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Designing a Phantom Option Plan for an NBFC
A fund is not just a pool of capital; it is a legal and institutional framework built to steward investor money, execute investments, and deliver returns. How that framework is constructed at formation determines whether the vehicle operates cleanly, scales efficiently, and avoids regulatory issues that can surface years later. The funds that scale successfully understand this from day one. The formation of the fund is foundational, the legal structure, compliance infrastructure, and governance systems define how effectively fund performs, beginning with capital calls to portfolio management to final distributions.
This guide covers the complete fund formation process: the regulatory framework, the essential legal documents, the governance structures, and the compliance foundations that enable professional fund operation.
The Primary Regulatory Question: Are You an Investment Adviser?
Before considering any other regulatory requirement, a fund manager must answer this question: Is the fund, or the entity managing the fund, an "investment adviser" under the Investment Advisers Act of 1940?
This determination shapes nearly everything that follows, including registration requirements, compliance obligations, reporting burden, and operational complexity.
The Advisers Act defines an investment adviser as any person who, for compensation, engages in the business of advising others about investing in securities. A fund manager who is compensated for managing a fund meets this definition.
The Dodd-Frank Act (2010) fundamentally changed adviser registration requirements:
If the fund manager (advising private funds) manages less than $150 million in U.S.-based assets under management, the adviser may qualify for the "private fund adviser exemption." This exemption allows:
Once the adviser crosses $150 million in AUM, SEC registration becomes mandatory (in most cases). The adviser must:
The transition is automatic upon crossing the threshold. The adviser has 90 days after filing its annual amendment to register.
Advisers with $1B+ AUM face enhanced requirements under the SEC's Large Adviser Rules, including:
Advisers exceeding $20 billion in AUM are subject to systemic risk assessment by the Financial Stability Oversight Council (FSOC). These advisers face potential designation as systemically important financial institutions (SIFIs), creating additional regulatory and capital requirements.
First-time GPs often structure their fund to qualify for the private fund adviser exemption initially ($150M target). This enables simpler regulatory compliance while establishing track record. Fund II is then typically raised larger (sometimes crossing $150M), triggering SEC registration.
This staged approach is intentional and common: establish proof of performance under simpler regulatory framework, then upgrade to full SEC registration when scale and track record justify it.
A separate regulatory framework the Investment Company Act of 1940 governs the structure of investment vehicles themselves.
Most private equity and venture capital funds qualify for exemption from Investment Company Act registration under Rule 3(c)(1):
Eligibility requirement: The fund must have:
The Look-Through Rule
The SEC applies a "look-through rule" when calculating the investor count: If a company holds more than 10% of the fund's interests, the SEC counts the underlying beneficial owners of that company as investors in the fund. This can unintentionally push a fund over 100 investors.
Example: A pension fund that owns 12% of the fund and has 150 beneficial owners would contribute all 150 owners to the investor count. If the direct LP count plus look-through count exceeds 100, the fund may be forced to register as an investment company.
Some GPs use the more restrictive but higher-capacity Rule 3(c)(7), which requires:
Strategic Advantage: Allows larger LP bases and easier fundraising.
Disadvantage: Restricts LP eligibility to large institutions and wealthy individuals.
Most PE/VC funds use 3(c)(1). It allows broader LP participation (smaller institutions, pension fund portions, HNIs with lesser assets) while providing regulatory simplicity.
Under Securities Act Regulation D, funds raising capital from accredited investors can operate without SEC registration, but they must file Form D.
The SEC maintains a database of Form D filings. While information is not used for regulatory enforcement, it demonstrates good faith compliance with Regulation D.
Strategic implication: Form D filing is ministerial but important. Failure to file can jeopardize the fund's exemption from registration.
Fund formation requires creating multiple legal documents, each serving distinct functions. The ensemble of documents collectively creates the contractual framework governing fund operations.
