Part of our regulatory series: This article covers the Investment Company Act. Also read about the Securities Act (how to raise money) and Investment Advisers Act (adviser regulation).
The Simple Question
Maya’s Neighborhood Investing Club
You’re great at markets, so a dozen friends suggest pooling money—about $250,000—into an LLC you’ll manage. You’ll post updates in a group chat, take a small management fee, and maybe a performance cut if things go well. After a few months, word spreads and friends-of-friends want in. “Why not let everyone join?” someone asks.
Are you now an investment company? Can you just keep adding investors?
The moment you pool money to invest in securities, you’re brushing up against the Investment Company Act of 1940. Most hedge funds avoid registering as retail “’40 Act” funds by fitting into narrow private-fund exclusions—most commonly Section 3(c)(1) or Section 3(c)(7).
The ‘40 Act creates a fork in the road: either qualify for a narrow exclusion, or register and operate like a retail fund. There isn’t much middle ground.
This single law shapes why hedge funds stay exclusive, cap investors, and follow private marketing rules. Let’s unpack the core mechanics.
What Makes You an Investment Company?
Under the ‘40 Act, an “investment company” generally includes an entity that:
Holds Itself Out as Investing
Publicly represents that it’s engaged in investing, reinvesting, or trading in securities
Is Actually Investing
Is in the business of investing, reinvesting, owning, holding, or trading in securities
40% Securities Test
Holds “investment securities” exceeding 40% of total assets (excluding government securities and cash items)
Every hedge fund fits this broad definition:
- They describe strategies centered on trading securities
- They actively invest in markets
- Most assets are investment securities
The Consequence:
Without an exclusion, a hedge fund would be regulated like a registered investment company — NAV/redemption mechanics, board oversight, derivatives/leverage limits, and periodic public reporting.
Registered Funds vs. Private Funds
If you’re an investment company and don’t rely on an exclusion, you register — and the rulebook gets heavy:
Registered Investment Company
(Mutual Funds, ETFs, Closed-End Funds)
- • NAV-based pricing and prompt redemption obligations for open-end funds
- • Independent board of directors (≥ 40%)
- • No traditional “carry”; fulcrum fees may be used under Advisers Act conditions
- • Derivatives & leverage subject to Rule 18f-4 (VaR limits, risk program & manager)
- • Periodic portfolio disclosure (e.g., Form N-PORT public quarterly) and shareholder reports
- • SEC examination and oversight; retail investor protections
Private Fund with Exclusion
(Hedge funds using 3(c)(1) or 3(c)(7))
- • Flexible liquidity terms (lockups, gates, side pockets as disclosed)
- • No board requirement
- • Performance-based compensation permitted (e.g., “2 and 20”)
- • Strategy flexibility (incl. derivatives), subject to offering docs and anti-fraud rules
- • Private reporting; investor-level transparency per fund documents
- • SEC oversight of the adviser, not the fund as a registered investment company
In short: registered funds are built for the retail market; private funds trade flexibility for limited access and private placement rules.
Core Hedge Fund Exclusions
Section 3(c)(1) — The 100-Investor Fund
100 beneficial owners
Typically Accredited Investors (from the Reg D side)
Not permitted — rely on private placement rules
Hedge funds, especially emerging managers
Look-Through: If an entity owns 10%+ of the fund, you may have to “look through” and count its owners toward the 100 cap.
Section 3(c)(7) — Qualified Purchaser Fund
No 100-owner cap (practical limits apply; watch Exchange Act §12(g) holders-of-record thresholds)
All investors must be Qualified Purchasers (e.g., individuals generally with ≥ $5M in investments)
Not permitted — still a private fund exclusion
Larger hedge funds, private equity, venture, and institutional pools
QP Verification & Look-Through: Entity investors must qualify as QPs; look-through may apply to ensure underlying owners meet QP status per the rules and definitions.
Critical Marketing Point (Both 3(c)(1) & 3(c)(7))
These are not registered investment companies, so there can be no public offering. However, you may raise under Rule 506(c) with general solicitation if all purchasers are verified accredited investors. Many managers still choose 506(b) (no advertising; up to 35 non-accredited sophisticated purchasers with Rule 502(b) disclosures) depending on their audience and materials.
Investor Counting & “Don’t Trip the Limits”
The biggest practical risk is miscounting beneficial owners or structuring vehicles that effectively defeat the exclusions.
Common Trouble Spots
Parallel or “Sidecar” Funds
Fund A (3(c)(1), 99 investors) and Fund B (another vehicle) with the same strategy, overlapping owners, and coordinated trades.
Expect scrutiny if structures appear designed to skirt 100-owner or qualification constraints in substance.
10%+ Entity Investors & Qualification
- • For 3(c)(1): look-through counting toward the 100-owner cap
- • For 3(c)(7): ensure entity and underlying owners meet QP standards as required
- • Build reps/info rights into sub docs and track changes over time
Operational Ways to Stay Clean
Use clear capacity tracking, maintain distinct strategies/investor bases across vehicles, and consider master–feeder setups that centralize trading without inflating beneficial-owner counts.
