SEC Proposes Registration Exemptions for Advisers to Venture Capital Funds and Certain Private Funds and Foreign Advisers
Investment Management Update
Date: December 02, 2010
On November 19, the Securities and Exchange Commission (SEC) proposed several rules under the Investment Advisers Act of 1940, as amended ("Advisers Act"), related to the ongoing implementation of the legislative mandates set forth in the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank Act").1 More specifically, the Proposing Release sets forth proposals that would implement exemptions from the registration requirements of the Advisers Act as set forth in Title IV of the Dodd-Frank Act, the Private Fund Investment Advisers Registration Act of 2010, for:
- Advisers solely to "venture capital funds," as such term is defined in the Proposing Release, without regard to the number of such funds advised by the adviser or the asset size of such funds;
- Advisers solely to private investment funds with less than $150 million in assets under management in the United States, without regard to the number or type of private funds advised; and
- Non-U.S. advisers with less than $25 million in aggregate assets under management from U.S. clients and private fund investors and fewer than 15 such clients and investors.
Prior to passage of the Dodd-Frank Act, most investment advisers to private investment funds, including private equity funds, hedge funds and venture capital funds, relied upon the exemption from registration as an investment adviser provided under Section 203(b)(3) of the Advisers Act ("Private Adviser Exemption"). In relevant part, Section 203(b)(3) provided an exemption from the registration requirements of the Advisers Act for an adviser that:
- Has had fewer than 15 clients in the preceding 12 months;
- Does not hold itself out to the public as an investment adviser; and
- Does not act as an investment adviser to a registered investment company or a company that has elected to be a business development company.2
However, the Dodd-Frank Act amended Section 203(b)(3) to replace the Private Adviser Exemption with several more targeted exemptions from registration, including those exemptions described in the Proposing Release.
Definition of Venture Capital Fund
Grandfathering Exemption for Certain Existing Funds
The definition of "venture capital fund" would include any private fund that represented to investors and potential investors at the time of the offering that it was a venture capital fund, has sold securities to one or more investors prior to December 31, 2010 and does not sell any securities to, including accepting any capital commitments from, any person after July 21, 2011.11 The Grandfathering Provision thus would include any fund that has accepted capital commitments by the specified dates even if none of the capital has been called.
New Reporting Requirements
Even if an adviser is able to avoid registration under the Advisers Act by solely managing one or more venture capital funds, the adviser nonetheless may be required to comply with new reporting, recordkeeping and other compliance requirements proposed under the Private Fund Investment Advisers Registration Act that are applicable to both registered and exempt advisers. As explained more fully in a separate release issued on November 19, 2010, the SEC has proposed specific reporting requirements that will be applicable to advisers relying on certain of the newly created exemptions from registration under the Advisers Act, including exemptions that are available to advisers solely to venture capital funds and advisers solely to private funds with aggregate assets of less than $150 million (each, an "exempt reporting adviser").12
More specifically, each exempt reporting adviser will be required to submit, and to periodically update, the following information from Part 1 of Form ADV, along with any required schedules implicated by any of the identified items: Item 1 (Identifying Information), Item 2.C. (SEC Reporting by Exempt Reporting Advisers), Item 3 (Form of Organization), Item 6 (Other Business Activities), Item 7 (Financial Industry Affiliations and Private Fund Reporting), Item 10 (Control Persons) and Item 11 (Disclosure Information). Exempt reporting advisers will be required to provide the foregoing information no later than August 20, 2011 and also must report the value of their assets under management, determined within 30 days of the filing. All information filed with the SEC via Form ADV will be publicly available.
