This is the seventh 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.” A “qualifying investment” is, roughly speaking, 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. In this post, I will discuss the third element of the definition, which regulates the degree to which a VC fund can utilize leverage.
The leverage restriction has two basic requirements. First, a VC fund may not borrow, incur indebtedness, or guarantee debts of portfolio companies in a total amount in excess of 15% of the fund’s aggregate capital contributions and uncalled committed capital. What is interesting about this rule is that during early periods in the lifespan of a fund, before it has called all its capital, it can incur significant leverage. For example, if a fund has total capital commitments of $10 million, but only $2 million has been called thus far, the fund could theoretically incur leverage of up to $1.5 million because the 15% calculation is made using the total aggregate number. VCs will certainly appreciate that the calculation used to determine the maximum permitted leverage is very easy and straightforward, and never changes throughout the life fund, making compliance easy. On the other hand, the 15% limit is quite low and may push many venture capital founds outside of the SEC’s definition, necessitating RIA registration.
The second restriction on leverage is that any borrowing (including the borrowing incurred in compliance with the 15% limit) must be for a non-renewable term of no longer than 120 calendar days, except for guarantees of portfolio company debt. Therefore, any borrowing that does occur by a fund must be short term, unless such borrowing is incurred by a portfolio company. In addition, if the fund does guarantee portfolio company debt for a period greater than 120 days, the total debt guaranteed cannot be larger than the fund’s investment in that portfolio company.
As a result of these two requirements, the leverage restrictions contained in the SEC’s definition of a portfolio company are very limiting, effectively preventing any funds that use significant leverage from utilizing the venture capital exception to investment adviser registration.
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.