Family Office Private Fund Investing: An Educational Guide

A family office is a private organization that manages the financial affairs of one or more wealthy families. A single-family office serves one family. A multi-family office serves several. Some families also work with a registered investment adviser (RIA) to handle part of this work.

A private fund is a pooled investment vehicle offered privately instead of to the general public. Interests in these funds are usually sold under exemptions from registration, most often SEC Rule 506(b) or Rule 506(c). Under Rule 506(b), the issuer may not use general solicitation. Under Rule 506(c), general solicitation is allowed, but all purchasers must be accredited investors and the issuer must take reasonable steps to verify that status.

Most private funds are open only to accredited investors under SEC Rule 501(a). Individuals can qualify through income or net worth tests set out in the rule, or through holding certain licenses, such as Series 7, 65 or 82. The August 2020 amendments added these license holders. They also added knowledgeable employees of a private fund and spousal equivalents. Entities and family offices with more than $5 million in investments or assets can qualify, as can RIAs and exempt reporting advisers. Private fund investments are speculative and illiquid, and investors can lose all of their value.

Families have often started by writing down their goals, time horizon, need for cash and tolerance for risk. Many then build an investment policy statement. It describes how decisions are made and who makes them.

Many family offices review private funds with an internal team, outside consultants, or both. Common steps include reading the offering documents, reviewing the manager's background and track record of conduct, and checking legal terms, fees and reporting practices. Some families also speak with other investors and the manager's service providers. Fund due diligence specialists are one resource for this work.

Some families invest directly in funds. Others use a fund of funds or a secondaries approach. These are different structures with different trade-offs in cost, access and complexity. Tax reporting often arrives on a Schedule K-1, which can come later than other tax forms. Where a fund holds qualifying small-company stock, QSBS under Section 1202 may come up in discussion. Tax treatment depends on individual circumstances, so families usually work with their own tax advisers.

The right independent fund manager may help a family office understand how a particular private fund is structured. They may explain what it holds, how it is meant to operate, and how it fits with the rest of a family's holdings. A good conversation is usually unhurried. It focuses on your goals and questions before any specific offering is discussed.

Useful questions to ask include: Which exemption does the fund rely on, and how is accredited status verified? What are the fees and expenses, and how are they described in the offering documents? How long may capital be tied up, and what are the terms for withdrawals or exits? How often will reporting arrive, and what tax forms should we expect?

You might also ask about conflicts of interest, how the manager is governed, and how decisions get made when markets are stressed. Ask who audits the fund and who serves as administrator. Past performance does not guarantee future results, so it helps to focus on process and transparency rather than headlines. Always read the offering documents and consult your own licensed attorney, tax professional and financial adviser before deciding.