Tag: venture capital

SEC Proposes Updated Definition to Help Three Funds

The press release for changes to “qualifying venture capital fund” caught my attention. I didn’t recall that definition, so I took a closer look. It’s in Section 3(c)(1) of the Investment Company Act, which makes it part of the “private fund” definition.

Section 504 of the Economic Growth, Regulatory Relief, and Consumer Protection Act of 2018 (“EGRRCPA”) amended section 3(c)(1) of the Investment Company Act by adding “qualifying venture capital funds” into the exemptions from the investment company definition. Other companies can only have 100 people. Qualifying venture capital funds can have up to 250 people. EGRRCPA created the new definition of “qualifying venture capital fund” as:

“a venture capital fund that has not more than $10,000,000 in aggregate capital contributions and uncalled committed capital.”

That seems like an really small fund and I would think that a change to the definition if it added an extra zero would be very meaningful. Then I read that the SEC was only proposing to increase the amount from $10 million to $12 million.

Why bother? The statutory definition in EGRRCPA requires this $10,000,000 threshold “be indexed for inflation once every 5 years by the SEC. Here it is five years later.

I rarely read the economic analysis of a proposed rule, but I was really interested in the impact.

Based on the Form ADV filings there are at least 23,759 venture capital funds. Of those, there are 14,822 qualifying venture capital funds. Of those, 653 have more than 100 beneficial owners.

Ultimately, the SEC estimates that there are three (3!) venture capital funds that are not currently excluded from registration under section 3(c)(1) but that could be defined as a qualifying venture capital fund if the threshold were adjusted for inflation to $12,000,000 as proposed.

I was floored to read how many small venture capital fund are out there. I was not surprised that the rule only helped a handful of funds.

Sources:

Can a Real Estate Fund Manager Be a Venture Capital Fund Manager?

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.

Venture Capital - Inscription on Red Road Sign on Sky Background.

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?

For me, venture capital has always been a fuzzy term. They generally invest in start-ups and provide early stage capital for their growth. As a company progresses through later rounds of funding, that definition does not seem to work that well. For example, would you label the latest rounds of funding in Facebook as “venture capital”?

The other problem for a venture capital fund is that liquidity events for their portfolio companies may leave them holding valuable chunks of publicly traded stock or mature private company securities, leaving their capitalization.

Until recently, an exact definition was not needed. Venture capital fund managers could operate across a spectrum of business models, depending on what limitations they promised to their fund investors.

Now, the Securities and Exchange Commission has required a more precise definition. Venture Capital fund managers can take advantage of an exemption from registration under the Investment Advisers Act. This exemption is not available for the rest of the private equity world of investment managers.

The SEC published the final definition under a new 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, 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;

(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).

They piece of the definition is the term “qualifying investments.”

Qualifying investment means:

(i) An equity security issued by a qualifying portfolio company that has been acquired directly by the private fund from the qualifying portfolio company;

(ii) Any equity security issued by a qualifying portfolio company in exchange for an equity security issued by the qualifying portfolio company described in paragraph (c)(3)(i) of this section; or

(iii) Any equity security issued by a company of which a qualifying portfolio company is a majority-owned subsidiary, as defined in section 2(a)(24) of the Investment Company Act of 1940 (15 U.S.C. 80a-2(a)(24)), or a predecessor, and is acquired by the private fund in exchange for an equity security described in paragraph (c)(3)(i) or (c)(3)(ii) of this section.

Qualifying portfolio company means any company that:

(i) At the time of any investment by the private fund, is not reporting or foreign traded and does not control, is not controlled by or under common control with another company, directly or indirectly, that is reporting or foreign traded;

(ii) Does not borrow or issue debt obligations in connection with the private fund‘s investment in such company and distribute to the private fund the proceeds of such borrowing or issuance in exchange for the private fund‘s investment; and

(iii) Is not an investment company, a private fund, an issuer that would be an investment company but for the exemption provided by § 270.3a-7 of this chapter, or a commodity pool.

