On June 22, 2011, the Securities and Exchange Commission (SEC) adopted new rules and rule amendments under the Investment Advisers Act of 1940, as amended (Advisers Act),1 which implement provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) relating to the registration of investment advisers. These final rules go into effect on July 21, 2011 and are designed to give effect to four new Dodd-Frank exemptions from registration under the Advisers Act: the “venture capital exemption,” the “private fund adviser exemption” and exemptions applicable to “foreign private advisers” and “family offices.”
Before Dodd-Frank, investment advisers were able to rely on the “private adviser exemption” and were not required to register as an investment adviser if they did not hold themselves out as advisers and had less than 15 clients2 in a preceding 12-month period. Dodd-Frank eliminated the private adviser exemption as of July 21, 2011 and adopted the four new exemptions. Pursuant to the latest SEC pronouncements finalizing these exemptions, advisers will have until March 30, 2012 to comply with applicable registration requirements, unless an exemption applies or they are not qualified to register with the SEC.
Venture Capital Exemption
The final rules exempt advisers who manage only venture capital funds from the registration requirements of the Advisers Act.3 Rule 203(l)-1 defines a venture capital fund as a private fund4 that:
(i) holds, immediately after the acquisition of any asset (other than qualifying investments or short-term holdings), no more than 20 percent of the fund’s capital commitments in non-qualifying investments (other than short-term holdings)
(ii) does not borrow or otherwise incur leverage, other than limited short-term borrowing (excluding certain guarantees of qualifying portfolio company obligations by the fund)
(iii) does not offer its investors redemption or other similar liquidity rights except in extraordinary circumstances
(iv) represents itself as pursuing a venture capital strategy to its investors and prospective investors, and
(v) is not registered under the Investment Company Act of 1940, as amended (Investment Company Act) and has not elected to be treated as a business development company.
Under the final rules, venture capital funds are allowed to hold up to 20 percent of their capital commitments in investments that are not qualifying investments. Generally, qualifying investments consist of any equity security issued by a qualifying portfolio company that is directly acquired by the fund and certain equity securities exchanged for the directly acquired securities.
The 20 percent threshold for non-qualifying investments is tested any time a fund makes an acquisition of any asset (other than qualifying investments or short-term holdings). It does not mean that 80 percent of the fund’s capital commitments must be invested in qualifying investments as it is recognized by the SEC that a fund rarely invests 100 percent of its capital commitments. For example, if a fund makes an investment in a non-qualifying investment that is equal to 5 percent of its capital commitments, and, on the date that investment is made, the fund has used 20 percent of its capital commitments to pay management fees, holds qualifying investments representing 65 percent of its capital commitments, and holds non-qualifying investments representing 10 percent of its capital commitments, then the new 5 percent non-qualifying investment would be permitted because immediately after its acquisition, the fund would be holding only 15 percent of its capital commitments in non-qualifying investments.
The final rules also have a grandfather provision that would treat any private fund as a venture capital fund if that private fund: (i) represented to investors and potential investors at the time the fund offered its securities that it pursues a venture capital strategy; (ii) has sold securities to one or more investors prior to December 31, 2010; and (iii) does not sell any securities to, including accepting any capital commitments from, any person after July 21, 2011. An investment adviser is eligible to rely on the venture capital exemption only if it provides investment advisory services solely to venture capital funds that meet all of the elements of the definition for venture capital funds, including by means of the grandfather rule.
In order to rely on the venture capital exemption, advisers need to evaluate the terms of the partnership agreements and operating agreements for the funds they manage to determine whether such terms would disqualify the funds from being considered as venture capital funds for purposes of the exemption. In addition, advisers should evaluate the investment strategies and holdings of the funds to ensure that they satisfy all elements of the venture capital fund definition. The following summarizes some of the provisions that a venture capital fund may want to include in its partnership agreement or operating agreement (and, for the borrowing limitation, potentially in its loan agreement) as a result of the final rules. The failure to include the provisions is not fatal to the ability to claim the venture capital exemption so long as the fund operates as if they were included.
- Restrictions on Non-Qualifying Investments. The fund must limit its investments in non-qualifying investments such that, immediately after the acquisition of any asset (other than qualifying investments or short-term holdings), no more than 20 percent of the fund’s capital commitments is invested in non-qualifying investments.
