This is the eighth post in a series exploring recent SEC regulations that 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.” The third element is the fund cannot borrow in excess of 15 percent of the fund’s aggregate capital contributions and uncalled committed capital. In this post, I will discuss the fourth element of the definition, which limits the redemption rights of investors in a venture capital fund.
The regulations require that a VC fund only issue securities the terms of which do not provide an investor with a right, except in “extraordinary circumstances,” to withdraw, redeem, or require the repurchase of such securities. A fund is permitted to make pro rata distributions to investors. The first question that comes to mind is what exactly does “extraordinary circumstances” mean. The SEC has provided some guidance in its comments to the rule, where it states that “extraordinary circumstances” would generally be limited to events beyond the control of the fund manager or investor. The sole example the SEC gives is a material change in law or regulation. Suffice to say that the SEC intends that this exception will be extremely limited in scope.
One issue that could crop up is whether a fund manager would be able to take distributions from its carried interest without a pro rata distribution to investors, as some fund managers do. The commentary implies that the SEC’s view is that it can. The reason for this is that the regulations provide that a VC fund can only issue securities that do not have redemption rights. A fund manager’s carried interest is usually in the form of a general partnership interest of a limited partnership or a managing member interest of a limited liability company, which in the context of a fund formation, would not be considered a security. However, there are some potential problems. Some fund structure their carried interest as a limited partnership interest held by a “special limited partner” that is an entity separate from the fund manager. Such a limited partnership interest may be deemed to be a security, and consequently, a fund structured in this manner may not be able to make distributions of the fund manager’s carried interest without a corresponding pro rata distribution to investors.
Another issue that this requirement raises is whether it prohibits transfers of an investor’s interest in a VC fund. The offering documents of private funds must restrict the transferability of interests in the fund as a condition to making use of Regulation D; however, there are certain exemptions such as Rule 144 or the so-called “Section 4(1 ½) exemption” that permit resale. Consequently, fund offering documents frequently provide that an owner of an interest in the fund may transfer its interest upon obtaining an opinion of counsel stating that a resale exemption applies. Does such a provision violate the redemption restriction? The commentary to the rule implies that the SEC’s opinion is that it does not, provided that the fund manager is not providing de facto redemption rights by regularly assisting the investors in finding potential transferees. Therefore, it is advisable that VC funds avoid offering to help their investors find potential tranferees.
The restrictions on redemptions are largely in keeping with the venture capital fund industry’s practices. However, there will be some funds that will not qualify under the SEC’s definition as a result of this requirement. Funds that are “evergreen” (that continually accept new investors and allow redemptions as hedge funds usually do) or funds that utilize a “special limited partner” and intend to make distributions to the special limited partner that are not pro rata with the investors may have difficulty qualifying under the definition. 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.