Restricted Securities

Tin Handcuffs

There is often considerable slippage between the returns reported by notably successful PI managers and the returns pocketed by these same managers' clients. Since most God-fearing PI managers report results net of fees, the slippage to which we're referring cannot be attributed to sums pocketed by the managers themselves. Rather, it is attributable primarily to the clients' necessarily imperfect handling of restricted securities - a/k/a "letter stock," "legend stock," "Rule 144 stock," or simply "144 stock." To be sure, many PI managers try to avoid distributing restricted securities to their clients, preferring instead to postpone in-kind distributions of shares in once private but now public companies until all restrictions on their sale have lapsed. But it is impossible to adhere to this rule in all cases (e.g., as a partnership approaches its termination date), and clients' inability to sell restricted securities immediately upon their receipt inevitably creates a gap between the internal rates of return ("IRRs") reported by PI funds making in-kind distributions and the IRRs actually pocketed by their investors. PI funds' IRRs are quite logically based on the market value of in-kind distributions on the date the distributions are made, regardless of the stocks' subsequent performance. If the shares in question soar in price after they're distributed, the gap to which we're referring can be hugely positive. Alas, the types of stocks that get distributed in-kind tend to be highly volatile, and ill-timed sales (after restrictions lapse) as well as the holding of shares that perform poorly post-distribution can cause the gap in question to be sharply negative. Consequently, it behooves all investors with exposure to private equity strategies to understand the rules governing restricted securities.

Unwitting Underwriters

The number 144 pops up a lot with respect to restricted securities because that is the number of the SEC Rule governing their sale. The aim of Rule 144 is to prevent companies from doing indirectly that which they cannot do directly, namely conduct a public offering of securities without filing a registration statement with the SEC. Actually, there are several perfectly legal ways of issuing securities without registering them with the SEC and several types of "144 transactions" that have nothing whatsoever to do with the types of investments comprising the TIFF PI Program. But for our purposes it's sufficient to note the following: if a private company sells stock to a venture capital fund and that fund in turn distributes the shares to its limited partners, the LPs cannot simply sell the shares on the open market. Absent numerous filings by the company in question and a proper time lag between the vc fund's initial purchase and the investors' open-market sales, the sales could cause the LPs to be deemed "underwriters." This may not be a horrible epithet to some readers - "undertaker" is arguably a nastier appellation, to say nothing of "gold bug" - but the legal consequences of being an unwitting underwriter are dreadful indeed.

Living By the Rules

With the caveat that readers should consult their own legal counsel before trading restricted securities, we will summarize as succinctly as possible relevant aspects of the rules governing their sale. By "relevant aspects" we mean rules governing the situation in which institutional LPs typically find themselves with respect to in-kind distributions. Typically, the shares in question will be those of a company that has "gone public" quite recently. Assuming that the LPs interested in selling are not "affiliates" of the company (i.e., in a position to control its affairs or obtain inside information about it), the two main hurdles that must be surmounted prior to a sale are (1) holding period restrictions and (2) sales volume restrictions. As of May 1997, the mandatory holding period applicable to most institutional LPs is just one year (down from two under pre-May 1997 rules). The volume restrictions are too arcane to discuss here, but they lapse entirely once the securities have been held for two years. Importantly, the holding period for most 144 sales involving institutional LPs (such as the TIFF PI Program) starts when the private equity fund in which they're investors itself purchased the shares.