Interestingly, the Dodd-Frank Act specifies neither the types of information that the SEC can require from exempt reporting advisers nor the purposes for which the SEC can use the information it collects. In the view of the SEC, the information identified in the Implementing Release will assist the SEC in identifying exempt reporting advisers, their owners and their business models, as well as assist the agency in determining whether "such advisers or their activities might present sufficient concerns as to warrant ... further attention in order to protect their clients, investors, and other market participants."13
For purposes of Proposed Rule 203(l)-1 under the Advisers Act, a "venture capital fund" would be defined as a "private fund" (i.e., a pooled investment vehicle excluded from the definition of "investment company" under Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940 ("1940 Act")) that meets the six criteria set forth below.3
Investment in qualifying portfolio companies. The fund solely, with the exception of cash and certain short-term investments described below, invests in the equity securities of "qualifying portfolio companies," as such term is defined below, in order to provide operating and business expansion capital and at least 80 percent of each company's securities owned by the fund were acquired directly from the qualifying portfolio company.
For purposes of the proposed definition, a "qualifying portfolio company" means any issuer that meets the following qualifications:
- At the time of any investment by the private fund, the company is not "publicly traded" (i.e., subject to the reporting requirements of the Securities Exchange Act of 1934, as amended ("Exchange Act"), or having securities listed or traded in a foreign jurisdiction) and is not a control affiliate of a public company. However, since the definition of qualified portfolio company looks to the time of investment, private funds could continue to hold public securities after a company's initial public offering so long as no follow-on investments were made in that company.
- The company does not borrow or issue debt obligations, redeem or repurchase securities of the company or distribute company assets in connection with the private fund's investment.
- The company is an operating company, as opposed to any sort of private fund or pooled investment vehicle, including, but not limited to, an investment company or a commodity pool. Accordingly, a fund of funds or special purpose holding vehicle, even if focused on venture capital or a particular venture capital investment, would not meet the definition of a venture capital fund and advisers to such vehicles would not qualify for the venture capital exemption.4
In addition to the equity securities of qualifying portfolio companies, the assets of a fund seeking to rely on the venture capital fund definition must consist solely of cash or cash equivalents and U.S. treasuries with a remaining maturity of 60 days or less.5 The term "equity securities" is defined in Section 3(a)(11) of the Exchange Act to include common stock and securities convertible into common stock, and therefore would include typical convertible preferred stock issued by most venture-backed companies as well as standard convertible notes issued in "bridge financings," but would not include most other debt instruments.
Significant management involvement or control. The fund, either directly or through its investment advisers, either has: 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 of the portfolio company.6
In certain respects, this requirement can be seen as the underpinning of the exemption for venture capital funds provided under the Dodd-Frank Act. In the view of the SEC, a key distinguishing characteristic of venture capital funds compared to other private investment funds is the level of involvement of such funds in the development and management of their portfolio companies.7 Thus, to rely on the exemption, a venture capital fund must go beyond merely providing capital and instead is expected to have a significant level of involvement in developing the portfolio companies of the fund by, among other things, being actively involved in the business, operations or management of each portfolio company.8
Limitation on leverage. The fund does not borrow, issue debt obligations, provide guarantees or otherwise incur leverage in excess of 15 percent of the fund's aggregate capital commitments and any such borrowing, indebtedness, guarantee or leverage has a non-renewable term of no longer than 120 days. In the view of the SEC, by specifying that any loans be non-renewable, it would not be possible to convert short-term debt into long-term debt without full repayment to the lender.9 During consideration of the Dodd-Frank Act, Congress noted that the implementation of highly leveraged trading strategies by private funds greatly contributed to the potential for systemic risk. Thus, this proposed element of the definition of a venture capital fund is designed to address concerns that "financial leverage may contribute to systemic risk by excluding funds that incur more than a limited amount of leverage" from the venture capital fund definition.
No redemption rights. The fund does not permit its investors to withdraw or redeem their interests, except in extraordinary circumstances. Although the circumstances under which an investor may redeem his or her interest in a venture capital fund are extraordinary, such circumstances may be foreseeable in that they are known to occur yet their timing and scope are unexpected. Thus, the ability of an investor to redeem his or her interest in a fund or be excluded from particular investments may be triggered by "a change in the tax law after an investor invests in the fund, or the enactment of laws that may prohibit an investor's participation in the fund's investment in particular countries or industries."10 The proposed definition still would permit a venture capital fund to make periodic, pro-rata distributions to all investors.