Three Real-World Scenarios
Emerging Manager’s First Fund
Former desk head launching with $10M from 15 investors
Structure
Start with 3(c)(1) — capacity up to 100 beneficial owners
Capital Formation Path
Begin with 506(b) relationships; consider 506(c) later for scale with verified accredited investors
Key Considerations
- Track beneficial owners (including any 10%+ look-through)
- Plan for scale before approaching the 100-investor cap
Institutional Expansion Path
$800M AUM fund expanding access to QP-only channels
Structure
Launch a 3(c)(7) sleeve for Qualified Purchasers while maintaining a 3(c)(1) vehicle
Advantages
No 100-owner cap; aligns with institutional/QP pipelines; marketing remains private placement
Key Considerations
- Verify QP status for all investors; set documentation and workflows
- Distinct docs/terms if operating both 3(c)(1) and 3(c)(7)
Global Master–Feeder Complex
$2B platform accepting U.S. and international investors
Challenge
Accommodate U.S. taxable, U.S. tax-exempt, and non-U.S. investors efficiently
Structure
Master–feeder with a U.S. 3(c)(1) feeder and a 3(c)(7)/Cayman feeder into a Cayman master
Benefits
- Tax efficiency across investor types
- Centralized trading; clearer capacity/qualification management
- Segmentation of Accredited vs. QP channels
Common Pitfalls That Can Destroy Exclusions
A single mistake can force registration or enforcement risk. Watch for:
✗ Sloppy Public Marketing
Wrong: Posting performance or offering terms on a public site without 506(c) controls
Right: For 506(b), keep outreach private and relationship-based; for 506(c), advertise only if you restrict sales to verified accredited investors and maintain records.
✗ Exceeding 100 Investors (3(c)(1))
Wrong: Accept investor #101 without a plan
Right: Monitor counts continuously, including look-through for 10%+ entities.
✗ QP Qualification Gaps (3(c)(7))
Wrong: Treating an entity as QP without confirming underlying ownership/qualification where required
Right: Capture representations and evidence; apply look-through where applicable to confirm QP status.
✗ Parallel Funds Without Distinctions
Wrong: Two vehicles with same strategy, same investors, same trades
Right: Maintain genuine differences (strategy, fees, investors) or centralize via a master–feeder.
How It Connects to Other Regulations
Securities Act of 1933
Private funds raise under Regulation D (see our Securities Act guide for details):
- • Rule 506(b): No general solicitation; may include up to 35 non-accredited sophisticated purchasers with Rule 502(b) disclosures
- • Rule 506(c): General solicitation allowed; sales only to verified accredited investors
- • Form D: File within 15 days after the first sale
Investment Advisers Act of 1940
Many emerging managers rely on the private fund adviser exemption (learn more in our Advisers Act guide):
- • < $150M in U.S. private fund AUM
- • Clients are exclusively private funds (3(c)(1) and/or 3(c)(7))
- • File as an Exempt Reporting Adviser (ERA); anti-fraud and marketing rules still apply
Exchange Act of 1934
Issuers can trigger reporting if holders-of-record exceed thresholds:
- • Section 12(g): 2,000 holders of record (or 500 non-accredited)
- • Another reason private funds limit investor counts and manage platforms carefully
The Bottom Line
Key Takeaways
- The ‘40 Act forces a choice: register as a retail fund or rely on private fund exclusions.
- 3(c)(1) caps you at 100 beneficial owners; 3(c)(7) requires Qualified Purchasers but has no 100-owner cap.
- Private placement routes: 506(b) (no ads; may include some non-accredited with disclosures) or 506(c) (ads allowed; verified accredited only).
- Avoid owner-count and qualification surprises with look-through, QP checks, and clear vehicle separation.
- Registered funds face Rule 18f-4 derivatives limits, board requirements, and periodic portfolio disclosure.
The Investment Company Act shapes hedge fund structure end-to-end. Know the limits, and build your capital formation plan around them.
Navigating the ‘40 Act with Hedgia
The ‘40 Act is complex. Hedgia helps 3(c)(1) and 3(c)(7) hedge funds stay within the lines while growing.
Automated Compliance Management
Hedgia supports private fund workflows that keep your status intact:
For New Funds
- • 3(c)(1) eligibility & owner-count tracking
- • 506(b) setup with Rule 502(b) disclosure support if needed
- • Optional 506(c) flow with verified-accredited controls
- • Parallel vs. master–feeder decision support
For Growing Funds
- • Capacity management across vehicles
- • QP-only sleeves and documentation (3(c)(7))
- • Monitoring for Exchange Act §12(g) holder thresholds
- • Marketing controls for 506(b)/506(c)
Hedgia helps you maintain your fund’s private status while you focus on generating returns.
Important Legal Notice
This content is educational and not legal, financial, or investment advice. Regulations change; verify requirements for your situation.