Are you raising equity to invest in Real Estate? Part II. Rules 506(b) and 506(c): What to know before launching your Real Estate Fund...
The 506(c) Difference
What is Rule 506(c)?
In 2012, Congress, as an aid to the US Economy, lifted the ban on publicizing securities offerings for issuers who raise investment equity from accredited investors.
The SEC created Rule 506(c) to outline the requirements investors must meet to participate in those offerings.
506(c)’s defining feature: A GP can perform general solicitation and advertising without any limitation on how much capital they can raise.
Who can invest in 506(c) securities?
Accredited investors are eligible to invest in 506(c) offerings, but unlike with the 506(b) exemption, the fund’s GP must take “reasonable steps to verify” that the purchasers are accredited or hire a third party to perform the verification.
How 506(c) investors can verify LP accreditation
What exactly does “reasonable steps to verify” mean? That depends on how the LP claims eligibility.
· If an LP is claiming accreditation based on income, the GP may need to obtain the LP’s tax forms for the previous two years. GPs also would have to obtain confirmation that the LP’s income will continue to meet the minimum threshold for accredited investors (which is $200,000 annually for an individual and $300,000 for a married couple) in the current year.
· If the LP claims accreditation based on net worth, GPs can review the LP’s assets by collecting proof of the purchaser’s assets and liabilities (for example, bank statements and brokerage reports) within the past three months. GPs must also obtain confirmation from the LP that all liabilities that could impact net worth have been disclosed. To be an accredited investor, an individual must have a net worth of more than $1 million, excluding their primary residence.
· If the LP claims accreditation based on one of the SEC’s recognized professional certifications, the GP would need to obtain a copy of that certification.
GPs may also get written confirmation from the investor’s attorney, broker dealer, registered investment adviser, or CPA confirming they took reasonable steps to verify the investor’s accreditation status in the past three months.
Once the fund manager verifies an investor’s accredited status, the investor can self-certify as an accredited investor with that GP for a period up to five years, assuming the GP doesn’t become aware of information to the contrary within that time-span.
506(c) benefits:
· Rule 506(c) offerings are not subject to state blue-sky laws.
· GPs can publicly market their capital-raising offer to a larger investor base, beyond just one-on-one conversations and emails within their personal and professional networks.
506(c) limitations:
· Verifying accredited investors takes up time and money.
· Many investors are reluctant to give sensitive information to GPs they don’t have a personal relationship with.
· Given the potential liability third parties take on when they certify investor accreditation, accountants and lawyers are unlikely to make these certifications except perhaps for very large, lucrative clients.
Due to these limitations, GPs with robust networks of accredited investors often seek to avoid compliance costs and regulatory risks by raising money under Rule 506(b).
On the flip side, emerging GPs without an established network of accredited investors could benefit from raising as a 506(c) because it allows them to solicit investors via social media, print advertising, or marketing.
Under the current rules, GPs that file a fundraise as a 506(b) offering are allowed to change the offering’s exemption status to 506(c) if they want to advertise their fund. But GPs who originally filed under 506(c) can’t reverse course and retroactively become a 506(b) if they’ve already advertised.