The Limited Partnership Agreement is the foundational legal document of the fund. It is effectively the constitution of the partnership, defining all rights, obligations, and procedures.
Scope of the LPA
A typical PE/VC LPA covers 100-150 pages and addresses:
The LPA is not standard. While market conventions exist, each LPA is customized based on GP strategy, fund characteristics, and LP negotiations. The ILPA (Institutional Limited Partners Association) publishes model LPAs providing market-standard language, but GPs typically diverge from these based on their specific needs.
Drafting timeline: 4-8 weeks for first-time GPs with counsel
Legal cost: $50K-$150K depending on complexity and customization
The PPM is the marketing and disclosure document provided to prospective LPs. It serves multiple functions:
Provides basis for securities law exemptions (establishes that offering is to accredited investors only)
Creates written disclosure record protecting the GP from later LP claims of non-disclosure
Drafting timeline: 3-6 weeks after LPA is substantially complete
Legal cost: $30K-$75K
Regulatory note: The PPM is not filed with the SEC. However, it must be accurate and cannot contain material misstatements (to comply with securities laws).
The Subscription Agreement is the contract executed by each LP when they commit to the fund. It establishes:
The Subscription Agreement is typically 10-20 pages and is based on market-standard language with minimal customization.
Side letters are supplemental agreements between the GP and individual LPs that modify the standard terms in the LPA. Common side letter provisions include:
Strategic note: Side letters introduce complexity and should be limited to true anchor LPs. Once one LP has a side letter, others demand them, creating administrative burden.
Best practice: Minimize side letters by baking favorable terms into the base LPA (lower fees, enhanced transparency) and applying uniformly to all LPs.
The General Partner Agreement governs the internal structure of the GP entity (the management company). It typically addresses:
The GPA is typically drafted after first close (when the GP team structure is finalized) rather than before. It is an internal document not shared with LPs.
Modern GPs maintain a data room containing all offering documents:
Professional funds maintain this registry in a secure virtual data room (Box, ShareFile, Citrix ShareFile) with version control and audit trails.
An LPAC is a committee of LP representatives established to provide oversight, address conflicts of interest, and approve certain significant actions by the GP.
LPACs typically address:
The LPA typically specifies that LPACs do NOT:
Professional funds establish LPAC operating procedures including:
The ILPA provides LPAC best practice guidance emphasizing formal procedures, transparent conflict disclosure, and written documentation. Funds following ILPA standards reduce litigation risk and demonstrate institutional maturity.
Some larger funds establish an Investment Committee to improve investment decision-making. The IC typically comprises:
The IC is internal to the GP and does not involve LPs directly. Its purpose is to formalize investment approval procedures and provide discipline to the investment process.
If the fund manager reaches $150 million in AUM, SEC registration becomes necessary.
Step 1: Exempt Reporting Adviser (ERA) Status
Before reaching $150M, the adviser typically registers as an Exempt Reporting Adviser by filing Form ADV Part 1. This filing:
Step 2: Transition to SEC-Registered Adviser
Upon reaching $150M, the adviser must file a complete Form ADV (Parts 1 and 2) and transition from ERA to SEC-registered status within 90 days.
Form ADV is the uniform application for investment adviser registration. It requires:
Part 1A (Form ADV-E): Basic information
Part 2A: Brochure (detailed disclosure document provided to clients)
Part 2B: Brochure supplement (individual adviser bios)
Form ADV filing: Electronic via SEC's EDGAR system
Cost implication: SEC charges fees based on regulatory AUM ($400-$5,000+ annually depending on size range)
If the adviser remains below $150M and qualifies for the private fund adviser exemption, state-level registration is typically required in the adviser's home state.
State registration requirements vary but typically include:
Some states (Texas, for example) have "notice filing" requirements rather than full registration.
SEC-registered advisers managing private funds with $150M+ AUM must file Form PF to provide data to the SEC and Financial Stability Oversight Council about private fund holdings, leverage, liquidity, and systemic risk factors.
