Section 203(l) of the Investment Advisers Act of 1940 (the “Advisers Act”), also known as the venture capital adviser exemption, provides that an investment adviser that solely advises venture capital funds is exempt from registration with the SEC under the Advisers Act. The term “venture capital fund” is not defined in the text of the Advisers Act; instead, the term is defined in SEC Rule 203(l)-1(a) as a private fund that meets certain conditions. This article looks at each of these conditions and explains what is needed to meet them.
Pursuing a Venture Capital Strategy
The first condition a fund must meet to qualify as a venture capital fund requires that the fund “[represent] to investors and potential investors that it pursues a venture capital strategy.” The standard for determining whether a fund is actually holding itself out as pursuing a “venture capital strategy” is a subjective one, depending on particular facts and circumstances. A fund is not necessarily required to use the words “venture capital” in the name of the fund. Rather, the SEC looks at the private fund adviser’s statements to investors and prospective investors as a whole. Nonetheless, in order to have a reasonable assurance that a private fund adviser is exempt from investment adviser registration, the offering materials of the fund should clearly and unambiguously state that the strategy being pursued is a venture capital strategy.
Investment Holding Limitation
The second condition requires that the fund:
“Immediately after the acquisition of any asset, other than qualifying investments or short-term holdings, holds no more than 20 percent of the amount of the fund’s aggregate capital contributions and uncalled committed capital in assets (other than short-term holdings) that are not qualifying investments, valued at cost or fair value, consistently applied by the fund”
In other words, the second element requires 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.” Both of these terms are defined in the regulation.
A “qualifying investment” is one of three things: (i) an equity security issued by a “qualifying portfolio company” that is acquired directly by the private fund from such qualifying portfolio company; (ii) any equity security that is issued by a qualifying portfolio company in exchange for another equity security of such qualifying portfolio company; and (iii) any equity security issued by a parent of a qualifying portfolio company in exchange for an equity security in that qualifying portfolio company. Item (ii) allows the fund to retain its interest in a qualifying portfolio company after a corporate reorganization or some other situation where there is some kind of exchange of equity interests. Item (iii) allows the fund to retain its interest in a qualifying portfolio company after the qualifying portfolio company has been acquired by another company, including a publicly traded company. In that instance, the qualifying portfolio company would become a majority-owned subsidiary of the new parent company.
There are two main consequences to this definition. First, qualifying investments must be equity and not debt. The term equity security is, thankfully, defined rather broadly and includes preferred stock, warrants, securities convertible into common stock, such as convertible debt, and limited partnership interests. However, bridge loans that are not convertible would not be considered a qualifying investment.
Second, they must be acquired by making an investment directly into a company and not acquired by purchasing them from a third party. So the venture capital fund would not be able to treat as a qualifying investment any interest in a company that it acquires on the secondary market or through buying out existing owners or management without treating that interest as part of its 20% non-qualifying basket. However, a qualifying investment retains its status as such after a corporate reorganization or buyout where the qualifying portfolio company’s equity interests are exchanged for new equity interests in the same company or in another company which acquires the qualifying portfolio company.
Qualifying Portfolio Companies
The next important question is: what is a “qualifying portfolio company?” A “qualifying portfolio company” has three requirements: (i) at the time of the investment by the fund, the company must not be a reporting company under the Securities Exchange Act of 1934 nor be listed or traded on any foreign exchange and is not an affiliate of (i.e. directly or indirectly under common control with) an Exchange Act reporting company or a publicly traded foreign company; (ii) the company may not borrow or issue debt obligations in connection with the fund’s investment in the company and distribute to the fund the proceeds of such borrowing or issuance in exchange for the private fund’s investment (i.e. no leveraged buyouts); and (iii) it cannot be a mutual fund, hedge fund, private equity fund, another venture capital fund, a commodity pool fund, or an issuer of asset backed securities.
The first requirement of a “qualifying portfolio company” ensures that any company that a venture capital fund invests in (other than its 20% non-qualifying basket) is not a publicly traded company. This is not a controversial requirement given that an essential element of a venture capital strategy is to invest in a young company and potentially take it public. The venture capital fund can retain this investment even after the company goes public as the test for whether an investment is a “qualifying investment” is applied at the time of initial investment by a fund. However, if the fund acquires additional shares of a portfolio company after it goes public, then that investment would not be considered a “qualifying investment.” Therefore, if a venture capital fund is asked to enter into an agreement to participate in all future rounds of financing of a portfolio company, that any such requirement carves out shares sold in an IPO. Such an agreement could inadvertently require them to purchase non-qualifying investments, which could result in the venture capital fund’s investment adviser being required to register with the SEC under the Advisers Act. The second requirement of the “qualifying portfolio company” definition ensures that leveraged buyout funds or other private funds that finance their portfolio acquisitions by causing their portfolio companies to incur indebtedness will not fit within the definition of a venture capital fund. Together with the requirement that a “qualifying investment” must be an equity security acquired directly from the portfolio company, this requirement effectively limits the variety of transactions that venture capital funds can enter into while still maintaining an exemption for its investment adviser.
