Tag: Restoring American Financial Stability Act

It Will be up to the SEC to Define Venture Capital

With the financial reform bill set to eliminate the 15 client rule exemption for registration under the Investment Advisers Act, the only remaining exemption for fund companies with over $150 million in assets under management will be for venture capital. The Congressional conference decided to not include the Senate’s exemption for private equity.

The bill would leave it up to the Securities and Exchange Commission to define “venture capital.” So what do you think that definition will be?

Wikipedia provides a nice overview, but lacks much in the way of a definition for regulators.

Venture capital is provided as seed funding to early-stage, high-potential, growth companies and more often after the seed funding round as growth funding round in the interest of generating a return through an eventual realization event such as an IPO or trade sale of the company. Venture capital investments are generally made in cash in exchange for shares in the invested company.

Next I turned to a trade group’s definition of venture capital. So I went to the website for the National Venture Capital Association. I had a hard time finding a comprehensive definition. Although I’m sure that they are working on some proposals for the SEC. Here are some tidbits:

Venture capitalists invest mostly in young, private companies that have great potential for innovation and growth.

Venture capitalists are long-term investors who take a very active role in their portfolio companies. When a venture capitalist makes an investment he/she does not expect a return on that investment for 7-10 years, on average.

Venture capital is a subset of the larger private equity asset class. The private equity asset class includes venture capital, buyouts, and mezzanine investment activity. Venture capital focuses on investing in private, young, fast growing companies. Buyout and mezzanine investing focuses on investing in more mature companies. Venture capitalists also invest cash for equity. Other private equity investors tend to use debt as part of their transactions.

Venture capital is more like a different business model for investing than a legally definable industry. Since the SEC is going to come up with a definition, that means that there will be a legal definition.

That also means that the SEC definition will most likely affect the types of investments by venture capital firms, the nature of their capital investment, and the exit strategy from their investments.

Here are some guesses:

  • Prohibition or limitation on holding debt
  • Limitation on holding preferred shares
  • Restricted to holding common shares in operating companies
  • Prohibitions or limitations on holding publicly-traded securities
  • Limitations on holding shares in companies that have debt obligations
  • Restrictions on the type of operating companies they can invest in

They are just guesses. But the industry should be very worried about the eventual definition. The SEC has expressed a desire to regulate all private investment funds so I would expect their eventual definition to be very narrow.

I’m sure that the venture capital industry views the exemption as a victory. But the exemption could end up being a heavy weight around their necks. They may need to change their operating approach and investing style to stay within the boundaries of the definition and the exemption.

In the end, it may just be easier to register and regain the flexibility for a wider variety of investment approaches.

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You can get the “Trust Me, I’m a Venture Capitalist” hat at Cafe Press.

Regulation of Advisers to Private Funds

One of the differences between the Senate and House financial reform bills is how they treat advisers to private equity funds. The Senate bill has an exemption for private equity and venture capital. The House bill only has an exemption for venture capital. Since I work for a private equity firm, I am very focused on how this gets resolved.

In reconciling the two bills at the conference, they removed the Senate exemption for private equity: Title IV as passed by the Senate conferees. They also agreed to the house provision creating an exemption from SEC registration for private fund advisers with less than $150 million dollars in assets under management. Those advisers will need to register and comply with state registration instead.

That means private equity fund advisers with more than $150 million in assets under management will need to register with the SEC as investment advisers and will be subject to the rules governing investment advisers.

The bill has not been passed yet, but it seems unlikely that they will be going back to further revise this section of the bill. There are much more contentious provisions that legislators still need to deal with.

Private Equity and the Custody Rule

With the impending removal of the 15 Client Rule exemption from registration with the SEC, I was scratching my head trying to figure how to make the SEC’s new custody rule work for private equity.

The SEC recently updated its guidance on custody rule compliance truing to add clarity for advisers to pooled investment vehicles.

Here is one:

Question II.3

Q: If an adviser manages client assets that are not funds or securities, does the amended custody rule require the adviser to maintain these assets with a qualified custodian?

A: No. Rule 206(4)-2 applies only to clients’ funds and securities. (Posted 2003.)

Actually that does not help. A private equity fund will hold interests in private companies. Those interests may be stock, LLC interests or partnership interests.  Just because the company is private, those interests may still be securities.

