By James Hamilton, J.D., LL.M.
Two private equity firms currently doing IPOS are not investment companies under either the orthodox or inadvertent tests developed under the Investment Company Act, emphasized SEC Investment Management Director Andrew Donahue in testimony before the Senate Finance Committee. Thus, the Fortress Investment Group LLC and The Blackstone Group L.P. are not subject to the substantive provisions of the 1940 Act.
The Investment Company Act has two main tests for determining whether an issuer is an investment company. The first test is whether the issuer is primarily engaged in the business of investing in securities. This orthodox investment company test defines issuers that hold themselves out, or otherwise are clearly recognizable, as investment companies.
The second test is whether the issuer is engaged in the business of investing, reinvesting, owning, holding, or trading in securities and owns investment securities the value of which exceeds 40% of its total assets. Companies that fall within this second test are often referred to as inadvertent or prima facie investment companies because they view themselves as industrial or operating companies rather than investment companies.
According to the director, the SEC staff carefully reviewed the registration statements and other information provided by Fortress and Blackstone and concluded that they are not investment companies under the 1940 Act.
Applying the orthodox investment company test, the staff found that Fortress and Blackstone are engaged primarily in the business of providing asset management and financial advisory services to others and not primarily in the business of investing in securities with their own assets.
With respect to determining if the two firms constitute inadvertent investment companies, the key test established by Congress is whether more than 40% of a company's assets are investment securities. The main assets relevant to the inadvertent investment company test are the general partnership and limited partnership interests in the underlying funds of the two firms. While limited partnership interests are treated as investment securities, general partnership interests are not securities if the profits relating to those interests generally come from the efforts of the general partners, as opposed to the efforts of others.
In the case of Fortress and Blackstone, noted the director, the issuers maintain control over the day-to-day management of the underlying funds, with senior employees exercising such management through wholly owned subsidiaries. The profits to the general partnership interests result from the efforts of the managers, not others, and those interests would thus not constitute securities. The fact that the public investors in the securities sold by Fortress and Blackstone have no voting rights with respect to the management of the underlying funds would not change this conclusion. Thus, the general partnership interests would not be securities and therefore not investment securities for Investment Company Act purposes.