Fundraising: The JOBS Act and general solicitation

Do you see that space? The one just to side of this article, currently occupied by an advertisement extolling the qualities of a service provider who for now shall remain nameless. Well, for the right price it's yours, fund manager. No longer held back by non-solicitation rules that prevent you from telling the world all about the dream team behind your latest fund, turn a page of AVCJ into your pulpit.

Tantalizing as the prospect may sound - now made theoretically possible by provisions in the US Jumpstart Our Business Startups (JOBS) Act - few managers are expected to capitalize on the opportunity.

"It doesn't really impact our clients in terms of offerings in the US because they can still use the traditional private offering exemption," says Xuan Zhang, Beijing-based counsel at O'Melveny & Myers. "For Asian fund managers that only plan on doing limited marketing in the US, general solicitation doesn't make sense."

Managers and advisors also list a string of obstacles - not exclusive to Asian managers - in taking advantage of the legislation, ranging from uncertainty about the compatibility of the new system with regulations in the US and other jurisdictions to wariness of the additional investor due diligence requirements. Above all, no one wants to put their reputation on the line and become the first adopter.

"Established firms can't take the risk because it is unproven. We are all holding back and watching how it develops," a regional buyout fund manager tells AVCJ. "No one wants to be the first guy in there and then get charged for something. You just keep your mouth shut until fundraising is over."

The mother lode?

The JOBS Act, which was signed into law in April, is the product of a bipartisan effort in the US to ease the regulatory burdens on smaller companies and facilitate capital formation.

From a private equity fundraising perspective, the key measure is an amendment to Rule 506 of Regulation D under the Securities Act: the removal of the prohibition on general solicitation and general advertising in certain private placements. However, participants in these offerings must still be accredited investors under the Securities and Exchange Commission (SEC) definition, and a greater burden is placed on the issuer to verify that these investors are indeed accredited.

The potential impact is significant - a manager could employ a full-scale marketing campaign in order to reach out to new investors. Restricted access websites already widely used in the industry under traditional private placement channels could be thrown open to the public; private equity executives would be free to talk to the media about their fundraising plans.

"There is a big business opportunity in terms of tapping capital that otherwise hasn't been available," says Brian McDaniel, a partner at Goodwin Proctor.

"Even though investors must be accredited, they previously might not have been sufficiently plugged into the community to participate. And the standard for permitted investors is actually quite low - it covers the comfortably well off, not just the rich. I could easily see the likes of doctors, lawyers and people who have been real estate investors participating."

As the regulations apply to individuals, an accredited investor has an annual income of at least $200,000, going back two years, or a joint income of at $300,000. Those with a net worth in excess of $1 million, excluding the value of their primary residence, also qualify.
Aside from the regulations being largely untested, concerns fall into two broad categories: how a private equity firm approaches potential investors and how it verifies the credentials of those who want to participate.

First, in terms of US domestic legislation, private equity firms that may launch general solicitation initiatives are ultimately financial entities are subject to other laws. These laws were designed to accommodate the traditional non-solicitation private placement model and have yet to be updated.

"It's not clear that the rest of the regulatory framework wants to catch up with the SEC on this," one industry participant notes.

For private equity firms targeting global investors, there is the added complication of foreign regulatory regimes that in many cases still outlaw general solicitation. Trying to restrict direct marketing and publicity efforts to the US may prove futile: dedicated fund websites might include mechanisms that ask users to confirm their region of origin and then shut out non-US investors, but it is a difficult line to draw and media exposure cannot be controlled at all.

"The SEC also mentioned that you can still do parallel offerings under Regulation S to non-US investors and rely on Regulation D exemptions for offerings in the US," says O'Melveny & Myers' Zhang. "There is potential here, but you would have to be careful as to what forms of general solicitation you use."

Regulation S, which falls under Section 5 of the Securities Act, covers offerings made by US and foreign issuers outside the US. Provided no direct selling efforts take place on US soil, there is no need for SEC registration.

Second, although the definition of an accredited investor remains unchanged, the steps a private equity firm must take to verify their credentials are more demanding than under the traditional private placement model. Whereas previously investors had a pre-existing relationship with the manager, under general solicitation this is no longer necessarily the case so proactive due diligence is required.

Goodwin Proctor's McDaniel explains the logic of the requirement by contrasting dealing with an unknown quantity to dealing with an institutional investor such as the California Public Employees' Retirement System (CalPERS).

"When we ask CalPERS to invest in a fund and it sends back the questionnaire saying it has more than $2 million in investment assets, we don't think twice about it. If you are talking about your partner, brother or an investment banker you've worked with for 10 years, there is also a degree of comfort," he explains.

"But when you are contacted by someone you have never met - who reached out via your website saying they are an accredited investor - is relying on them to fill out the questionnaire enough?"

Should non-accredited investors slip through the net, a fund manager might be deemed to have done a bad private offering, which means LPs have the right to ask for their money back and walk away.

Verification issues

Verifying accredited status may involve inspecting tax returns and other financial records. There has even been talk of a cottage industry developing of third-parties providing these services. Much like a bank can obtain a credit report on an individual before agreeing to extend a loan, a fund manager might order a verification report on a potential investor.

In this context, the lines between a placement agent and a facilitator may become blurred.

However, there is a degree of uncertainty as to what happens to verification materials once they have been processed. While the burden of establishing proof lies with fund manager, several industry participants have seen the SEC's proposed additional changes in the final rules, which include a requirement that PE firms submit relevant documentation to the regulator.

They say it is unclear whether this would just be a paper filing or could potential be used as the basis for a substantive review.

Ian O'Donnell, a partner in Cooley's venture capital practice group, based in San Francisco, notes that a number of his clients have studied the requirements for verifying accredited status and found them unappealing and intrusive. They don't want to jeopardize existing LP relationships - forged under the traditional private placement model of non-solicitation - by being pushy on documentation.

As such, he expects little change in the fundraising status quo. Cooley represents about 250 fund organizations - most of them in the US - and at any given time 50-60 are actively in the market. None have elected to take advantage of general solicitation as it stands.

"Some firms are going to continue to operate as clubs essentially, where they have a group of investors that they continually go to and really have no reason to publicize their offerings," O'Donnell adds.

"Other firms may well want to talk about their fundraising in the press, but these regulations that require more stringent analysis of accredited status may dissuade them from doing it. They may well look at the rules and conclude that it's not really worth it."

Picking up on the point about well-established firms operating as investor clubs, another disincentive to opt for the general solicitation route is simply ego. Managers want the wider world to perceive their funds as heavily oversubscribed, with existing LPs re-upping at larger amounts and prospective investors clamoring for a slice of the remainder. Indeed, some actively cultivate such perceptions.

In this context, direct solicitation - you going to investors rather than investors coming to you - could be seen as a sign of weakness.

"I would think that the big guys aren't going to do it any time soon," says Joseph Sevack, a Hong Kong-based partner with Troutman Sanders. "They may feel like if they go out there and start advertising people will start thinking they are having trouble raising money. There is a bit of mystery about the business and they probably like that."

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