The Family Office Rule: Considerations under the Investment Advisers Act for Puerto Rico-based fund managers

As discussed in a previous alert, “Private equity and hedge funds in Puerto Rico – key tax considerations,” Puerto Rico has experienced an emerging private equity fund and hedge fund industry over the past ten years. This development is largely attributable to two legislative initiatives:

1. The enactment of Act 185-2014 (the Private Equity Funds Act or PEF Act), which is now codified under the Puerto Rico Incentives Code (Act 60), and
   
   
2. The relocation of financial industry professionals from the United States to Puerto Rico to benefit from individual resident investor decrees under Act 60. These decrees offer full exemption from Puerto Rico income tax on shares of interest, dividends, and capital gains, including those derived from pass-through investment funds. If residency and holding period requirements are met, the investor’s share of capital gains may also be exempt from US federal income tax.

Puerto Rico-based managers of investment funds – regardless of whether the investment fund itself is based in Puerto Rico – are subject to federal and state investment adviser regulations. Generally, a Puerto Rico-based investment adviser must register with the US Securities Exchange Commission (SEC) if it manages assets exceeding USD100 million, and with the Puerto Rico Office of the Commissioner of Financial Institutions if it manages less than that amount, subject to certain exemptions. Typically, Puerto Rico-based fund managers have been relying on the Exempt Reporting Adviser exemption (this applies to fund managers who solely manage private funds and have less than USD150 million in assets under management), although some have registered with the SEC.

This alert discusses another potential exemption: the family office exclusion.

Background

A single family which desires to manage its investments through a fund structure may organize and control a dedicated fund manager, and such fund manager will not be deemed an investment adviser pursuant to the “family office exclusion” under Section 202(a)(11)(G) of the US Investment Advisers Act of 1940 (Advisers Act) and Rule 202(a)(11)(G)-1 (Family Office Rule) thereunder. Since offices that meet the Family Office Rule criteria are excluded from the definition of “investment adviser” under both federal and Puerto Rico law, they are not required to register as such, nor are they subject to the Advisers Act. This exclusion may be relevant to investors holding individual resident investor decrees under Act 60 that desire to manage their investments through a fund structure, and to investors that are ineligible for such decrees (i.e., wealthy local families) that desire to manage their investments through a qualifying fund under the PEF Act (or through a traditional fund structure).[1]

Three core conditions

To qualify under the Family Office Rule, an office must meet the following three conditions:

1. Exclusivity of clients: The office must have “no clients other than family clients.” If a non-family individual inadvertently becomes a client (e.g., by inheriting an interest), they are deemed a family client for one year.
   
   
2. Ownership and control: The office must be wholly owned by family clients and exclusively controlled (directly or indirectly) by family members and/or family entities. Key employees may hold minority, non-controlling equity interests, which enables offices to replicate the carried-interest and incentive-compensation structures of traditional asset managers. However, control must remain in family hands.
   
   
3. No public holding out: The office must not present itself to the public as an investment adviser. Any marketing to non-family investors – including through websites or pitch decks – jeopardizes the exemption.

Who qualifies as a “family client”?

The role of key employees and compensation structures

The Family Office Rule acknowledges that single-family offices compete with hedge funds and private-equity firms for investment talent. By classifying key employees as “family clients,” the rule enables family offices to:

1. Grant profit interests, carried interests, or other forms of equity to portfolio managers
2. Permit key employees to co-invest alongside the family in proprietary private funds or direct deals, and
3. Retain minority employee ownership in the advisory entity, provided control remains with family members or family entities.

However, limitations apply. For example, upon termination, former key employees may not make new investments through the family office, although pre-existing investments and contractually committed capital may be managed to term.

Regulatory compliance

Failure to satisfy the requirements of the Family Office Rule would result in the fund manager being an unregistered investment adviser, which would trigger retroactive application of the registration, recordkeeping, custody, and compliance obligations of investment advisers under the Advisers Act. Pursuant to the Family Office Rule, and in accordance with Section 206 of the Advisers Act, the SEC may sanction offices that stray into multi-family services or solicit outside capital. Failure of an office to meet the requirements of the Family Office Rule will not prevent the office from providing advisory services to family clients, either collectively or individually. Nevertheless, the office will need to register as an investment adviser under the provisions of the Advisers Act (unless another exemption is available) or seek an exemptive order from the SEC. However, the SEC has previously indicated that such orders are unavailable for offices intending to serve multiple, unrelated families.

Conclusion

Puerto Rico-resident individuals – whether holding resident investor decrees or seeking tax benefits available under the PEF Act – are increasingly organizing fund managers and investment funds to manage their assets. These individuals may wish to assess whether they qualify for the Family Office Rule under the Advisers Act.

Learn more

For more information, please contact the authors.

^{[1] The PEF Act requires a qualifying fund to employ an investment adviser that is registered or exempt from registration. Under the Advisers Act and applicable Puerto Rico law, an office is not defined as an investment adviser. However, considering that these offices engage in the same investment management functions as an investment adviser, the Office of the Commissioner of Financial Institutions, if consulted, may consider an office as an investment adviser for purposes of the PEF Act.}