The big limitation throughout the definition is on the debt limitation.

Many funds use a subscription credit facility secured by the uncalled capital commitments. This gives them quicker access to cash for investments. Then the facility is paid down after capital is called. The use of a credit facility also allows the capital calls to be spread out and can be used to give fund investors more lead time to pull together their own cash. It seems this new rule will severly limit the ability of a venture capital fund to use a subscription credit facility.

Sources:

Image – Multiple sources across the internet. Let me know if you are the original creator

SEC Extends Deadline and Adopts Rules for Advisers and Private Funds

At an open meeting on June 22, the Securities and Exchange Commission adopted new rules under the Investment Advisers Act of 1940 aimed at investment advisers, private fund managers, venture capital funds, and family offices.

Based on the statements at the meeting, there will be three new rules would:

Delay Registration Deadline and a New Form ADV. The new registration/reporting deadline for new Advisers Act registrants and “exempt reporting advisers” will be March 30, 2012. Previously exempt private advisers, particularly those to hedge funds and private equity funds, will not be required to register until March 30, 2012. All advisers will be required to make a filing in the first quarter of 2012. Those previously registered advisers who no longer qualify for SEC registration will be required to withdraw by June 28, 2012.

The SEC staff pointed out that 2012 is a leap year, so the 90 day deadline is March 30 instead of March 31 in 2012.

Form ADV is going to change. No surprise. Under the amended adviser registration form, advisers to private funds will have to provide:

  • Basic organizational and operational information about each fund they manage, such as the type of private fund that it is (e.g., hedge fund, private equity fund, or liquidity fund), general information about the size and ownership of the fund, general fund data, and the adviser’s services to the fund.
  • Identification of five categories of “gatekeepers” that perform critical roles for advisers and the private funds they manage (i.e., auditors, prime brokers, custodians, administrators and marketers).
  • More information about conflicting or potential conflicting relationships.

Define Venture Capital Funds. Under the definition, a venture capital fund is a private fund that:

  • Invests primarily in “qualifying investments” (generally, private, operating companies that do not distribute proceeds from debt financings in exchange for the fund’s investment in the company); may invest in a “basket” of non-qualifying investments of up to 20 percent of its committed capital; and may hold certain short-term investments.
  • Is not leveraged except for a minimal amount on a short-term basis. Borrowing is limited in time as well.
  • Does not offer redemption rights to its investors.
  • Represents itself to investors as pursuing a venture capital strategy.
  • Is not registered under the Investment Company Act.

There will be a rule on grandfathering substantially as proposed in November, with the three conditions that the fund had been represented to be a “venture capital fund,” that the first closing was prior to December 31, 2010 and that no new capital commitments are made after July 21, 2011.

The new category of venture capital fund advisers and other “exempt reporting advisers” will file portions of Part 1 of Form ADV. Commissioner Schapiro noted that there was no current intention to subject exempt reporting advisers to routine examinations, while also noting that the SEC retains the authority to examine those advisers in its discretion. The Staff noted that the Form ADV will include a uniform calculation for “assets under management.”

Family Office Exemption. This exemption should be consistent with no-action relief previously provided and the proposed rule. It sounds like there will be some expansion to address a broader universe of permitted family clients and ta longer transition period (through December 31, 2013) for the termination of relationships with charitable entities that were not exclusively funded by the family.

These rules will have completed most of the rulemaking required under Title IV of Dodd-Frank, the Private Fund Investment Advisers Registration Act.

My printer is still cranking out the text of the new rules and I need to dive deeper into the details.

Sources:

Time for the SEC to Extend a Deadline

Dodd-Frank set a July 21 deadline for changes to the Investment Advisers Act in Title IV:  The Private Fund Investment Advisers Registration Act. This included the  expiration of the private adviser exemption from registration under the Investment Advisers Act, the addition of an new exemption for “venture capital fund advisers” and the increase in the threshold for registration with the SEC to $100 million.

