Introduction

For sponsors seeking to offer private wealth investors access to private markets outside of a fund registered under the Investment Company Act of 1940, as amended, the operating company (OpCo) structure offers a unique access point. The OpCo structure can provide access to a range of asset classes, including private equity, infrastructure and asset-backed assets and flexible economics. An OpCo is structured to fall outside the definition of an “investment company” under the 1940 Act and, accordingly, may provide a greater degree of regulatory flexibility than other structures that either register under the 1940 Act or rely on other exclusions from “investment company” status. This article explains how to utilize an OpCo structure and examines its principal benefits and drawbacks.

To see how OpCos can be structured to fall outside the definition of an investment company, it is necessary to examine the two principal paths in the 1940 Act by which an issuer may be deemed an investment company—and thus, how the issuer might be excluded from such a designation. The first path, Section 3(a)(1)(A), focuses on whether the issuer is primarily engaged in the business of investing, reinvesting or trading in securities, while the second, Section 3(a)(1)(C), looks to whether the issuer holds investment securities in excess of the statutory 40% threshold on an unconsolidated basis. Although the two provisions are related, they address different questions and should be analyzed separately.

Section 3(a)(1)(A): The Primary Engagement Test

Section 3(a)(1)(A) under the 1940 Act defines an “investment company” as any issuer that is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting or trading in securities. Determining whether an issuer engages in these activities depends not only on the composition of an issuer’s assets but also on the nature of its business and how it presents itself to investors. The primary test used to make this determination was promulgated by the U.S. Securities and Exchange Commission in its decision in Tonopah Mining Co. (26 S.E.C. 426 (1947)), which analyzes the following five factors: (1) an issuer’s historical development, (2) its public representations of policy, (3) the activities of its officers and directors, (4) the nature of its present assets and (5) the sources of its present income (together, the “Tonopah Factors”). In the case of an OpCo structure, the threshold question under Section 3(a)(1)(A) is, therefore, whether the issuer is primarily engaged in an operating business, directly or through majority-owned subsidiaries, rather than in the business of investing in securities. That inquiry comes before, and is distinct from, the separate asset-based analysis under Section 3(a)(1)(C), including the 40% test, which we discuss next.

Section 3(a)(1)(C): The 40% Test

Section 3(a)(1)(C) under the 1940 Act defines an “investment company” as any issuer that is engaged, or proposes to engage, in the business of investing, reinvesting, owning, holding or trading in securities and that owns or proposes to acquire “investment securities” having a value exceeding 40% of the value of its total assets (exclusive of U.S. government securities and cash items) on an unconsolidated basis.

Importantly, Section 3(a)(2) provides that the term “investment securities” does not include securities issued by majority-owned subsidiaries of the owner (i.e., where the parent owns 50% or more of the outstanding voting securities) provided that such subsidiaries are not themselves investment companies and are not relying on the exclusions from the definition of investment company in Section 3(c)(1) or 3(c)(7) of the 1940 Act.

OpCo structures take advantage of this “carve out” provided for in Section 3(a)(2) by organizing as holding companies that conduct business through majority-owned subsidiaries, each of which qualifies for an exception from the 1940 Act other than the exceptions in Sections 3(c)(1) and 3(c)(7). The OpCo can utilize this structure to keep its investment securities below 40% of total assets and therefore fall outside the 1940 Act’s definition.

The Asset Classification Framework: Good Basket, Bad Basket

In applying the Section 3(a)(1) (C) 40% test and the definition of “investment securities” in Section 3(a)(2), an OpCo’s assets are often grouped into “good” and “bad” baskets. The good basket generally consists of securities issued by majority-owned subsidiaries that are not investment companies and are not relying on Sections 3(c)(1) or 3(c) (7). The bad basket generally consists of securities issued by subsidiaries that rely on Section 3(c)(1) or 3(c)(7), as well as minority equity interests and debt investments that constitute investment securities.

One key implication of this classification framework is that, because the 40% test is applied at the OpCo level on an unconsolidated basis, leverage incurred at the subsidiary level can expand a subsidiary’s asset base without necessarily increasing the value of the parent’s investment in that subsidiary and therefore may permit growth of the subsidiary’s portfolio without a corresponding increase in the parent’s bad basket.

