The Dodd-Frank Act repealed the “private adviser exemption” contained in section 203(b)(3) of the Investment Advisers Act on which advisers to many venture capital funds vehicles had relied in order to avoid registration under the Investment Advisers Act. Section 407 of the Dodd-Frank Act created an exemption from registration under the Investment Advisers Act for those who act as investment advisers solely to venture capital funds and directed the SEC to define the term “venture capital.” The SEC has issued proposed rules (Release No. IA-3111) regarding the definition of the term. Ultimately, the SEC proposal may define venture capital so narrowly to make the exemption of little practical significance. And even if a venture capital fund can rely on the exemption, it may still be subject to burdensome SEC reporting requirements under another SEC proposal.
The SEC proposes to define a venture capital fund as a private fund that:
- invests in equity securities of private companies in order to provide operating and business expansion capital (i.e., “qualifying portfolio companies,”) and at least 80 percent of each company’s securities owned by the fund were acquired directly from the qualifying portfolio company;
- directly, or through its investment advisers, offers or provides significant managerial assistance to, or controls, the qualifying portfolio company;
- does not borrow or otherwise incur leverage (other than limited short-term borrowing);
- does not offer its investors redemption or other similar liquidity rights except in extraordinary circumstances;
- represents itself as a venture capital fund to investors; and
- is not registered under the Investment Company Act and has not elected to be treated as a business development company, or BDC.
Qualifying Portfolio Company
The SEC proposes to define a venture capital fund for the purposes of the exemption as a fund that invests in equity securities issued by “qualifying portfolio companies,” which the SEC defines generally as any company that:
- is not publicly traded;
- does not incur leverage in connection with the investment by the private fund;
- uses the capital provided by the fund for operating or business expansion purposes rather than to buy out other investors; and
- is not itself a fund (i.e., is an operating company).
Private Companies. The SEC proposes to define a venture capital fund as a fund that invests in equity securities of qualifying portfolio companies and cash and cash equivalents and U.S. Treasuries with a remaining maturity of 60 days or less. At the time of each investment by the venture capital fund, the portfolio company could not be publicly traded nor could it control, be controlled by, or be under common control with, a publicly traded company. Under the proposed definition, a venture capital fund could continue to hold securities of a portfolio company that subsequently becomes public.
Equity Securities Etc. The SEC proposes to define venture capital fund for purposes of the exemption as a fund that invests in equity securities of qualifying portfolio companies, cash and cash equivalents and U.S. Treasuries with a remaining maturity of 60 days or less. Under the proposed definition, a fund would not qualify as a venture capital fund for purposes of the exemption if it invested in debt instruments (unless they met the definition of “equity security”) of a portfolio company or otherwise lent money to a portfolio company, strategies that are not the typical form of venture capital investing. The SEC proposes to use the definition of equity security in section 3(a)(11) of the Securities Exchange Act of 1934, or the Exchange Act, and Rule 3a11-1 thereunder. This definition is broad, and includes common stock as well as preferred stock, warrants and other securities convertible into common stock in addition to limited partnership interests.
Portfolio Company Leverage. Proposed Rule 203(l)-1 would define a qualifying portfolio company for purposes of the exemption as one that does not borrow, issue debt obligations or otherwise incur leverage in connection with the venture capital fund’s investments. This definition of qualifying portfolio company would only exclude companies that borrow in connection with a venture capital fund’s investment, but would not exclude companies that borrow in the ordinary course of their business (e.g., to finance inventory or capital equipment, manage cash flows, and meet payroll). The SEC would generally view any financing or loan (unless it met the definition of equity security) to a portfolio company that was provided by, or was a condition of a contractual obligation with, a fund or its adviser as part of the fund’s investments as being a type of financing that is “in connection with” the fund’s investment.
