Regulating Frontier Market Funds as Value Creating Enterprises

Imaduddin Ahmed

I.      Introduction

Do the current U.S. laws regulating the fund-raising activities of private equity funds raising capital for portfolio companies adequately balance the interests of sophisticated investors seeking higher returns, foreign private equity funds and firms in least developing countries requiring growth capital with the interests of lay investors? This is the question that I will attempt to answer in the forthcoming paper.

It is a question that came to the fore when sent a response by a colleague on a networkers’ email listserv. I, a graduate student, had invited colleagues via email to attend a speaker event that I was organising on my campus; the principal of TLG Capital was to present how his private equity fund delivered both high social as well as financial value in frontier markets. My email, however, was interpreted by my colleague as a fund-raising solicitation.

To tackle the question, I will begin by laying out the interests at stake, which of those the U.S. government concerns itself with and which of those interests clash with one another. I will then examine how the U.S. government has attempted to balance those interests in terms of the regulations in place. I will examine registration requirements, exemptions and modifications made by the Dodd-Frank Act subsequent to the 2008 financial crisis. Having lain out the policy objectives and described the policy in place, I will then assess whether the government’s laws meet its objectives, and, if not, make recommendations for how it could better achieve those objectives.


II.      Key interests at stake

When it comes to regulating to ensure consumer protection, the government usually has to balance the interests of the lay consumer with those of the U.S. economy, at least theoretically. (The interests of corporations without regard to the benefits bestowed overall on the U.S. economy also get weighed.*[1])  So it is with the protection of lay investors from fraud, inadequate disclosure and manipulation of stock prices[2]: the government has to consider the potentially clashing interests of the U.S. economy in both the short-term, and the long-term, as well as the freedom of informed U.S. investors to make their own choices. Arguably, the U.S. government should also take into account the impact that its regulations could have on the development of lesser developed countries, without regard to its own enlightened self-interest.

Certainly, when it comes to the welfare of people of lesser developed nations, the U.S. has sacrificed short-term benefits to its own economy, and the benefits of doing so are not always couched in terms of self-interest, as is demonstrated by President George W Bush’s State of the Union address on January 29th, 2003 relating to the introduction of the President’s Emergency Plan for Aids Relief (Pepfar), which was to save more than a million people with HIV in Africa[3] at the expense of $15 billion to the U.S. economy:

“As our nation moves troops and builds alliances to make our world safer, we must also remember our calling, as a blessed country, is to make the world better [ . . . ] I ask the Congress to commit $15 billion over the next five years, to turn the tide against AIDS in the most afflicted nations of Africa and the Caribbean.”[4]

Besides humanitarian considerations, the U.S. government has its long-term interests to think of. A weak sub-Saharan Africa (SSA) represents cause for concern in terms of security, as well as lost opportunities for American businesses. The post-World War II rebuilding of Japan and Europe with the Marshall Plan has gained U.S. corporations access to deep markets and gained the U.S. economy invaluable trading partnerships that continue today. Facilitating, therefore, investment into SSA that will help improve the growth and liquidity of companies in the region, which will in turn address consumer demand for solutions to healthcare problems, as well as unemployment, is a desirable policy goal for the U.S. government. Indeed, it is congruent with the objectives of the Generalised System of Preference and the Africa Growth and Opportunity Act that the U.S. has acted upon.

More direct long-term interests to be thought of are maintaining the U.S.A.’s status as home of the world’s leading capital markets, which requires openness to foreign issuers. Too, hindering sophisticated investors from taking a  different set of risks restricts not only their individual freedom – anathema to the spirit of America*[5] – but hinders them from not diversifying the risk of their portfolios, and hinders them from achieving superior returns that could be circulated within the U.S. economy.

At the same time, the U.S. government has a duty to protect its citizens from becoming victims of crime, such as fraud, and will want to ensure that its markets run efficiently, with low transaction costs. To use the language of the International Organization of Securities Commissioners (IOSCO), the U.S. government will want to protect investors from ‘misleading, manipulative or fraudulent practices’ and ensure that markets are ‘fair, efficient and transparent’.[6]

III.      Protecting investors and capital formation

To this end, Congress passed the Securities Act of 1933 and the Investment Company Act of 1940; access to the U.S.A.’s public financial markets would be conditioned upon disclosure. Further, Congress passed the Securities Exchange Act of 1934, creating an agency whose raison d’etre would be to protect investors, as well as capital formation.[7] Such a siloing of purpose means, as will be seen, that not all matters of interest to the U.S. government are given due consideration.

