Non-compliance errors made by early-stage fund managers are failures in regulatory adherence, disclosure protocols, or operational processes that place a fund's general partner at legal risk, strain the firm's LP relationships, or invite regulatory enforcement. These mistakes are typically foreseeable; they are most prevalent during the first two years of a fund's existence, and their remediation usually costs more than their prevention. Identifying where new GPs repeatedly stumble is essential if firms hope to avoid falling into the same traps. The regulatory environment for emerging fund managers is far more complex than is commonly assumed for a fund under $150M AUM. State and federal registration thresholds, and exemptions therefrom, vary according to fund structure, AUM, and investor composition. Fund marketing and investor communication requirements underwent significant changes as of the 2023 full implementation of the SEC's 2023 Marketing Rule. Additionally, the private fund adviser rules, which were finalized by the SEC in 2023 and remain subject to ongoing court challenges, created new obligations for disclosure and reporting that must be observed regardless of whether or not a fund manager registers with the SEC.
The six non-compliance errors most likely to do harm to an emerging manager are described below. Mistake 1: Confusing Registration Requirements The most common compliance misconception among emerging fund managers is the belief that they do not need to be registered until the fund reaches $150M AUM. It is not the case, for example, that the Exempt Reporting Adviser exemption would allow you to simply "register with the SEC once your fund reaches $150M AUM". An Exempt Reporting Adviser that is exempt from full registration as an SEC registered adviser is generally one that is registered as a "venture capital fund adviser" or a "private fund adviser" with fewer than 15 investors. Regardless, the ERA still must file the truncated Form ADV as well as observe certain substantive obligations relating to your fund's strategy and your LP base. In addition, there is a second layer of complexity in that state registration requirements, and exemptions therefrom, differ from one state to another.
An advisor that is considered an Exempt Reporting Adviser at the SEC level may still be required to register as an investment adviser at the state level; for example in the state in which the advisor is physically located and/or in which one or more LPs are located. As one example, states such as California, New York and Texas have different investment adviser registration thresholds and exemptions that are not directly tied to the federal registration thresholds. As an indication of recent enforcement action related to registration violations, in 2024 the SEC took action against 28 investment advisers, many being emerging managers, primarily for failing to properly register as investment advisers with the SEC. Other registration enforcement actions involved managers operating as registered investment advisers, when they were actually required to operate as exempt reporting advisers (ERAs) but failed to report as such to the SEC. The penalties ranged from $50,000 to $400,000 and, in some cases, included clawbacks of management fees collected during the period the fund operated in an improperly registered capacity.
One emerging manager, reflecting upon the cost of his firm getting this wrong, stated: "We operated as an ERA for 18 months without filing the required Form ADV. When our LP engaged us for Fund II, my CCO immediately told them. We filed late, incurred a small fine, and explained the situation to Fund II LPs. As a result, two LPs cut down their commitments. The price of getting the filing correct initially would have been pennies compared to what the late filing ended up costing us in LP capital." Mistake 2: Insufficient Disclosure in Investor Materials The SEC's Marketing Rule (Rule 206(4)-1 under the Advisers Act, updated as of November 2022) regulates all investor communications and advertising by investment advisers, including ERAs. The rule prohibits materially misleading omissions, false statements, the communication of gross returns without net returns, and the display of cherry-picked track records. It also places certain requirements on the use of third party ratings, testimonials, and endorsements.
Emerging managers typically breach the Marketing Rule in three main ways. First, the use of gross IRR figures in pitch documents without also disclosing the net IRR. Gross performance, which excludes management fees, carried interest, and fund expenses, can differ meaningfully from the net performance, and the exclusive use of gross performance presents a materially misleading impression to investors. Second, using testimonials from LPs or founders of portfolio companies without the necessary disclaimer stating that the testimonial does not necessarily reflect what other clients may experience, and without disclosing any remuneration paid in respect of the testimonial. And third, presenting cherry-picked returns (focusing on the fund's most successful exits while omitting unrealized positions or realized losses) which is not presented in a manner which fairly represents the overall performance of the fund. The Division of Examinations of the SEC has identified marketing rule compliance as an examination priority area for 2025, specifically targeted at the marketing material of emerging managers.
Funds which have not yet conducted a compliance review of their pitch decks, websites, and LP update letters against the Marketing Rule requirements are carrying unnecessary regulatory risk. Mistake 3: Improper Side Letter Monitoring and MFN Management Side letters are arrangements entered into between the general partner of a fund and certain LPs which alter or otherwise augment the provisions of the limited partnership agreement. They are common in the institutional fund marketplace, and most often address topics such as fee breaks, co-investment opportunities, additional reporting and ERISA representations, and most-favored-nation (MFN) provisions. MFN provisions provide that any LP benefiting from an MFN right must receive the benefit of any more favorable term provided to any other LP with respect to its side letter. Proper administration of MFN rights necessitates the general partner maintaining a complete database of all side letter provisions with respect to all LPs, and providing notice to MFN LPs whenever a side letter is entered into which gives rise to a decision point on the part of the MFN LP.
New managers generally don't realize the administrative headache that MFN administration creates. A fund with 30 LPs and 15 side letters can have dozens of overlapping MFN obligations. If a new LP comes along and receives a side letter giving it a reporting package that supersedes the reporting package available to an existing MFN LP, and the existing LP isn't told about its right to elect the package, the GP will have breached its contract with that LP and, possibly, its fiduciary duty. Administrators who keep track of side letters in a structured way, so that each LP's entitlements can be queried, have a manageable MFN problem to solve. Administrators who have the side letters stored as PDFs in a folder, and who depend on institutional memory to track the MFNs, will consistently run afoul of their contractual obligations as their LP base grows. Mistake 4: Treating the Annual Fund Audit as Optional Many first-time managers view the annual audit as one of those administrative niceties they can postpone until a larger, institutional LP demands one.