For real estate private equity, the deeds to the underlying property would fall outside the custody rule. The intermediate entities, REITs and joint ventures may not fall outside the custody rule.

§ 275.206(4)-2(b)(2) has an exemption for certain privately offered securities, if the securities are:

(A) Acquired from the issuer in a transaction or chain of transactions not involving any public offering;
(B) Uncertificated, and ownership thereof is recorded only on the books of the issuer or its transfer agent in the name of the client;
and
(C) Transferable only with prior consent of the issuer or holders of the outstanding securities of the issuer.

This exemption is available only if the fund is audited, and the audited financial statements are distributed, as described in paragraph (b)(4) of this section.

The “uncertificated” requirement can be a problem. It is common practice for lenders relying on private company interests to require they be certificated to get better priority under the UCC.

The limits on transfer are a problem because as the holder of the interests, you want the flexibility to transfer interests.

The financial statements requirement is another extra burden, although may not be a problem for many funds. This requires:

  • annual audit
  • in accordance with GAAP
  • within 120 days of the end of the fiscal year
  • independent accountant registered and subject to inspection by PCAOB

(I’m not sure how quickly the SEC can change this rule if the Supreme Court rules PCAOB unconstitutional.)

In looking towards Capitol Hill, the Senate’s would exempt private equity firms from having to comply with the custody rule since they would not have to register. The House’s would not exempt private equity firms from registration and they would be subject to the custody rule.

One interesting aspect of the bills is that fund advisers that are currently registered because they have more than 15 clients/funds may no longer have to be registered if they fall under the venture capital fund advisers exemption or private equity fund advisers exemption. (Assuming those exemptions survive in the final bill.)

Sources:

Image of Old West Bank – It’s a beautiful bank is by oddsock

Private Fund Manager Registration Status

Shearman & Sterling put together a great client publication on private fund manager registration requirements being considered by Congress: Private Fund Manager Registration as U.S. Financial Reform Legislation Approaches the Finish Line.

Among the many provisions to be reconciled in the 1,600+ pages of each bill are those that would require private fund managers to register as investment advisers with the U.S. Securities and Exchange Commission. The registration provisions would strike the existing registration exemption on which many fund managers now rely, that being the so-called “private adviser” or “fourteen or fewer clients” exemption. The result is that many fund managers that are currently exempt from SEC investment adviser registration will be forced to register in due course. With that background, this alert highlights differences between the Senate and House treatment of these registration requirements.

Side-by-Side Comparison Chart of Financial Reform Bills

The Wall Street Reform and Consumer Protection Act of 2009, passed by the House on December 11, 2009 is over 1300 pages long. The Restoring American Financial Stability Act of 2010, passed by the Senate on May 20, 2010, is over 1600 pages long.

You have lots of reading to figure out the differences between the two bills.

Davis Polk put together a great side-by-side chart that compares key issues in the Senate and House Bills. At a 160 pages, the chart provides a much more detailed analysis than any other I have seen published.

Dodd Bill, Private Placements and Accredited Investors

I previously wrote about how the Restoring American Financial Stability Act being tossed around in the Senate could affect private investment funds by changing the definition of accredited investor and altering the process for a Regulation D private placement.

It looks like much of that is going to be wiped out of the bill. Senate Amendment 4056, proposed by Senator Bond, was passed by a voice vote.

The amendment directs the SEC to adjust the net worth needed to attain accredited investor status to $1,000,000, excluding the value of the primary residence. Within the period of four years after enactment, however, the net worth standard must be $1,000,000, excluding the value of the primary residence. The proposal would give the SEC the power to adjust the the definition of “accredited investor” every four years.

Senate Amendment 4056 also removed the 120 review period for private placements.

I have found Senate process for dealing with financial reform bill to be incredibly opaque and fast moving. There have been almost 400 amendments proposed since the bill was submitted last month, with the text of most of the amendments not being available until after vote has taken place.

Sources:

Accredited Investors under the Restoring American Financial Stability Act

Senator Dodd

One of the surprises in the Restoring American Financial Stability Act of 2010 is that it proposes to raise the standard for being an accredited investor. Section 412 of the bill would require the SEC to increase the dollar thresholds to be qualified as an accredited investor. Section 413 would require the GAO to study the appropriate criteria.

