The Dodd-Frank Wall Street Reform and Consumer Protection Act split the world of fund managers into a few groups. One group that was able to grab a limited exemption from the Investment Advisers Act registration was venture capital fund managers. What does it take to be a venture capital fund manager? And could a real estate fund manager take advantage of it? I ask because I came across a real estate crowdfunding platform that took this choice.
Under Rule 203(l)-1, a venture capital fund is any private fund that:
(1) Represents to investors and potential investors that it pursues a venture capital strategy;
(2) 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;
(3) Does not borrow…… 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 day….;
(4) 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; and
(5) Is not registered under section 8 of the Investment Company Act of 1940 (15 U.S.C. 80a-8), and has not elected to be treated as a business development company pursuant to section 54 of that Act (15 U.S.C. 80a-53).
I gave up on this treatment because the debt limitation in (3) makes it hard to use a subscription secured credit facility. But if you’re not using a credit facility, the other provisions seem achievable for private equity funds or other funds investing in private securities, including real estate.
The big limitation would be that the fund “pursues a venture capital strategy.”
So I poked around looking for a definition of “venture capital” or “venture capital strategy” in the SEC’s rule release.
The rule and its release never bother to define “venture capital” or “venture capital strategy.” The rule merely states that the fund manager has to represent that it pursues a venture capital strategy. I found no color on what is and what is not “venture capital” or “venture capital strategy.”
I poked around on the National Venture Capital Association website. I thought the big trade association would have an easy to find definition. I was wrong. I could not find a meaningful definition of “venture capital.”
At the end of 2013, the SEC issued a guidance update on the exemption for advisers to venture capital funds. This guidance helped with some of the legal structures and the terms “qualifying investments” in part (2) of the definition. It does not discuss “venture capital strategy.”
I looked at some of the real estate crowdfunding platform’s documents and found these provisions:
In addition, the Subscriber understands that the Manager is not registered as an investment adviser under the Investment Advisers Act of 1940, as amended. The Manager is expected to be treated as an investment adviser exempt from federal or state registration under the venture capital strategy being pursued by the Company….
The Company is pursuing a venture capital strategy through investments in operating companies that manage and develop real estate.
I think it’s a bold approach to call itself a venture capital fund manager. But it kind of works. It may not make sense from a common sense perspective or a common expectation of what “venture capital strategy” is. But it’s a term that is not well defined in common practice. The SEC did not even try to define it.
The big problem is the consequences. The release for Rule 203(l)-1 says that you can’t merely state that you are pursuing a venture capital strategy; You have to actually pursue that strategy. (Again, without defining it.)
In the rule release, the SEC also states that it is a violation of the anti-fraud provisions if you merely state that you are pursuing a venture capital strategy when you are not actually engaged in that strategy.
A real estate fund with an opportunity investing style or value-add investing style could argue that it is a “venture capital strategy.” Those fund types are looking to invest in companies and get them to grow. Of course, each investment is likely a single-asset real estate company.
I would not sleep well at night, worrying that the SEC was going to challenge that regulatory choice.
Sources:
- What is a Venture Capital Fund?
- SEC Release No. IA-3222 – Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers With Less Than $150 Million in Assets Under Management, and Foreign Private Advisers (.pdf – 208 Pages)
- Guidance on the exemption for advisers to Venture Capital Funds IM Guidance Update 2013-13
