (PPMs) and soliciting investments. It is not uncommon, however, for the questionnaire and 30-day “cooling-off period” to constitute all there is to a “pre-existing substantive relationship”.

Since the PSR requires that offers can only be made prior to a fund’s launch, hedge funds – which are marketed on a continual basis — have never been able to comply completely with the rule. Venture capital and private equity funds, on the other hand, which commonly raise their capital on a close-ended basis have not therefore been faced with the same dilemma.

As soon as the JOBS Act is passed, the SEC will have ninety days to issue revised rules governing the implementation of the newly-unfettered private placement regime. Since the Act’s elimination of the ban on general solicitations is applicable only to private offerings aimed exclusively at accredited investors, private funds will still have to administer financial questionnaires to investors responding to their tweets, e-mails or ads, but it would clearly defeat the capital-raising purpose of the JOBS Act to require otherwise suitable investors who happen to have no previous relationships with funds to wait as long as thirty days for their PPMs.

In just a few months, then, private fund managers should be able to say good-bye to the PSR and open their funds for the first time to total strangers.