Smaller fund managers and advisers to venture capital funds now have concrete rules to permit continued exemption from Securities and Exchange Commission registration as investment advisers. However, even these exempt managers will need to report substantial information to the SEC beginning in 2012.
The SEC adopted final rules to implement the exemptions from registration for VC and smaller fund managers introduced by the Dodd-Frank Act1. At the same time, it granted a reprieve until March 30, 2012 for private equity and hedge fund managers who currently rely on the longstanding exemption for advisers with 14 or fewer clients to register as investment advisers. Therefore, such advisers must file Form ADV with the SEC by February 15, 2012.
The “Venture Capital Fund” Exemption. A fund manager will be exempt from registration with the SEC if its only clients are “venture capital funds,” each of which is a private fund that:
- represents to investors that it pursues a venture capital strategy,
- holds at least 80% of its “capital”2 (other than short term holdings of cash, cash equivalents and money market funds) in “qualifying investments,”
- does not borrow, provide guarantees or otherwise incur leverage in excess of 15% of its capital, and any such borrowing, guarantee or indebtedness is for a non-renewable term of not more than 120 days (any guarantee by the fund of a “qualifying portfolio company’s” obligations up to the amount of the value of the fund’s investment in the company is not subject to the 120 day limit),
- does not permit investors to withdraw or redeem their interests except in extraordinary circumstances, and
- is not registered as an investment company or a business development company.
A “qualifying investment” means:
- an equity security issued by a qualifying portfolio company that has been acquired directly by the fund from the qualifying portfolio company,
- any equity security issued by a qualifying portfolio company in exchange for an equity security described above, or
- an equity security issued by a company of which a qualifying portfolio company is a majority-owned subsidiary, or a predecessor, and is acquired by the fund in exchange for an equity security described above.
A “qualifying portfolio company” is a private operating company that:
- is not an affiliate of a public company, and
- does not borrow in connection with the fund’s investment and distribute to the fund the proceeds of such borrowing in exchange for the fund’s investment.
An existing VC fund may be grandfathered, even if it does not meet all the criteria for the new exemption, so long as it has:
- represented to investors at the time of the offering of its securities that it pursued a venture capital strategy,
- sold securities to one or more unrelated investors prior to December 31, 2010, and
- does not sell securities to or accept any new capital commitments from any person after July 21, 2011 (although it may call previously committed capital).
The Smaller Fund Exemption. Dodd-Frank also introduced a new exemption from SEC registration for fund managers with less than an aggregate of $150 million in assets under management, determined on an annual basis. Assets under management is the current market value (or fair value) of the fund’s assets, calculated using the same method the fund used to report account values to clients or to calculate fees, plus the contractual amount of any uncalled commitments. This exemption could apply to a manager that couldn’t fit within the venture capital fund exemption.
State Registration Requirements Still Apply. Note that (as now) a fund manager that it is exempt from SEC registration may still have to register with one or more states unless there is an applicable state law exemption. State registration typically also involves examinations and registration for advisory and sales personnel.
Reporting Requirements for Exempt Managers. Managers relying on the new venture capital fund or less-than-$150m exemptions (“exempt reporting advisers”) must comply with new reporting requirements. These will cover the following areas:
- identification of the manager, its owners and affiliates,
- other business activities of the manager that present conflicts of interest,
- financial industry affiliations of the manager,
- disciplinary history of the manager and its employees,
- organizational and operational information about the funds they manage, such as general information about the funds’ investment practices, the types of investors, and the adviser's services, and
- identification of the "gatekeepers" – auditors, prime brokers, custodians, administrators and marketers – that perform critical roles for the manager and the funds.
Fund managers who currently rely on the 14-client exemption and become exempt reporting advisers will need to file reports on the Commission's investment adviser electronic filing system (IARD), beginning no later than March 30, 2012. Those reports will be publicly available on the Commission's website.
Exempt fund managers will need to expand their existing supervisory / compliance procedures to ensure compliance with the elements of the exemption, as well as to cover the new reporting requirements.3