Of issuers, the International Organisation of Securities Commissions recommends the ‘full, accurate and timely disclosure of financial results and other information which is material to investors’ decisions’.[8] This philosophy the S.E.C. abides by for securities that are publicly traded. The types of disclosures the S.E.C. requires include forms S-1, S-3, F-1 (for foreign issuers, Form 20-F, Form 6-K),  descriptions of the business and its properties, descriptions of risks, legal proceedings or environmental problems that the firm faces, a description of the compensation of the top management, a description of the securities and the capital structure, a disclosure of shareholders with greater than 5% ownership in the company, a description of the plan of distribution and arrangements made with underwriters, a description of the plan of the use of proceeds, a management discussion of the firm’s financial situation and any changes in the financial condition since the previous year, disclosure of any other material information, audited balance sheets for 2 years, audited income statements for 3 years, an audit report and cash flows.[9] The firm’s auditors are required to be independent and the firm’s accounts must reconcile with USGAAP, unless the issuer is foreign, in which case IFRS is now acceptable.*[10]

Liability for faulty misstatements or omissions of material facts in the prospectus is strict, and according to Section 11, there is no defense for this. Underwriters and directors also have strict liability, but have recourse to a due diligence defense.[11]

For securities that are intended for investors more sophisticated than the general public, however, the S.E.C. does away with the registration and disclosure requirements. These securities ‘lack the same degree of transparency required of publicly offered issuers, on the theory that these investors can “fend for themselves,”’ explains Andrew Donohue, Director of the S.E.C. Division of Investment Management.[12]

Driven by the reluctance of foreign issuers to enter the U.S. market with such stringent registration requirements, the S.E.C. adopted Rule 144A in 1990.[13] Within a year, foreign firms were responsible for one-third of the $16.7B in issuance of Rule 144A stock [ . . . ], as compared with 16% and 7% of offerings made in private and pubic bond markets respectively.[14] In 2007, nearly 80% of capital raised by foreign firms in the U.S. was done through the 144A market. [15]

Rule 144A applies to issuers of private offerings to Qualified Institutional Buyers (QIBs), exempt from registration under section 4(2) of the Securities Act of 1933. The securities must not be fungible with securities trading in public markets and a two year holding period is generally required. Alternatively, the offering can be made under Rule 144, where there is a six-month holding period for reporting companies and one year for non-reporting companies.[16]

Qualified Institutional Buyers must own and invest a minimum of $100 million in securities or must be owned by firms or individuals all of whom qualify as QIBs. If the firm is a bank or a thrift, it must have a net worth of $25 million. A QIB can only make purchases for itself or for another QIB.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 further decreases the participation of QIBs in private equity funds, to 3% of Tier 1 Capital through the second Volcker Rule.[17]

Disclosure under Rule 144A is minimal – only required at the purchaser’s request, and, according to Hal Scott, ‘some minimal financial information’, which can be waived if the foreign issuer files home country reports under Rule 12g3-2(b). Failure to disclose or misstatements are only subject to private actions under Rule 10b-5 liability.

Under this exemption, unsolicited transactions – including, according to Rule 15a-6(a)(1), placing telephone calls, advertising through broadcast media or publications in general circulation in the U.S. or conducting seminars for U.S. investors – are prohibited.

In May 2006, the highly leveraged buyout private equity fund Kohlberg Kravis Roberts (KKR) sold its offering to U.S. institutional investors through the Rule 144A market. Writes Scott[18], ‘it appears they did not list in the U.S. due to concerns as to whether the offering would be regarded as an investment company under the 1940 Investment Company Act, with the effect that significant restrictions, eg as to leverage and fees, would be imposed on their operations, and result in the need for greater disclosure about the fortunes of the private companies in which they invest.’

Another avenue that private equity funds can take in order to raise funds without registering is through individuals,  by using the private fund exemption under Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act of 1940, together with the section 4(2) exemption of the Securities Act of 1933.[19] The former limits the number of investors to 100, while the latter permits only “qualified investors”[20] who also meet the “accredited investor” test of Regulation D[21] – individuals or family partnerships with at least $5 million in investable assets and companies with at least $25 million. – to invest.[22] For exemption, Rule 506 of Regulation D prohibits the offering or selling its securities using “general solicitation or general advertising.”[23] Such solicitation is defined in Rule 502(c) and include print advertising, media broadcasts, an invitation to a seminar or meeting by such methods as constituting general solicitation or advertising.[24] Emails soliciting capital must be targeted at only accredited or otherwise sophisticated investors.[25]

Rule 506 does allow for the sale to up to 35 non-accredited investors who are financially sophisticated, ie possess  “such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment.”[26] To remain exempt, funds must take steps to prevent their securities from being resold by the purchaser without registration or qualification for another exemption, by, for example, inquiring as to whether the purchaser is an underwriter with the intent to resell and making clear in writing to investors of their inability to resell without registering under the Securities Act.[27]

Either way, private equity managers meet the definition of “investment adviser” under the Advisers Act of 1940, since they ‘engage in the business of advising others’ for compensation as to the advisability of investing in securities, and do not fall into one of the exempted professions.