Advisers must file Form PF quarterly event reports for certain trigger events:
Form PF Compliance: Recent amendments (adopted February 2024, effective October 1, 2026) significantly expanded Form PF requirements.
As noted earlier, funds relying on Regulation D must file Form D with the SEC within 15 days of first capital raised.
Form D filing: Via SEC EDGAR system
SEC-registered advisers must adopt and implement a written compliance program addressing:
Chief Compliance Officer (CCO): Advisers must designate a CCO responsible for compliance program development and implementation.
Funds must comply with audit requirements specified in the LPA. Typical requirements:
Cost: Annual audit: $50K-$300K depending on fund size and complexity
Funds must implement AML/KYC procedures including:
SEC regulatory amendments (Regulation S-P) implemented in 2024-2025 require:
Funds must ensure fund assets are properly custodied with qualified custodians:
Proper fund formation follows a logical sequence. Attempting to expedite this timeline typically creates downstream problems.
Parallel activity: Begin building compliance infrastructure
Fund formation is not administrative busywork—it is the foundation upon which professional fund management operates. The legal documents, governance structures, and compliance infrastructure created during formation determine whether the fund can scale, raise capital efficiently, and manage operations cleanly.
GPs who prioritize proper fund formation:
The upfront investment in proper formation both in time and financial resources pays dividends through the fund's entire lifecycle. It reduces operational friction, prevents regulatory complications, and demonstrates institutional maturity to LPs.
Delaware has sophisticated limited partnership law (DRULPA), extensive case law interpreting partnership agreements, a specialized Chancery Court for business disputes, and strong precedent for enforcing partnership agreements. Additionally, Delaware LLCs and LPs offer flexibility and favorable tax treatment. Most LPs expect Delaware domiciliation.
Best practice is to establish a separate GP entity (typically an LLC) that serves as the General Partner to the fund LP. The separation creates legal clarity, enables multiple funds under one GP entity, and facilitates succession planning. The GP LLC is typically owned by the fund managers personally or through a holding company.
Exempt Reporting Advisers (ERAs) relying on the private fund adviser exemption must file Form ADV Part 1 but are not subject to full SEC oversight. They avoid most Advisers Act requirements (custody rule, marketing rule, fiduciary duty enhancements) but must still comply with anti-fraud provisions and maintain compliance policies. SEC-registered advisers face the full scope of Advisers Act requirements but gain access to the SEC regulatory framework and ability to manage larger asset bases.
If relying on Rule 3(c)(1), maximum 100 investors (applying look-through rule). If using Rule 3(c)(7), unlimited investors (but all must be qualified purchasers). Most PE/VC funds use 3(c)(1) to allow broader LP participation. Mega-funds sometimes use 3(c)(7) to accommodate larger LP bases.
Yes, though less common. LLCs provide flexibility but typically involve different tax treatment and operating procedures. Most PE/VC funds prefer the LP structure because it's standard, familiar to LPs, and aligns with market conventions.
Form the fund after soft circle is established (30-40% soft commitments) but before first close. This avoids filing legal documents without LP demand but ensures documentation is ready for first close. Premature fund formation creates unnecessary legal costs; late formation creates risk of missing first close timeline.
Typical costs for first-time GPs:
This is before management team salaries, office, and operational costs. Most emerging managers budget $300-400K for first 18 months of fund formation and setup.
Missing Form D deadlines jeopardizes the fund's Reg D exemption and could force registration. Missing Form ADV or Form PF deadlines can result in SEC enforcement action. Missing state registration deadlines can result in state enforcement. Missing compliance updates can result in SEC examination findings. These are all significant and material. Maintain systematic calendars and use compliance checklists to prevent missed deadlines.
Yes. Form ADV allows advisers to manage multiple fund types. However, the adviser must disclose all fund types and comply with all applicable regulations for each. Compliance complexity increases materially. Some advisers maintain separate entities to simplify compliance.