Finally, although a fund prohibiting redemptions would be a venture capital fund for purposes of the exemption, the proposed definition does not specify a minimum period of time for an investor to remain in the fund. Thus, at least in theory, a venture capital fund could be structured so as to provide some sort of redemption feature after an initial holding period while still satisfying the requirements of the proposed exemption.
Represents itself as a venture capital fund. In order to satisfy the definition of a venture capital fund, the fund must represent to its investors and potential investors that it is a venture capital fund. As described in the Proposing Release, 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 proposed definition.
Is a private fund. In order to satisfy the definition of a venture capital fund, the fund must be a "private fund." In other words, the fund must not be registered as an investment company in reliance on Section 3(c)(1) or 3(c)(7) of the 1940 Act and must not have elected to be treated as a BDC under the 1940 Act.
Exemption for Private Fund Advisers with Less Than $150 Million in Assets Under Management
As the name suggests, the Private Fund Adviser Exemption is available to advisers solely to "private funds."14 If an adviser with its principal office and place of business in the United States ("U.S. Adviser") that is seeking to rely on the Private Fund Adviser Exemption acquires any clients other than a private fund, the adviser would have to register under the Advisers Act unless another exemption from registration is available to the adviser.15 The Private Fund Adviser Exemption does not place a limit on the number of private funds managed by the adviser, provided, however, that the aggregate assets of all of the private funds advised by the adviser are less than $150 million.16
U.S. Adviser would need to consider all of its client accounts (both U.S. and non-U.S.) in determining whether it solely advises private funds. In contrast to a non-U.S. adviser, as described more fully below, all of the private fund assets of a U.S. Adviser (whether managed in the United States or elsewhere) would be counted toward the $150 million limit.
In order to ensure consistent application of the requirements of the Private Fund Adviser Exemption, the SEC has indicated that Form ADV will be amended to provide a uniform method of calculating assets under management for all regulatory purposes under the Advisers Act. In that regard, sub-advisers to a private fund only will have to count assets for which the sub-adviser has responsibility.17 However, private funds that rely on capital commitments, for example, most private-equity funds, would have to take into account all capital commitments, regardless of whether or not such commitments have been called, in calculating assets under management. Finally, the Private Fund Adviser Exemption will require advisers seeking to rely on the exemption to calculate assets under management at the end of each calendar quarter based on the fair value of fund investments (cost values cannot be used). If an adviser exceeds $150 million in United States assets under management during a fiscal quarter, it must register with the SEC by the end of the following quarter.
The Private Fund Adviser Exemption treats non-U.S. advisers differently from advisers having their principal place of business in the United States. As proposed, the Private Fund Adviser Exemption specifies that an adviser with its principal office and place of business outside of the United States ("Non-U.S. Adviser") can rely on the Private Fund Adviser Exemption if all of its U.S. clients are private funds and all assets managed by the adviser from any place of business in the U.S. are solely attributable to private funds (i.e., the adviser does not manage separate advisory accounts from a U.S. place of business) with aggregate assets of less than $150 million. Thus, a Non-U.S. Adviser could provide advisory services to non-private fund clients without being required to register under the Advisers Act, provided, however, that any such non-private fund clients are not managed from a place of business in the United States.18
As amended by the Dodd-Frank Act, Section 203(m) of the Advisers Act directs the SEC to exempt from registration as an investment adviser any adviser solely to private funds with aggregate assets under management of less than $150 million ("Private Fund Adviser Exemption"). As set forth in the Proposing Release, Proposed Rule 203(m)-1 under the Advisers Act seeks to implement the so-called Private Fund Adviser Exemption.
