What is a Private Investment Fund?

A private investment fund is an investment company that does not solicit capital from retail investors or the general public. Members of a private investment company typically have deep knowledge of the industry as well as investments elsewhere. To be classified as a private fund, a fund must meet one of the exemptions outlined in the Investment Company Act of 1940. The 3C1 or 3C7 exemptions within the Act are frequently used to establish a fund as a private investment fund. There is an advantage to maintaining private investment fund status, as the regulatory and legal requirements are much lower than what is required for funds that are traded publicly.

Key Takeaways

  • Private investment funds are those which do not solicit public investment.
  • Private funds are classified as such according to exemptions found in the Investment Company Act of 1940.
  • Hedge funds and private equity funds are two of the most common types of private investment funds.

Understanding a Private Investment Fund

Private funds are expected to meet certain criteria to keep their status. Generally, the requirements limit both the number and type of investors that can own shares in the fund. In the U.S., under the aforementioned Investment Company Act of 1940, a 3C1 fund can have up to 100 accredited investors, and a 3C7 fund can have a soft limit of around 2,000 qualified investors. Both the definition of qualified and accredited investor come with individual wealth tests. Accredited investors need to have more than $1 million in net worth without counting their primary residence and/or $200,000 in annual income for an individual and $300,000 for a couple. Qualified investors have to hold assets in excess of $5 million.

Why Funds Stay Private

A private investment fund may choose to stay private for a number of reasons. As mentioned, the regulations around private investment funds are much looser than for public funds. Private investment funds enjoy more freedom in how they handle everything from reporting to redemptions. This allows private investment funds to look at illiquid investments that a public fund would shun due to the difficulties of regular valuation and liquidation in the case of rising redemptions. Many hedge funds are private investment funds so they can continue to use aggressive trading strategies that the manager of a public fund would avoid due to the potential for investor lawsuits resulting from unreasonable risk-taking. Most importantly, there is no public reporting of positions for private investment funds, which allows them to avoid tipping their hand to the market and eroding the profitability of a stealthily built position.

In addition to investment flexibility, private investment funds can be vehicles of choice for handling significant family wealth. Extremely wealthy families can create private investment funds to invest the wealth with the family members as shareholders. Often a company serves as the initial structure for this arrangement, and it is repurposed to create a capital investment arm from the profits of the business. In this case, the family doesn't want or need outside capital, so there is no incentive to take the fund public.