Understanding private investment funds: An inside look

Private investment funds are the backbone of the private markets. Learn the basics of private funds, including how they’re structured, managed, and regulated.

What is a private investment fund?

A private investment fund is a type of pooled investment vehicle created to invest capital on behalf of a select group of investors. This means it gathers money from multiple sources to make investments that would be difficult for individuals to access on their own. Common examples of private funds include private equity (PE) funds, venture capital (VC) funds, real estate funds, and hedge funds. Each type of private fund has a distinct investment strategy and risk profile, but they all share the core structure of pooling money to invest in private markets.

Managed investment funds are considered investment companies under the Investment Company Act of 1940, a law that regulates the activities of investment companies in the United States. Unless they qualify for an exemption, investment companies must register with the U.S. Securities and Exchange Commission (SEC).

Private funds are able to remain exempt from registration as investment companies if they follow the restrictions outlined in either Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act. Qualifying for exemption under one of these sections is what distinguishes a private fund from a public fund, or registered investment company.

How do private funds differ from public funds?

To understand what makes a private fund unique, it’s helpful to compare it directly with a public fund. The key differences stem from their regulatory status and intended investor base, which impacts everything from how they operate to the level of risk involved.

Who can invest in private funds?

The registration exemptions under Section 3(c)(1) and Section 3(c)(7) restrict investment in the fund to either accredited investors or qualified purchasers, depending on the exemption the fund pursues. Investors from the general public, also called retail investors, aren’t allowed to invest in private funds. Private funds also are limited to a certain number of beneficial owners, depending on whether they seek exemption under Section 3(c)(1) or Section 3(c)(7).

This framework ensures that only individuals, family offices, or institutional investors with sufficient financial knowledge and resources can invest.

Accredited investors vs. qualified purchasers

The two main categories of eligible investors are accredited investors and qualified purchasers. A fund’s legal structure, specifically its choice of regulatory exemption, dictates which type of investor you can accept.

• Accredited investors: This category is defined by specific income or net worth thresholds set by regulators. A fund operating under the Section 3(c)(1) exemption of the Investment Company Act is generally limited to a certain number of these investors.

• Qualified purchasers: This category represents a much higher standard of wealth. Funds that are structured under the Section 3(c)(7) exemption are open only to qualified purchasers.

Advantages and risks of private funds

For the investors who are eligible to invest, private funds offer a unique set of potential benefits and significant risks. Regulators restrict investment in private funds because they’re generally regarded as riskier investments than public funds like mutual funds. The higher risks, however, come with unique advantages. Understanding this tradeoff is essential before you commit your capital.

Advantages of private funds

Investors contribute to private funds for several reasons:

• Potential for higher returns: Private funds aspire to beat public market averages by investing in opportunities not available to the general public.

• Portfolio diversification: Private assets have longer investment horizons that don’t correlate directly to cyclical trends in public equities markets.

• Access to specialized opportunities: These funds offer a way to invest in innovative private companies.

Risks of private funds

Despite the potential for outsized returns, private funds present a number of risks, including:

• Limited liquidity: Private funds typically limit redemption opportunities, which means investors can’t cash out of the fund except in certain circumstances.

• Longer return timelines: Depending on the fund’s investment strategy, it can sometimes take years before investors begin to receive distributions from the fund.

• Limited transparency: Private funds often provide quarterly financial reports to investors, but they’re not required to make the same extensive disclosures as public funds.

• Limited regulatory oversight: Although the SEC regulates private funds, it doesn’t apply the same regulatory controls or scrutiny to private funds as they do for public funds.

How are private funds structured?

The foundational legal blueprint for most private funds, including VC and PE, is the limited partnership. This structure is created and governed by a critical legal document known as the limited partnership agreement (LPA).

The limited partnership: General partners and limited partners

Within the limited partnership structure, there are two primary roles:

• General partner (GP): The GP is the active fund manager responsible for the entire private funds management process.

• Limited partners (LP): The LPs are the investors who contribute capital to the fund. Their role is passive, meaning they do not participate in the fund's management.

How are private funds managed?

The management for private funds is handled by professional fund managers known as fund advisers. They formulate the fund’s investment strategy, pitch investors, and close investors into the fund.

The fund adviser’s role

The fund adviser is responsible for the entire lifecycle of the fund.

Key responsibilities include:

• Formulating the fund's investment strategy
• Sourcing deals
• Conducting due diligence
• Managing the portfolio of investments
• Handling all back-office operations

What regulations govern private funds?

Private funds are governed by the SEC and state securities agencies. Regulations control how the fund raises money and how private fund advisers interact with investors.

Key exemptions under federal securities laws

• The Investment Company Act of 1940
• The Investment Advisers Act of 1940
• The Securities Act of 1933

What are the common private fund strategies?

“Private fund” covers a wide range of investment approaches within the private capital markets.

Private equity

Private equity investments involve taking a majority or controlling stake in established companies.

Venture capital

Venture capital (VC) focuses on making minority investments in early-stage, high-growth companies.

Fund of funds (FoF)

A fund of funds (FoF) uses its capital to purchase stakes in other private funds.

Hedge funds

Hedge funds pursue a variety of complex trading strategies across many different asset classes.

Private credit funds

Private credit investing involves acting as a direct lender by providing loans to companies.

Special purpose vehicles (SPVs)

A special purpose vehicle (SPV) is created to make an investment in a single company.

What are the economics of a private fund?

The economics of a private fund are typically achieved through a common compensation model known as the two-and-20 fee structure:

• Management fees
• Carried interest

Frequently asked questions about private funds

How do private funds generate returns?

Private funds generate returns through exit events such as initial public offerings (IPOs), mergers or acquisitions (M&A), or sales to another investor in the secondary market.

How much money do you need to invest in a private fund?

The minimum investment amount is set by the fund manager and can vary widely.

What are the main types of private investment funds?

Primary types include VC, PE funds, hedge funds, and private credit funds.

Are private investment funds risky?

Private funds are generally considered higher-risk investments, a fact reflected in the wide dispersion of their returns.