Good basket subsidiaries generally qualify for exception from the 1940 Act in one of two ways: due to the type of assets held and due to their form. The following high-level summary of applicable exclusions from the 1940 Act is intended only as a guide and should be considered together with analysis of applicable SEC rules, regulations and guidance.

Asset-Based Exclusions

Section 3(c)(3) and Rule 3a-6—Insurance Companies. U.S. and foreign insurance companies (as defined under the 1940 Act), respectively.

Section 3(c)(4) — Small Loan Companies. A person substantially all of whose business is confined to making small loans, industrial banking or similar businesses.

Sections 3(c)(5)(A) — Purchasers of Sales Financing. Any person who is not engaged in issuing redeemable securities and who is primarily engaged in purchasing or otherwise acquiring “notes, drafts, acceptances, open accounts receivable, and other obligations representing part or all of the sales price merchandise, insurance, and services.”

Sections 3(c)(5)(B) — Originators of Sales Financing. Any person who is not engaged in issuing redeemable securities and who is primarily engaged in “making loans to manufacturers, wholesalers, and retailers of, and to prospective purchasers of, specified merchandise, insurance, and services.”

Section 3(c)(5)(C) — Real Estate. Any person who is not engaged in issuing redeemable securities and who is primarily engaged in purchasing or otherwise acquiring “mortgages and other liens on and interests in real estate.”

Section 3(c)(6) — Holding Company. Any company primarily engaged, directly or through majority-owned subsidiaries, in one or more of the businesses described in paragraphs (3), (4) and (5) of Section 3(c), or in one or more of such businesses (from which not less than 25% of such company’s gross income during its last fiscal year was derived) together with an additional business or businesses other than investing, reinvesting, owning, holding or trading in securities.

Section 3(c)(9) — Energy and Mineral Companies. Any person “substantially all of whose business consists of owning or holding oil, gas or other mineral royalties or leases, or fractional interests therein, or certificates of interest or participation in or investment contracts relative to such royalties, leases or fractional interests.”

Form-Based Exclusions

Asset Management Subsidiaries. Companies organized primarily to provide asset management services. (Note that minority ownership of or debt investments in asset managers would not qualify.)

Rule 3a-7 Subsidiaries. Issuers of fixed-income or other non-redeemable securities whose holders receive payments depending primarily on the cash flow from “eligible assets”—financial assets that by their terms convert into cash within a finite time period, including secured and unsecured loans, mezzanine loans, preferred equity with a fixed maturity and CLO debt tranches. The issuer is limited in its ability to buy and sell assets and must engage a trustee.

Benefits and Drawbacks

The OpCo structure offers certain advantages over a fund that is registered under the 1940 Act:

• not subject to 1940 Act restrictions on affiliate transactions, leverage, custody and board composition;
• ability to issue multiple share classes with varied management and performance fee structures, including performance fees on capital gains, by class;
• reporting under the Securities Exchange Act of 1934 only;
• potential freedom from the 25% ERISA limitation on ownership by benefit plans, IRAs, and other tax-exempt investors; and
• access to hard assets (aviation, infrastructure, real estate) and consumer credit strategies (auto loans, student loans, litigation finance, peer-to-peer loans) through a single holding company vehicle.

The drawbacks are:

• Significant investor and intermediary education is required, as the structure is unfamiliar compared to funds registered under the 1940 Act.
• No secondary trading absent an exchange listing; limited liquidity for investors.
• Sales are limited to “accredited investors” absent a Securities Act of 1933 registered offering.
• Subscription agreements are required, and securities are not NSCC eligible, creating distribution friction.
• Continuous structuring and monitoring obligations are required to maintain operating company status at every tier of the structure.

Conclusion

The OpCo structure can be a useful vehicle for sponsors seeking access to alternative asset classes outside of the 1940 Act’s regulatory regime. Success requires disciplined entity-by-entity analysis of the 40% test on an unconsolidated basis, careful good/bad basket management and integration of tax efficiency from Day One. The consequences of inadvertently crossing the investment company threshold are severe, and continuous monitoring is essential. For sponsors and their counsel prepared to invest in structuring work, the OpCo framework offers commercial, operational and investor-level flexibility that is harder to replicate in a 1940 Act registered fund.

Private Equity Report Spring 2026, Vol 26, No 1