The current standards come from Section 2(a)15 of the Securities Act of 1933

ii. any person who, on the basis of such factors as financial sophistication, net worth, knowledge, and experience in financial matters, or amount of assets under management qualifies as an accredited investor under rules and regulations which the Commission shall prescribe.

In 1982, the SEC prescribed the standard in Rule 501 of Regulation D:

5. Any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of his purchase exceeds $1,000,000;

6. Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;

If you adjust for inflation from 1982, those levels could increase to $459,000 if single and $688,000 if married, with the net worth requirement becoming $2.29 million. The bill is not clear on what to use as an inflation index. I used the Consumer Price Index for All Urban Consumers (CPI-U) comparing March 1981 (94.5) to February 2010 (216.741).

The Private Fund Investment Advisers Registration Act passed by the House in the Wall Street Reform and Consumer Protection Act of 2009 (H.R.4173) required the SEC to start increasing the asset levels. The Dodd bill (still not in the Thomas system) takes the issue on more forcefully.

The result is that there will be fewer investors for private investment funds. Under and , you are limited to 35 non-accredited investors in a private fund offering, with an unlimited number of accredited investors.

Sources:

Financial Overhaul Moves Forward

Senator Dodd

With the health care reform now out of the hands of Congress, there is now movement with financial overhaul. Senator Dodd introduced the Restoring American Financial Stability Act of 2010 last week  without a Republican co-sponsor [Dodd Goes Solo].

Instead plugging in amendments, the Senate Banking Committee voted on straight party lines to advance the bill as introduced by Senator Dodd. The bill is moving so fast that it has not even made into the Thomas system for tracking legislative activity. The vote on Monday night lasted less than 25 minutes.

According to reports, Republicans filed more than 200 amendments on Friday, but withdrew all of them and let the bill pass quickly through committee. I assume the strategy will be to attack the bill in the full Senate instead of in the Banking Committee.

UPDATE: There were 114 pages of amendments made to the bill. Most look like clean-ups and small changes that do not have a big impact on the bill.

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Dodd’s Solo View on Private Investment Funds

Senator Dodd

Senator Dodd did not forget about private investment funds. Tucked into page 366 of his 1366 page Restoring American Financial Stability Act of 2010 is the Private Fund Investment Advisers Registration Act.

This is largely the same language in the Private Fund Investment Advisers Registration Act of 2009 contained in Dodd’s draft Restoring American Financial Stability Act of 2009. He circulated that draft back in November to start negotiations with Republicans.

Venture Capital Fund Advisers

There is an exemption from registration for the “provision of investment advice relating to a venture capital fund.” The bill gives the SEC the responsibility for defining a “venture capital fund.”

Private Equity Fund Advisers

Unlike the bill passed by the House, Dodd proposes an exemption from registration or reporting requirements with respect to advice given to private equity funds. The SEC is tasked with defining the term “private equity fund.”  Unlike venture capital funds, private equity funds will be subject to SEC record-keeping requirements to the extent the SEC determines it is “necessary and appropriate in the public interest and for the protection of investors.”

State versus Federal Registration of Investment Advisers

Section 410 of the bill raises the federal registration level to $100 million from $25 million. So investment advisers and funds of less than $100 million will be subject to state regulators instead of federal regulators. David Tittsworth, executive director of the Investment Adviser Association, said the change would shift about 4,200 of the 11,000 money managers now registered at the SEC to state regulation.

Accredited Investors

The Dodd bill would change the threshold for “accredited investor.” Currently, the threshold is $200,000 income for a natural person (or $300,000 for a couple) or $1,000,000 in assets. The SEC would have the power to increase those levels  as “appropriate and in the public interest, in light of price inflation since those figures were determined.”

The Comptroller General is also directed to study the financial thresholds for investor eligibility in private funds.

Regulation D Offerings

Separately in the bill, Senator Dodd is proposing to tinker with exemption from registration under Rule 506. Section 926 of his bill, gives the SEC the power to designate certain Rule 506 offerings to not be “covered securities.”  That would get the states more involved in the review and regulation of private offerings, including private fund offerings.

Now What?

This bill still has a long way to go in the Senate. Most reports indicate that private funds are not one of the hotly contested issues in the bill. Assuming the Senate passes the bill, they will need to negotiate the differences between the House and Senate. Assuming it passes, it looks like a big chunk of work would be dropped onto the SEC to define the fund types.

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