Section 407 of the Dodd-Frank Act provides an exemption from registration as an investment adviser if the investment adviser provides advice solely to one or more venture capital funds. The Dodd-Frank Act goes on to require the SEC to define the term “venture capital fund.”

The SEC previously attempted to regulate hedge funds, but not private equity groups or venture capital funds, when it adopted Rule 203(b)(3)-2 under the Investment Advisers Act. Rule 203(b)(3)-2 was ultimately invalidated in the case of Goldstein v. SEC (D.C. Cir. June 23, 2006). However, the Rule’s history demonstrates the difficulty the SEC will have in distinguishing venture capital funds from private equity and hedge funds.

Rule 203(b)(3)-2 was adopted in SEC Release No. IA-2333. In that release, the SEC noted that one of the distinguishing characteristics of a venture capital fund was that venture capital funds are generally organized to invest in the start-up or early stages of a company. That does not seem to be a precise enough line on which to exclude venture capital funds from regulatory jurisdiction. In that same release, the SEC also said distinguishing a venture capital fund from a hedge fund based on investment strategy or portfolio composition was not appropriate because the SEC was concerned that it could serve to chill advisers’ use of certain investment strategies solely in order to avoid registration under the Investment Advisers Act, which might negatively affect the markets.

The task is further complicated because of the similarities between venture capital funds and private equity funds. The SEC noted that venture capital funds have the same features that distinguish private equity funds generally from hedge funds, such as capital contributions over the life of the fund and the long-term nature of the investment. Finally, the SEC noted that a venture capital fund typically seeks to liquidate its investment once the value of the company increases above the value of the investment.

The SEC distinguished private equity and venture capital funds from hedge funds in Release No. IA-2333 by basing the determination on whether the fund permits investors to redeem their interests in the fund within two years of purchasing them. Since both private equity and venture capital funds share that characteristic, it does not provide a useful tool to isolate venture capital funds.

The SEC has a difficult task in defining the term “venture capital fund.” It appears the only avenue is to base the determination on investment strategy or portfolio composition, but the SEC has previously rejected that mechanic.