The final requirement of the definition ensures that the definition of the term “venture capital fund” will not include any kind of fund of funds, even if the underlying funds are themselves venture capital funds. Of course, a venture capital fund can invest in other funds as part of its non-qualifying basket.
Recall that at least 80% of the fund’s investments must be in “qualifying investments” or “short-term holdings.” The definition of “short-term holdings” is limited to the following: (i) bank deposits, certificates of deposit, bankers acceptances, and similar bank instruments; (ii) U.S. Treasuries with a remaining maturity of 60 days or less; and (iii) money market funds. This definition is very restrictive. While some funds may want to park their assets in relatively low-risk liquid investments such as commercial paper, municipal bonds, foreign debt, and repurchase agreements, none of these assets would qualify. A venture capital fund may certainly invest in these assets as part of its 20% non-qualifying basket but must steer clear of them as a general cash management tool.
The Non-Qualifying Basket
The “non-qualifying basket” refers to the portfolio of investments which are not “qualifying investments” or “short-term holdings.” No more than 20% of a venture capital fund’s total assets, including committed but not yet invested capital, can be invested in the non-qualifying basket.
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 valuation 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 adviser 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 adviser may be tempted 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.
Limits on Leverage
The third condition of a “venture capital fund” requires that the fund:
“Does not borrow, issue debt obligations, provide guarantees or otherwise incur leverage, in excess of 15 percent of the private fund’s aggregate 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, except that any guarantee by the private fund of a qualifying portfolio company’s obligations up to the amount of the value of the private fund’s investment in the qualifying portfolio company is not subject to the 120 calendar day limit”
The leverage restriction consists of two basic requirements. First, a venture capital 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. This means 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.
The second requirement 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. 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. Outside of that exception, any borrowing that does occur by a fund must be short term.
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.
No Redemption Rights for Investors
The fourth condition requires that the fund:
“Only issues 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 but may entitle holders to receive distributions made to all holders pro rata.”
The SEC has provided some guidance as to what “extraordinary circumstances” means in its comments to the rule, where it states that the term would generally be limited to events beyond the control of the fund adviser or the investor. The sole example the SEC gives is a material change in law or regulation. Clearly the SEC intended that this exception will be extremely limited in scope.
One issue that could arise is whether the fund’s adviser would be able to take distributions from its carried interest without a pro rata distribution to investors, as some fund advisers do. The commentary to the rule implies that it can. The reason for this is that the regulations provide that a venture capital fund can only issue securities that do not have redemption rights. The fund adviser’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 advisers structure their carried interest as a limited partnership interest held by a “special limited partner” that is an entity separate from the fund adviser. 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 adviser’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 venture capital 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, Section 4(a)(7) of the Securities Act of 1933, or the so-called “Section 4(1½) 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 adviser is not providing de facto redemption rights by regularly assisting the investors in finding potential transferees. Therefore, it is advisable that venture capital funds avoid offering to help their investors find potential transferees.
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.
Prohibition Against Investment Company Act Registration
The fifth and final condition requires that the fund: (i) not be registered under the Investment Company Act of 1940 and (ii) not elected to be treated as a business development company pursuant to the Investment Company Act. This requirement should not significantly affect most venture capital funds.
Typically, funds that are registered as investment companies are publicly traded mutual funds. In contrast, most venture capital funds are private funds, which are funds that are exempt from the registration provisions of the Investment Company Act. A venture capital fund typically uses one of two exemptions: the “3(c)(1)” exemption or the “3(c)(7)” exemption. The 3(c)(1) exemption exempts from Investment Company Act registration any fund with 100 or fewer investors. The 3(c)(7) exemption exempts from Investment Company Act registration any fund that is sold exclusively to qualified purchasers (which roughly speaking, is a person or entity with $5 Million or more in investment assets). Practically speaking, this means that private funds, such as venture capital funds, are either (i) limited to 100 or less accredited investors or (ii) limited to qualified purchasers.
The venture capital exemption from investment adviser registration also does not apply to advisers to a fund which has elected to be treated as a business development company under the Investment Company Act. A business development company is a form of publicly traded private equity fund designed to provide capital to small, developing, and financially troubled companies. Advisers to such funds will be required to register as an investment adviser with the SEC, unless another exemption applies.
Although it may seem simple to qualify for the venture capital adviser exemption by limiting the adviser’s business to advising solely venture capital funds, whether a fund meets the complex conditions for being a “venture capital fund” can be quite complex. Also note that a private fund adviser exempt under the venture capital exemption is still an exempt reporting adviser, which means it will still be required to provide an abbreviated Form ADV to the SEC. In addition, fund advisers exempt from the SEC may also still nonetheless be subject to state investment adviser registration requirements. 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 or with state authorities and what filings are required.
© 2018 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.