This is the sixth post in a series exploring recent SEC regulations which define the term “venture capital fund” for the purposes of determining whether a fund’s manager is exempt from SEC registration requirements under the Dodd-Frank Act.
Previously in the first installment of this series, I provided a general overview of how the SEC has defined the term “venture capital fund.” A private fund manager that solely advises venture capital funds (as defined in SEC regulations) qualifies for an exemption from investment adviser registration under the Investment Advisers Act. There are five elements to the definition. The first element is that the fund must represent to investors and potential investors that it pursues a venture capital strategy. The second element is that no more than 20% of the fund’s total assets (including committed but not yet invested capital) can be invested in assets that are not “qualifying investments” or “short term holdings.” In the third installment and the fourth installment of this series, I discussed what constitutes a “qualifying investment,” which, roughly speaking, is an equity security issued by a private company which is not an investment fund and which does not incur debt in connection with the VC fund’s investment. The fifth installment discussed what constitutes a “short-term holding.” In this sixth installment, I will discuss what the “non-qualifying basket” is and how it works.The “non-qualifying basket” refers to the portfolio of investments which are not “qualifying investments” or “short term holdings.” As I’ve mentioned previously, no more than 20% of a venture capital fund’s total assets, including committed but not yet invested capital, can be invested in assets that are not “qualifying investments” or “short term holdings.” Therefore, the non-qualifying basket can be no larger than 20% of the fund’s total assets, including committed capital.
The fund must make the calculation as to whether it exceeds the 20% limit at the time each investment is made. However, the test is not applied continuously, so if certain qualifying investments subsequently decline in value or if non-qualifying investments increase in value, the fund will still be in compliance with regulations even if such price changes would cause the non-qualifying basket to exceed the 20% limit. Nonetheless, the fund would be unable to acquire any non-qualifying investment until the percentage of non-qualifying investments fell back below the 20% threshold.
Another wrinkle is that all capital commitments must be bona fide; that is, a fund cannot have “investors” commit to provide capital with the understanding that the capital would never be called. The SEC has taken the position that any such arrangement would reduce the amount of committed capital used in calculating the ratio. However, if an investor never provides the capital despite the bona fide intent by the fund manager to call it, the committed capital still counts in calculating the ratio.
In addition, venture capital funds may choose one of two methods in its ongoing calculations used to verify compliance with the limits on non-qualifying investments. A fund may choose to value each investment at its fair value, which essentially is a “mark to market” approach. So, if the value of a fund’s non-qualifying basket declined due to market fluctuations, the fund would be permitted to purchase additional non-qualifying investments if they did not cause the fund to exceed the 20% limit when all assets are valued at fair market value. However, this could get expensive, as many of the fund’s investments are likely to be illiquid and thus difficult to value, necessitating frequent appraisals. The other approach a fund may take is to value all investments at their historical cost, so that the value of an investment never changes regardless of market fluctuations. This approach avoids the frequent appraisals that would be necessary if the fund chose to use fair value in its calculations. A fund manager may be temped to use one method on some occasions and another method on other occasions, but the SEC has taken the view that this is not permitted. The same method must be used to value all investments continuously throughout the life of the fund.
The non-qualifying basket is a useful tool for venture capital funds to enter into non-qualifying transactions, such as bridge loans to portfolio companies or potential portfolio companies or purchases of publicly traded securities, without losing their status as a venture capital fund. As always, you should consult an attorney who is familiar with securities regulatory issues in assessing whether your particular fund management business is required to register with the SEC.
© 2011 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.