The SEC has proposed rules regarding the exemptions from the registration requirements of the Investment Advisers Act of 1940, as amended (the Advisers Act) for certain “private funds,” including venture capital funds.
The proposed rules would provide clarifications for purposes of implementing the new exemptions from registration enacted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act). Most significantly, the proposed rules would define “venture capital funds” whose managers may be exempt from registration and propose more limited recordkeeping and reporting requirements as to such funds.
The proposed rules would have a significant impact on venture capital funds and are likely to elicit comment from the venture capital community. Comments on the proposal will be due 45 days after the proposal is published in the Federal Register.
For dynamic updates regarding these issues, please visit our Seattle Venture Capital blog, The Venture Alley.
The Advisers Act imposes registration and other regulatory requirements on an “investment adviser,” which generally includes any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing or selling securities. Historically, advisers to private investment funds had relied on the so-called “private adviser” exemption, which exempted from registration those advisers with fewer than 15 clients (with each investment partnership treated as one client) and who neither hold themselves out generally to the public as investment advisers nor act as investment advisers to a registered investment company or business development company.
Due to “systemic risk” and other concerns primarily relating to hedge funds, the Dodd-Frank Act repealed the private adviser exemption and created new, and significantly more limited, exemptions. As a result, any pooled investment vehicle – from hedge funds to private equity buyout funds to venture capital funds – that had previously relied on the private adviser exemption must now either rely on one of the new, narrower exemptions or register as an investment adviser.
The SEC’s proposed rules implement the new, limited exemptions provided in the Dodd‑Frank Act for:
- Advisers solely to “venture capital funds”
- Advisers with less than $150 million in assets under management (AUM)
- Foreign advisers with less than $25 million in AUM attributable to US investors
This e-alert addresses the first exemption and the definition of “venture capital fund” for such purposes. Managers of even one fund that does not fall within the definition would be required to register under the Advisers Act (as there currently is no de minimis exception in the proposed rules) unless they qualify for another exemption.
The “Venture Capital Fund” Adviser Exemption
The SEC’s proposed rules define a “venture capital fund” for purposes of this exemption from registration as a fund that meets all of the following requirements:
- The fund must be a “private fund.” This means that the fund would be required to register as an investment company but for the exemptions provided in Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act of 1940, as amended. By way of background, among other limitations, 3(c)(1) funds have no more than 100 beneficial owners and 3(c)(7) funds may have more than 100 beneficial owners but all must be “qualified purchasers.”
- The fund must have represented itself to investors as a venture capital fund. We expect this requirement will elicit comments, particularly from funds that are “venture-like” but have attempted to market themselves differently to investors.
- The fund must own solely “equity securities,” cash, cash equivalents or US Treasuries with a maturity of 60 days or less. “Equity securities” is defined in 3(a)(11) of the Securities Exchange Act of 1934, as amended, and Rule 3a11-1 there under, and generally includes common stock, preferred stock, warrants and convertible securities (including convertible debt). This would restrict many types of highly liquid, short-term investments. It will also impose limitations on the types of debt investments a fund may make. For example, venture capital funds sometimes engage in non-convertible short-term bridge lending to their portfolio companies pending an upcoming financing, which would be prohibited by the proposed new rules.
- The fund must invest solely in “qualifying portfolio companies.” A “qualifying portfolio company” is a company that:
- Is not publicly traded (or controlled by a publicly traded company), measured at the time of each investment in the portfolio company by the fund.
- Does not borrow or issue debt obligations, directly or indirectly, in connection with the private fund’s investment in the portfolio company. This requirement will be an issue with various recapitalizations that involve combined debt and equity issuances by companies.
- Does not redeem, exchange or repurchase any securities of the company, or distribute to pre-existing security holders cash or other company assets, directly or indirectly, in connection with the private fund’s investment in such company. While this provision is intended to require the portfolio company to use funds for operating capital or expansion, it would also limit the ability of a portfolio company to resolve disputes that are common in start-up and closely held companies by buying out founders or dissident security holders.
- Is not itself a fund, whether an investment company (but for certain exemptions), a private fund or a commodity pool.
- The fund must acquire at least 80 percent of the equity securities of each qualifying company directly from the private company. Secondary transactions with a portfolio company’s existing investors or founders would be significantly limited, which complicates the ability to provide liquidity to founders in connection with an investment.
- The fund must control or have an arrangement whereby the fund or the investment adviser offers to provide and, if accepted, does so provide “significant guidance and counsel” concerning the management, operations or business objectives and policies of each qualifying portfolio company. This appears to be similar to “management rights” for purposes of ERISA’s venture capital operating company requirements and, presumably, a typical management rights letter (and the fund’s regular exercise of such rights) would satisfy this requirement.
- The fund must not incur leverage. The fund may not borrow, issue debt obligations, provide guarantees or otherwise incur leverage in excess of 15 percent of the fund’s aggregate capital contributions and uncalled committed capital, and any such leverage must be non-renewable and for a term of less than 120 calendar days. This requirement effectively removes buyout funds that utilize leverage for purposes of their acquisitions and investments.
- The fund must not offer redemption rights to its investors. The fund may only issue securities the terms of which do not provide a holder with any right, except in “extraordinary circumstances,” to withdraw, redeem or require the repurchase of such securities, although the fund may entitle holders to receive pro rata distributions.
Grandfather Relief for Existing Funds
Generally, these proposed rules would also treat certain existing funds as a “venture capital fund” for purposes of the above exemption, provided that the existing fund:
Has represented to investors and potential investors at the time of the offering of the private fund’s securities that it is a venture capital fund;
Prior to December 31, 2010, has sold securities or commitments to one or more investors even if those commitments have not been called (provided that they are not related persons of any investment adviser of the private fund); and
Does not sell any securities to (including accepting any additional capital commitments from) any person after July 21, 2011.
If the fund meets these grandfathering conditions, it would not be required to satisfy the stricter definition of a venture capital fund applicable to new funds.
Record Keeping Requirements for Exempted Funds
The SEC has also proposed rules that would require ongoing recordkeeping and reporting requirements for exempted funds (including venture capital funds meeting the above definition or exempted under the grandfathering conditions). Under the proposed rules, exempt reporting advisers would still be required to file, and periodically update, reports with the SEC, using the same registration form as registered advisers. Rather than completing all of the items on the form, however, exempt reporting advisers would fill out a limited subset of items, including:
- Basic identifying information of the adviser and the identity of its owners and affiliates.
- Information about the private funds the adviser manages and about other business activities that the adviser and its affiliates are engaged in that present conflicts of interest that may suggest significant risk to clients.
- The disciplinary history of the adviser and its employees that may reflect on their integrity.
Exempt reporting advisers would file reports on the Investment Adviser Registration Depository (IARD) system, and these reports would be publicly available on the Investment Adviser Public Disclosure (IAPD) website.
These exemptions would not limit the SEC’s statutory authority to examine the books and records of advisers relying on the new exemptions; however, it is not yet clear whether and how the SEC would attempt to use this authority in this context.
It is critical that the SEC’s definition of “venture capital fund” function for the venture capital community. Unfortunately, several aspects of the proposed rule may create challenges for start-up company capital formation and ongoing operation. In light of the SEC’s tight timetable for adopting an unprecedented number of Dodd-Frank Act rulemakings, it is important that fund managers closely review the proposed rules, evaluate how they will impact their business and, if appropriate, contact the SEC directly or through counsel to comment on the proposed rules.
We are actively monitoring these issues and would be happy to answer any questions you may have.
You may also enjoy our reports on breaking developments around Dodd-Frank