Foreign Private Advisers
Calculation of Clients and Investors
The foreign private adviser exemption is much more limited in scope than the existing Private Adviser Exemption. In particular, the foreign private adviser exemption, as proposed, eliminates the provision allowing advisers not to count as clients those clients from which the adviser receives no compensation. However, multiple legal entities with identical owners will be considered one client.
An "investor" will generally be defined as any person who would be included in determining the number of beneficial owners of a private fund under Section 3(c)(1) of the 1940 Act, or in determining that the outstanding securities of a private fund are owned exclusively by "qualified purchasers" under Section 3(c)(7) of the 1940 Act. However, "knowledgeable employees" and owners of short-term paper issued by a fund will also count as "investors." For purposes of the 15-client threshold, identical investors in two or more funds only need to be counted once and if an adviser has already counted a U.S. investor in a non-U.S. fund, it does not need to "double count" the fund as a client.
Section 403 of the Dodd-Frank Act replaces the former Private Adviser Exemption with a new exemption for a "foreign private adviser," as such term is defined in new Section 202(a)(30) of the Advisers Act. A foreign private adviser will be exempt from registration under the Advisers Act where such adviser:
- Has no place of business in the United States;
- Has, in total, fewer than 15 clients and investors in the United States in private funds advised by the investment adviser;
- Has aggregate assets under management attributable to clients in the United States and investors in the United States in private funds advised by the investment adviser of less than $25 million; and
- Does not hold itself out generally to the public in the United States as an investment adviser, nor act as an investment adviser to a registered investment company or a BDC.
1Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers With Less Than $150 Million in Assets Under Management, and Foreign Private Advisers, Rel. No. IA-31111 (Nov. 19, 2011) (the "Proposing Release"). A copy of the Proposing Release can be found at http://sec.gov/rules/proposed/2010/ia-3111.pdf.
2Most advisers to private investment funds treated the fund as a single client for purposes of the Private Adviser Exemption. Thus, many private fund complexes structured their operations so as to limit the number of funds to 14 or fewer. As a result, advisers to large pools of capital with many investors were able to avoid registration under the Advisers Act.
3It is worth noting that, in proposing the subject definition, the SEC borrowed heavily from the provisions of the 1940 Act governing a business development company ("BDC"). The Proposing Release, supra n. 1 at 12. In the view of the SEC, the provisions of the 1940 Act governing a BDC ("BDC Provisions") and the venture capital fund exemption reflect many similar policy considerations and, as a result, the SEC has looked, at least in part, to language Congress previously used to describe a BDC.
6Proposed Rule 203(l)-1(a)(3). Under Section 202(a)(12) of the Advisers Act, "control" is defined to mean "the power to exercise a controlling influence over the management or policies of a company, unless such power is solely the result of an official position with such company."
8Id. The SEC noted that the level of involvement may vary as the needs of a given portfolio company change over the course of the life cycle of the company. As noted previously, the SEC borrowed heavily from the BDC Provisions. In that regard, the SEC modeled the proposed approach to "managerial assistance" to the analogous requirement under the BDC Provisions. See generally, the definition of "making available significant managerial assistance" as set forth in Section 2(a)(46) of the 1940 Act.
12Rules Implementing Amendments to the Investment Advisers Act of 1940, Rel. No. IA-3110 (Nov. 19, 2010) ("Implementing Release"). A copy of the Implementing Release can be found at http://sec.gov/rules/proposed/2010/ia-3110.pdf.
14Proposed Rule 203(m)-1(a)(1) under the Advisers Act limits the availability of the Private Fund Advisers Exemption to "qualifying private funds," which are defined in Proposed Rule 203(m)-1(e)(5) under the Advisers Act as "any private fund that is not registered under section 8 of the ... [1940 Act] and that has not elected to be treated as a ... [BDC]." It is worth noting that the definition of a qualifying private fund set forth in the proposed rule is very broad and is not limited to funds relying on Sections 3(c)(1) or 3(c)(7) of the 1940 Act.