What Is the 3(c)(7) Exemption?

The 3(c)(7) exemption refers to a portion of the Investment Company Act of 1940 that allows private investment companies an exemption from some Securities and Exchange Commission (SEC) regulation, providing that they meet certain criteria. 3C7 is shorthand for the 3(c)(7) exemption.

Understanding the 3(c)(7) Exemption

The exemption, found in section three of the act, reads in part: 

Section 3
(3)(c) Notwithstanding subsection (a), none of the following persons is an investment company within the meaning of this title:
(7)(A) Any issuer, the outstanding securities of which are owned exclusively by persons who, at the time of acquisition of such securities, are qualified purchasers, and which is not making and does not at that time propose to make a public offering of such securities.

To qualify for the 3C7 exemption, the private investment company must show that they have no plans of making an initial public offering (IPO) and that their investors are qualified purchasers. A qualified purchaser is a higher standard than an accredited investor; it requires that the investor owns not less than $5 million in investments. The term “qualified purchaser” is defined in Section 2(a)(51) of the Investment Company Act.

3C7 funds are not required to go through Securities and Exchange Commission registration or provide ongoing disclosure. They are also exempt from issuing a prospectus that would outline investment positions publicly. 3C7 funds are also referred to as 3C7 companies or 3(c)(7) funds.  

The Investment Company Act of 1940 defines an “investment company” as an issuer that “holds itself out as being engaged primarily or proposes to engage primarily, in the business of investing, reinvesting or trading in securities.” 3C7 is one of two exemptions in the Investment Company Act of 1940 that hedge funds, venture capital funds, and other private equity funds use to avoid SEC restrictions.

This frees up these funds to use tools like leverage and derivatives to an extent that most publicly traded funds cannot. The vast majority of new hedge funds, private equity funds, venture capital funds, and other private investment vehicles are organized so as to fall outside the purview of the Investment Company Act of 1940.

That said, 3C7 funds must maintain their compliance to continue utilizing this exemption from the 1940 Act. If a fund were to fall out of compliance by taking in investments from non-qualified purchasers, for example, it would open itself to SEC enforcement actions as well as litigation from its investors and any other parties it has contracts with. 

3C7 Funds vs. 3C1 Funds

Both 3C7 and 3C1 funds are exempted from the requirements imposed on “investment companies” under the Investment Company Act of 1940 (the “Act”). However, there are important differences between them. 3C7 funds, as noted, take investments from qualified purchasers, whereas 3C1 funds work with accredited investors.

Investors in 3C7 funds are held to a higher wealth measure than those in 3C1 funds, which can limit the investor pool that a fund is hoping to raise money from. That said, 3C1 funds are capped at 100 investors total, limiting the number of investors the fund can take in from the wider pool they are allowed to pull from.

3C7 funds don’t have a set cap. However, 3C7 funds will fall under the regulation that is stipulated in the Securities Exchange Act of 1934 when they reach 2,000 investors. At this point, private funds are subject to increased SEC scrutiny and have more in common with public companies.

What Is the Average Annual Return (AAR)?

The average annual return (AAR) is a percentage used when reporting the historical return, such as the three-, five-, and 10-year average returns of a mutual fund. The average annual return is stated net of a fund’s operating expense ratio. Additionally, it does not include sales charges, if applicable, or portfolio transaction brokerage commissions.

In its simplest terms, the average annual return (AAR) measures the money made or lost by a mutual fund over a given period. Investors considering a mutual fund investment will often review the AAR and compare it with other similar mutual funds as part of their mutual fund investment strategy.

Understanding the Average Annual Return (AAR)

When you are selecting a mutual fund, the average annual return is a helpful guide for measuring a fund’s long-term performance. However, investors should also look at a fund’s yearly performance to fully appreciate the consistency of its annual total returns.

For example, a five-year average annual return of 10% looks attractive. However, if the yearly returns (those that produced the average annual return) were +40%, +30%, -10%, +5% and -15% (50 / 5 = 10%), performance over the past three years warrants examination of the fund’s management and investment strategy.

Components of an Average Annual Return (AAR)

There are three components that contribute to the average annual return (AAR) of an equity mutual fund: share price appreciation, capital gains, and dividends.

Share Price Appreciation

Share price appreciation results from unrealized gains or losses in the underlying stocks held in a portfolio. As the share price of a stock fluctuates over a year, it proportionately contributes to or detracts from the AAR of the fund that maintains a holding in the issue.

For example, the American Funds AMCAP Fund’s top holding is Netflix (NFLX), which represents 3.7% of the portfolio’s net assets as of Feb. 29, 2020. Netflix is one of 199 equities in the AMCAP fund. Fund managers can add or subtract assets from the fund or change the proportions of each holding as needed to meet the fund’s performance objectives. The fund’s combined assets have contributed to the portfolio’s 10-year AAR of 11.58% through Feb. 29, 2020.

Capital Gains Distributions

Capital gains distributions paid from a mutual fund result from the generation of income or sale of stocks from which a manager realizes a profit in a growth portfolio. Shareholders can opt to receive the distributions in cash or reinvest them in the fund. Capital gains are the realized portion of AAR. The distribution, which reduces share price by the dollar amount paid out, represents a taxable gain for shareholders.

A fund can have a negative AAR and still make taxable distributions. The Wells Fargo Discovery Fund paid a capital gain of $2.59 on Dec. 11, 2015, despite the fund having an AAR of negative 1.48%.

Dividends

Quarterly dividends paid from company earnings contribute to a mutual fund’s AAR and also reduce the value of a portfolio’s net asset value (NAV). Like capital gains, dividend income received from the portfolio can be reinvested or taken in cash.

Large-cap stock funds with positive earnings typically pay dividends to individual and institutional shareholders. These quarterly distributions comprise the dividend yield component of a mutual fund’s AAR. The T. Rowe Price Dividend Growth Fund has a trailing 12-month yield of 1.36%, a contributing factor to the fund’s three-year AAR of 15.65% through Feb. 29, 2020.

Special Considerations

Calculating an average annual return is much simpler than the average annual rate of return, which uses a geometric average instead of a regular mean. The formula is: [(1+r₁) x (1+r₂) x (1+r₃) x … x (1+r_i)] ^(1/n) – 1, where r is the annual rate of return and n is the number of years in the period.

The average annual return is sometimes considered less useful for giving a picture of the performance of a fund because returns compound rather than combine. Investors must pay attention when looking at mutual funds to compare the same types of returns for each fund.