The SEC proposed a new Form ADV in November to deal with these changes. But the final form has not been published.

The SEC proposed a definition of “venture capital fund adviser” in November. The final definition has not been published.

With the increase in the registration threshold to $100 million, about 4,000 investment advisers will be moved to the state authorities for supervision. Many states are still in the middle of revising their statutes and regulations to deal with the changes.

Since the SEC has a 45 day review period on the Form ADV, the filing deadline in June 6. That’s just two weeks away. Throw in Memorial Day weekend in the middle of that to lose a few more days.

In April, the SEC hinted that they would extend the July 21 deadline.  The IARD registration system would not be ready for the new Form ADV until the end of 2011. It sounded like the SEC is not ready.

I think it’s unrealistic for the SEC to release the new regulations and forms in the next two weeks and expect their regulated constituents to be able to pull the pieces together. Actually, it’s probably unrealistic to expect that the SEC will be ready in the next two weeks. They keep talking about have the regulations in place by July 21. That’s 45 days too late. Looking at this week’s SEC meeting, the subject is not on the agenda.

This week, I’m sitting down to start registering on the old Form ADV. The boxes don’t fit very well and some of the dollar amounts are wrong. It may be a waste of time, but we are out of time.

To entertain myself in the face of this deadline, I present the deadline post-it video

The SEC Defines Venture Capital

The SEC is moving much faster in releasing proposed rules after the SEC Open Meetings. After Friday morning’s open meeting discussing the exemption from registration for venture capital funds, the SEC has released the full text of the proposed rule merely several hours later.

I have been waiting to see how broad this exemption will be. I’m still holding on to the slim chance that I could squeeze into the exemption. Given that the SEC is still looking for some broad reporting and subjecting venture capital firms to examination, I’m not sure the exemption will offer much benefit.

Here is the SEC’s proposed definition of a venture capital fund for purposes of the exemption:

A venture capital fund is any private fund that:

(1) Represents to investors and potential investors that it is a venture capital fund;

(2) Owns solely:

(i) Equity securities issued by one or more qualifying portfolio companies, and at least 80 percent of the equity securities of each qualifying portfolio company owned by the fund was acquired directly from the qualifying portfolio company; and

(ii) Cash and cash equivalents, as defined in § 270.2a51-1(b)(7)(i), and U.S. Treasuries with a remaining maturity of 60 days or less;

(3) With respect to each qualifying portfolio company, either directly or indirectly through each investment adviser not registered under the Act in reliance on section 203(l) thereof:

(i) Has an arrangement whereby the fund or the investment adviser offers to provide, and if accepted, does so provide, significant guidance and counsel concerning the management, operations or business objectives and policies of the qualifying portfolio company; or

(ii) Controls the qualifying portfolio company;

(4) 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;

(5) 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

(6) 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).

SEC Release IA-3111 Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers With Less Than $150 Million in Assets Under Management, and Foreign Private Advisers

Can I Be a Venture Capital Fund Manager?

That was one of the topics for the Securities and Exchange Commission Open Meeting on November 19.

In Shapiro’s opening remarks, it was clear that the SEC wants all private funds to register. Even thought venture capital funds are exempt from registration, they will need to supply information to the SEC.

The key in defining “venture capital” will be the lack of leverage in the funds and the non-public status of their investments.

They will not have to disclose the full panoply of information that is required by Part 2 of Form ADV. So they will not have to disclose compensation and conflict information.

The SEC has only been able to examine 10% of registered investment advisers each year.

They made it clear that private fund advisers will not be excluded from the “systemically important” label under Dodd-Frank. Big advisers will need to keep an eye on this rulemaking, scheduled to be released in January.

Then on to the specifics.

There are proposed changes to Form ADV to reflect the new thresholds for registration and some other changes. private funds will need to disclose key gatekeepers such as auditors and third-party marketers.