That's a bad strategy for two distinct reasons. First, the SEC Custody Rule (Rule 206(4)-2) mandates that registered investment advisers (and some other RAAs) with custody of client assets must annually supply audited financial statements to their investors. A fund that is accepting LP capital has almost certainly assumed custody of those assets. Supplying audited financials to LPs is thus a requirement of regulatory rules, not simply a best practice. Second, LP demand for audits has evolved over the last five years. Family offices and HNWIs who were comfortable with receiving unaudited fund financial statements are increasingly acting more like institutional LPs, and requiring an annual audit as a condition of investment. The first-time fund with no audited financials for Fund I is at a significant disadvantage to those who have them when it is trying to raise Fund II and presenting a track record without the endorsement of an independent auditor.
The cost of an audit in the first year for a $50M-under fund with fewer than 25 LPs and 10 to 15 portfolio companies is typically $15,000-$35,000. That cost is an expense of the fund, and is therefore borne by the LPs, not by the GP personally. The fundraising price of not having audited financials (lost LP commitments, lower credibility with institutional allocators) is often 10x the cost of the audit. Mistake 5: Ignoring the Qualified Purchaser/Accredited Investor Distinction Funds relying on the 3(c)(1) exemption in the Investment Company Act are able to accept up to 100 investors, and those investors need only be accredited investors (AI) as defined by the regulations promulgated by Rule 501(a) of Regulation D. While a 3(c)(7) fund can have an unlimited number of investors, those investors must all be qualified purchasers (a much more demanding standard than “accredited investor,” which requires at least $5 million in investments for individuals and $25 million for institutions).
It is very hard to fix a 3(c)(1)/3(c)(7) mixed fund. If someone who is not a QP invests in a 3(c)(7) fund (even if he or she is an accredited investor), it could be a violation of the Investment Company Act that would require the redemption of that person’s investment in the fund, or restructuring of the fund structure. The requirement that a fund use its best efforts to confirm the status of all of its LPs as accredited investors under Regulation D Rule 506(c) is an additional compliance pitfall. Funds that advertise broadly, including in social media or public conference speaking engagements, may be deemed to have used general solicitation and thus would need to affirmatively verify that their LPs are accredited investors; it is not enough to obtain a subscription confirmation from each LP. Mistake 6: Having a compliance program only after first close. The cost of establishing a compliance program prior to first close is far less than the cost of retrofitting such a program after the fact.
Even a basic compliance program for an emerging manager will consist of a compliance manual addressing the fund's strategy and investors, an annual review of the compliance program, a code of ethics containing personal trading restrictions, an insider trading policy, a review process for marketing materials, and a Chief Compliance Officer (either in-house or outsourced). The cost of outsourced CCO services for a fund with under $100M of AUM is between $8,000 to $20,000 annually. This expense would likely be significantly less than the cost of a single enforcement action or the legal fees of a single LP in a dispute regarding inadequate disclosure. Several fund-of-funds that have allocated to emerging manager funds have advised that they have made a qualified outsourced CCO a prerequisite to an investment, along with financial statements audited by an independent CPA firm and a qualified fund administrator. Q & A: Do funds with less than $25M of assets have to register with the SEC?
Funds with less than $25M of AUM typically would be required to register with their home state as an investment adviser and not with the SEC. However, they would have to file a limited Form ADV with the SEC if they qualify as an exempt reporting adviser under either the venture capital fund exemption or the private fund adviser exemption (i.e. the funds have less than 15 clients and less than $150M of AUM, respectively). Which exemption and registration requirement applies depends on the fund's structure, strategy, and LP base; fund formation counsel will provide guidance on the applicable analysis. What is the most common finding at SEC examinations for emerging managers? Through 2024, we can identify the most common finding based on SEC examination priorities and enforcement actions. For emerging managers, those are inadequate/missing Form ADV filings; marketing materials in violation of the Marketing Rule, such as gross-only performance; custody rule violations due to lack of audited financials; and inadequate books and records.
Another frequent examination finding involves having compliance policies that exist on paper, but are not actually followed. How does the SEC Marketing Rule impact what GPs can say about their track record? Any performance presented to prospective investors must also include the net performance over the same period, consistent time periods must be used when comparing the presented performance to other performance and presented performance cannot include cherry-picked results that don't include comparable investments and time periods. A GP presenting predecessor performance, returns from past investments made at a prior fund or firm, has additional requirements around portability and disclosure. Both pitch decks and LP update letters are subject to the Marketing Rule. What is an outsourced CCO and when should a fund engage one? An outsourced Chief Compliance Officer is an external compliance advisor who serves as the fund's designated compliance officer, but is not a full-time employee of the fund.
An outsourced CCO is appropriate for an emerging manager who cannot support or justify a full-time CCO, yet must designate a CCO under the Advisers Act. An outsourced CCO can review the fund's compliance policies annually, review regulatory filings, oversee marketing materials, and act as a resource to answer compliance-related questions on an on-demand basis. A fund should engage an outsourced CCO in advance of its first close, not after being contacted by the SEC in response to an examination question or filing deficiency. What compliance documents are required before a fund accepts its first commitment? In advance of accepting any LP capital, a fund must have, among other things: LP agreement and subscription documents, reviewed by fund formation counsel, a private placement or offering memorandum with required disclosures, a Form ADV filing (or an exemption from registration confirmation), a compliance manual and code of ethics, an insider trading policy, a conflicts of interest disclosure, and an anti-money laundering policy.
A fund administrator should also be engaged and onboarded before first close so that capital call and investor reporting infrastructure are in place to accommodate a fund's first LP commitment.