However, section 203(b) of the Investment Advisers Act of 1940, as amended by section 403 of the Private Fund Investment Advisers Registration Act of 2010,  exempts from registration ‘any investment adviser that is a foreign private adviser’, which is convenient for a London-based growth equity fund. Before the amendment, a manager at TLG Capital may have found exemption in the clause that this new clause supplants, had the manager not had more than 15 clients.

Funds engaging in private placements pursuant to section 4(2) and Regulation D are subject to liability under the Securities Act, the Securities Exchange Act and the Advisers Act, and can be sued by the S.E.C. not only for fraudulent and misleading statements and omissions, but for negligence.[28]

We will not concern ourselves with Regulation S since ownership in funds is seldom traded and we are concerned with the direct selling of securities in the U.S.A.

IV.      Critique

Fund-raising through Rule 144A and through Regulation D exemptions will face different advantages and disadvantages. Both methods stymie solicitation, though emails by students advertising funds visiting their universities would not likely have contravened these limitations because a) they are not solicitations for capital raising[29] and b) students are not compensated for sending out emails advertising events they themselves organise.[30]

A specified required holding period of up to two years, as stipulated for funds raising through Rule 144A, should not harm growth equity funds, which often require lock-in periods of 5+2 years.[31] Many funds will, in any case, count IRR from the time of divestment, as opposed to the time that the investor receives his money back.[32]

The S.E.C. will sue for misstatement, fraud and omissions, intended or otherwise, for funds raising capital through Regulation D, and understandably so, given that the targets are individuals rather than Qualified Institutional Buyers, which possess, in the words of Scott, ‘the most sophisticated knowledge of the securities market’.[33] Without the resources of an institution to carry out the requisite due diligence, individuals rely on the information provided to them. The disadvantage with raising capital only through Rule 144A, however, is that smaller frontier market funds (such as TLG Capital, which in 2009 only had $25 million under management[34]) will be less likely to target individuals, who may be more appropriate investors at the earlier stages of fund growth.

That Volcker’s rules reduce the participation of QIBs in growth equity funds, despite the fact that they are not highly levered and their investments in commercial companies do not pose the systemic risk that Volcker’s rules try to protect the economy from (unless they were financial institutions, in which case they would be regulated for that part of their business like other financial services holding companies[35]), makes little sense. It also makes little sense that the number of QIBs should be limited to 500 without triggering regulation under the Securities Exchange Act of 1934 and Sarbanes Oxley.

The restriction on investors by number or by wealth through Regulation D is, however, a nonsense. In the case of hedge funds, the S.E.C. worries that qualified investors “may find it difficult to appreciate [ . . . ] complicated investment strategies.”[36] While this can be said of hedge funds, it cannot be said of growth equity funds, whose most complex transactions are call options. And if this were so, why allow up to 100 investors (where there is a lower investment test presumably because of the limit on investors[37]), or up to an arbitrary 35 non-accredited ‘financially sophisticated’ investors, in the case of section 3(c)(7) Act of 1940, get fleeced? Another fault with the limit on beneficial ownership is that, according to Scott[38], many foreign investment companies will either refuse to offer their shares in the U.S. or make it very difficult for U.S. investors to buy shares in their funds, out of fear that one additional shareholder beyond 100 would cause them to no longer be exempt from the 1940 Act.

Moreover, the limit on investors, or on financially sophisticated investors who do not possess $5 million in investments, but do possess business sense and financial literacy, denies thousands of bankers, strategy consultants, chartered accountants, corporate lawyers, financial journalists, finance and business law academics, credit rating analysts and students of finance potentially superior financial returns. It denies sophisticated investors the opportunity to decide for themselves what their risk-reward trade-off should be. In the case of funds which also achieve social returns, the limit also denies the many sophisticated investors from supporting initiatives that help develop under-financed economies in a dignified and accountable way and would, perhaps, suit their ideologies better than do most charities. Charities, which often do not support people in a dignified and accountable way, do not require have sophisticated investor[39]  requirements.[40] Why then limit the number of sophisticated investors who can hold accountable the funds purporting to do this?

These are questions that perhaps the S.E.C may forget it can answer. Though it is an agency with siloed responsibilities, it has a duty to maintain fair markets[41] and facilitate capital formation[42]. It is hardly fair to prevent those with less than $5 million in investments from becoming rich, and it does not facilitate capital formation to stand in the way of funds accumulating capital in order to create company growth and profit growth, which would be repatriated to U.S. investors. Going forward, the S.E.C. should remove arbitrary restrictions on the limit on sophisticated investors who can invest in private equity funds, particularly growth equity funds, and review the Volcker Rules as pertaining to unlevered private equity funds.

[1] *Consider the effects of the agricultural lobby.