They will also include information for the venture capital funds that have to report, but not register. These exempt-reporting advisers will still be using Form-ADV. They will need to disclose information about ownership, fund structures, and disciplinary activity.

As for venture capital funds, it seemed clear that they struggled trying to come up with a definition of a “venture capital fund.” The definition in the proposed rule will include these limitations:

  • must get 80% of the shares directly from the company
  • investments must be in a private company
  • provide significant management assistance to the company
  • only borrow a portion of their fund’s capital
  • limited redemption rights to limited partners
  • self-label as a venture capital fund

They will allow a grandfathering for venture capital funds, giving them some time to restructure to fall under the definition. That should be a relief for fund wondering how they can meet the July 21, 2011 deadline and not take a hit on their illiquid investments.

Commissioner Casey did not like the approach of the rule on venture capital funds and Form ADV. She noted that the statute is ambiguous on the reporting requirements and thinks the rule is putting too much of a burden on venture capital funds.

(I missed Commissioner Walter’s remarks.)

Commissioner Aguilar focused on the valuation and leverage discussions for funds. He seemed to really be interested in having such a big database of information about private fund advisers.

Commissioner Paredes focused on the insertion of the venture capital exemption outside of the Section 203 exemptions.  To him that means they are subject to much more oversight and subject to examination. He is concerned about the distraction of the fund mangers from growing small companies. He seemed skeptical that the regulatory oversight will help investors. He was concerned about the requirement of “providing managerial assistance” and how that may affect a VC investor that does not get a board seat. He realizes that the SEC is stuck with the statutory framework enacted by Congress. (I guess that’s the problem with getting an exemption tacked on to the bill instead of a thoughtful reworking of the regulatory framework.)

As usual with the SEC, the actual text of the rules was not released as part of the meeting and we will have to wait to see the details. Of course, these are just proposed rules so there will be an opportunity to comment and the SEC may make some changes to the rules based on the comments.

SEC to Consider New Rules for Fund Managers

On Friday, The Securities and Exchange Commission will be considering rules that should be of interest to private investment fund managers.

It looks like we may have the first look at how the SEC will define a venture capital fund and who will fit into that new exemption to registration under the Investment Advisers Act. Section 407 of Dodd-Frank puts the onus on the SEC to define ‘venture capital fund.’

My guess is that the definition will be very narrow and many venture capital fund managers will not be happy with the definition.

Open Meeting – Friday, November 19, 2010 – 10:00 a.m.

The subject matter of the Open Meeting will be:

  • The Commission will consider whether to propose new rules and rule amendments under the Investment Advisers Act of 1940 to implement provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act. These rules and rule amendments are designed to give effect to provisions of Title IV of the Dodd-Frank Act that, among other things, increase the statutory threshold for registration by investment advisers with the Commission, require advisers to hedge funds and other private funds to register with the Commission, and address reporting by certain investment advisers that are exempt from registration.
  • The Commission will consider whether to propose rules that would implement new exemptions from the registration requirements of the Investment Advisers Act of 1940 for advisers to venture capital funds and advisers with less than $150 million in private fund assets under management in the United States. These exemptions were enacted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The proposed rules also would clarify the meaning of certain terms included in a new exemption for foreign private advisers.
  • The Commission will consider whether to propose new rules under Section 763(i) of the Dodd-Frank Wall Street Reform and Consumer Protection Act governing the security-based swap data repository registration process, the duties of such repositories, and the core principles applicable to such repositories.
  • The Commission will consider whether to propose Regulation SBSR under Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act to provide for the reporting of security-based swap information to registered security-based swap data repositories or the Commission and the public dissemination of security-based swap transaction, volume, and pricing information.

At times, changes in Commission priorities require alterations in the scheduling of meeting items. For further information and to ascertain what, if any, matters have been added, deleted or postponed, please contact: The Office of the Secretary at (202) 551-5400.

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.

Sources:

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