Capital Used for Operating and Business Purposes. A qualifying portfolio company is one that does not distribute company assets to other security holders in connection with the venture capital fund’s investment in the company (which the SEC believes could be an indirect buyout). Under the proposed rule, an exempt adviser relying on section 203(1) of the Investment Advisers Act would not be eligible for the exemption if it advised these types of private equity funds that in effect acquire a majority of the equity securities of portfolio companies directly from other security holders. Correspondingly, the SEC also proposes to define a qualifying portfolio company for purposes of the exemption as one that does not redeem or repurchase outstanding securities in connection with a venture capital fund’s investment. Because at least 80% of each portfolio company’s equity securities in which the fund invests must be acquired directly from the portfolio company, a venture capital fund relying on the exemption could purchase the remainder of the securities directly from existing shareholders (i.e., a “buyout”). Under the proposed definition, however, a company that achieves an indirect buyout of its security holders, such as through the complete recapitalization or restructuring of the portfolio company capital structure would not be a qualifying portfolio company.
Operating Companies. Proposed Rule 203(l)-1 would define the term qualifying portfolio company for the purposes of the exemption to exclude any private fund or other pooled investment vehicle.
To qualify as a venture capital fund under the proposed definition, the fund or its investment adviser would:
- have an arrangement under which it offers to provide significant guidance and counsel concerning the management, operations or business objectives and policies of the portfolio company (and, if accepted, actually provides the guidance and counsel); or
- control the portfolio company.
The SEC believes a key distinguishing characteristic of venture capital investing is the assistance beyond the mere provision of capital. Therefore it proposes that advisers seeking to rely on the rule have a significant level of involvement in developing a fund’s portfolio companies. According to the SEC, managerial assistance generally takes the form of active involvement in the business, operations or management of the portfolio company, or less active forms of control of the portfolio company, such as through board representation or similar voting rights. The SEC acknowledges that the nature of managerial assistance may evolve over time as the needs of qualifying portfolio companies change, and hence the proposed rule does not specify that managerial assistance has a fixed character.
Limitation on Leverage
Under proposed Rule 203(l)-1, the definition of a venture capital fund for purposes of the exemption would be limited to a private fund that does not borrow, issue debt obligations, provide guarantees or otherwise incur leverage, in excess of 15 percent of the fund’s capital contributions and uncalled committed capital, and any such borrowing, indebtedness, guarantee or leverage is for a non-renewable term of no longer than 120 calendar days.
No Redemption Rights
Proposed Rule 203(l)-1 would define a venture capital fund as a fund that issues securities that do not provide investors redemption rights except in “extraordinary circumstances” but that do entitle investors generally to receive pro rata distributions. Unlike hedge funds, venture capital funds do not typically permit investors to redeem their interests during the life of the fund, but rather distribute assets generally as investments mature. Although venture capital funds typically return capital and profits to investors only through pro rata distributions, such funds may also provide extraordinary rights for an investor to withdraw from the fund under foreseeable but unexpected circumstances or rights to be excluded from particular investments due to regulatory or other legal requirements. The trigger events for these rights are typically beyond the control of the adviser and fund investor (e.g., tax and regulatory changes).
Represents Itself as a Venture Capital Fund
Proposed Rule 203(l)-1 would limit the definition of venture capital fund for the purposes of the exemption to a private fund that represents itself as being a venture capital fund to its investors and potential investors. A private fund could satisfy this definitional element by, for example, describing its investment strategy as venture capital investing or as a fund that is managed in compliance with the elements of the SEC’s proposed rule. Without this element, a fund that did not engage in typical venture capital activities could be treated as a venture capital fund simply because it met the other elements specified in the proposed rule (because for example it only invests in short term treasuries, controls portfolio companies, does not borrow, does not offer investors redemption rights, and is not a registered investment company).
The SEC proposes to define a venture capital fund for the purposes of the exemption as a “private fund,” and exclude from the proposed definition funds that are registered investment companies (e.g., mutual funds) or have elected to be regulated as BDCs. A “private fund,” as defined in the Investment Advisers Act, is an entity that would be an investment company under the Investment Company Act but for the exceptions in section 3(c)(1) or 3(c)(7) of the Investment Company Act.
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