[2] C. Edward Fletcher, III, “Sophisticated Investors Under the Federal Securities Laws,” Duke Law Journal 6 (1988): 1081, 1133.

[3] Chris McGreal, “George Bush: A Good Man in Africa,” The Guardian, February 15, 2009, accessed March 13, 2011,

[4] “Bush’s State of the Union Speech,” CNN, January 29, 2003, accessed March 13, 2011,

[5] *Please note the precedence given to the term ‘secure the Blessings of Liberty’ in the preamble of the U.S. constitution

[6] “Objectives and Principles of Securities Regulation,” International Organization of Securities Commissioners (IOSCO), (1998): 6-7.

[7] “The Investor’s Advocate: How the SEC Protects Investors, Maintains Market Integrity, and Facilitates Capital Formation,” U.S. Securities and Exchange Commission, accessed March 14, 2011,

[8] International Organization of Securities Commissioners (IOSCO), Objectives and Principles of Securities Regulation (1998)

[9] Joel Trachtman, “Securities Regulation,” Fletcher School of Law and Diplomacy In-Class Presentation, January 31, 2011, 19-22.; Hal S. Scott, International Finance: Transactions, Policy and Regulation (Foundation Press 17th ed. 2010), 58-61.

[10] *USGAAP requirements ended for foreign issuers using IFRS as of 2009.; Scott, International Finance: Transactions, Policy and Regulation, 174.

[11] Trachtman, “Securities Regulation,” 22-23.

[12] Andrew J. Donohue, “Regulating Hedge Funds and Other Private Investment,” (Speech presented at the Fordham Journal of Corporate and Financial Law’s 3rd Annual Symposium on the Regulation of Investm,ent Funds, New York, New York, February 19, 2010),

[13] Scott, International Finance: Transactions, Policy, and Regulation, 187.

[14] Scott, International Finance: Transactions, Policy and Regulation, 189.

[15] Scott, International Finance: Transactions, Policy and Regulation, 189.

[16] SEC Release No 33-8869, December 6, 2007

[17] Viral V. Acharya et al., Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance, (New York: New York University Stern School of Business, 2011), 47.

[18] Acharya et al., Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance, 111.

[19] Shadab, “Fending for Themselves: Regulatory Reform to Create a U.S. Hedge Fund Market for Retail Investors,”  New York University Journal of Legislation and Public Policy 11 (Spring 2008): 285, accessed March 15, 2011

[21] Scott, International Finance: Transactions, Policy and Regulation, 947.

[22] Donohue, “Regulating Hedge Funds and Other Private Investment.”

[23] Regulation D, Rule 506, 17 C.F.R. §§ 230.502(c) & 506(b)(1) (2007)

[24] Regulation D, 17 C.F.R. § 230.502(c)(1) (2007)

[25] See In re CGI Capital, Inc., Securities Act Release No. 7904 (Sept. 29, 2000)

[26] Regulation D, Rule 506(b)(2)(i)–(ii), 17 C.F.R. § 230.506(b)(2)(i)–(ii) (2007)

[27] Shadab, “Fending for Themselves: Regulatory Reform to Create a U.S. Hedge Fund Market for Retail Investors,”  New York University Journal of Legislation and Public Policy 11 (Spring 2008): 288, accessed March 15, 2011

[28] Shadab, “Fending for Themselves: Regulatory Reform to Create a U.S. Hedge Fund Market for Retail Investors,”  New York University Journal of Legislation and Public Policy, 300-301.

[29] See In re CGI Capital, Inc., Securities Act Release No. 7904 (Sept. 29, 2000).

[30] § 80b-3(b)(3)

[31] Oliver Gottschalg, “Managing a Buyout and its Exit”, HEC School of Management Paris In-Class Presentation, December 1, 2010.

[32] Ibid.

[33] Scott, International Finance: Transactions, Policy, and Regulation, 188.

[34] Carolyn Cohn, “Signs of life seen in Africa private equity”, Forbes, October 6, 2009, Accessed March 13, 2011,

[35] Scott, International Finance: Transactions, Policy, and Regulation, 113.

[36] Shadab, “Fending for Themselves: Regulatory Reform to Create a U.S. Hedge Fund Market for Retail Investors,”  New York University Journal of Legislation and Public Policy 11 (Spring 2008): 293, accessed March 15, 2011

[37] Scott, International Finance: Transactions, Policy, and Regulation, 947.

[38] Ibid., 945.

[39] *In the sense that they require social returns

[40] Conversation with Trachtman, 14th March

[41] “The Investor’s Advocate: How the SEC Protects Investors, Maintains Market Integrity, and Facilitates Capital Formation.”

[42] “The Investor’s Advocate: How the SEC Protects Investors, Maintains Market Integrity, and Facilitates Capital Formation.”


Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s