- Limitations on Borrowing. The fund must limit its borrowings that remain outstanding for more than 120 days (including guarantees of a qualifying portfolio company’s obligations) to no more than 15 percent of the fund’s total capital contributions and uncalled capital commitments
- Redemption Rights. Investors in the fund must have no redemption rights except in “extraordinary circumstances” (such as changes in law or in the event of a merger). However, the fund can provide investors the right to be excluded from particular investments due to regulatory or other legal requirements.5
In addition, emerging venture managers often have an array of investment vehicles that precede the first committed venture fund that they manage. For example, the manager may have previously been a fundless sponsor and may still be managing several single-investment vehicles. The services offered by the adviser to these predecessor vehicles often carry on for years. Any such adviser that anticipates that it will be rendering services to these predecessor vehicles after the July 21, 2011 implementation date should closely examine and determine whether the services provided to the predecessor vehicles are investment advisory services for compensation. If they are, then the predecessor vehicles must be reviewed to determine if they are private funds that meet the venture capital fund definition or are grandfathered into that definition. If they do not, the predecessor, carryover vehicles may preclude use of the venture fund exemption available under the Advisers Act.
Private Fund Adviser Exemption
The private fund adviser exemption6 exempts from registration any investment adviser that provides investment advisory services only to qualifying private funds that have, in the aggregate, less than $150 million in assets under management in the United States. The rule defines qualifying private funds as (i) private funds (i.e., 3(c)(1) and (3)(c)(7) funds), and (ii) any fund that qualifies for an exclusion from the definition of investment company as defined in Section 3 of the Investment Company Act in addition to the exclusions provided by Section 3(c)(1) or 3(c)(7) of that Act. For example, a real estate fund that relies on the exclusion from the definition of an investment company provided by Section 3(c)(5) and Section 3(c)(7) of the Investment Company Act would be a qualifying private fund and its assets would count towards the $150 million threshold of the private fund adviser exemption.
An investment adviser may advise an unlimited number of qualifying private funds, so long as the aggregate value for all the assets under management of the qualifying private funds is less than $150 million. Investment advisers that have one or more clients that are not qualifying private funds are not eligible for the private fund adviser exemption. So, a single separate account will disqualify the adviser from eligibility for the private fund adviser exemption.
Investment advisers with a principal office and place of business outside the United States (a non-U.S. adviser) may also rely on the private fund adviser exemption as long as all of the non-U.S. adviser’s clients that are U.S. persons are qualifying private funds.7 A non-U.S. adviser need only count those private fund assets it manages at a place of business in the United States toward the $150 million threshold of the private fund adviser exemption. As a result, a non-U.S. adviser is not required to limit the type or number of its non-U.S. clients or the amount of assets it manages outside the United States in order to qualify for the private fund adviser exemption.
Foreign Private Adviser Exemption
Dodd-Frank exempts “foreign private advisers” from registration under the Advisers Act and the final rules clarify the exemption. The exemption is available to a foreign private adviser that meets all of the following conditions:
(i) it has no place of business in the United States
(ii) it has fewer than 15 clients in the United States and investors in the United States in private funds advised by it
(iii) it has less than $25 million of assets under management attributable to clients in the United States and investors in the United States in private funds advised by it, and
(iv) it does not hold itself out generally to the public in the United States as an investment adviser.
Family Office Exemption
Dodd-Frank created a new exclusion from the Advisers Act under which family offices, as defined by the SEC, are not investment advisers under the Advisers Act and therefore are not subject to Advisers Act regulation.8 The final rules define a “family office” as a company that (i) has no clients other than family clients,9 (ii) is wholly-owned by family clients and is exclusively controlled (directly or indirectly) by one or more family members and/or family entities, and (iii) does not hold itself out to the public as an investment adviser. A family office that meets these conditions would not be considered an investment adviser for purposes of the Advisers Act. If it is not an investment adviser, it is not covered by the registration or other provisions of the Advisers Act.
Measuring Assets Under Management
The ability of an investment adviser to rely on the private fund adviser exemption or the foreign private adviser exemption is conditioned upon the adviser not exceeding specified amounts of “assets under management.” How to measure assets under management has been a topic of much discussion. In the final rules, the SEC amended the instructions to Form ADV to provide a uniform method for calculating assets under management for regulatory purposes, including eligibility for federal (i.e., SEC), rather than state, registration; reporting assets under management for regulatory purposes on Form ADV; and determining eligibility for the private fund adviser exemption and the foreign private adviser exemption. The amended instructions are technical and detailed. Following is a summary of some of the key guidelines for calculating assets under management.
Generally, the amended instructions require advisers to determine their assets under management based on current market values of the assets as determined within 90 days prior to the date of filing their Form ADV. Assets under management must be valued and calculated annually. Advisers must calculate their regulatory assets under management on a gross basis, that is without deduction of any outstanding indebtedness or other accrued but unpaid liabilities.
Advisers must include in their regulatory assets under management (i) the market value of any private fund over which they exercise continuous and regular supervisory or management services, and (ii) the amount of any uncalled commitments made to a private fund managed by them. Uncalled commitments are included for so long as the investor is subject to an obligation to contribute them, regardless of whether the adviser intends to call the commitment or not. In determining the market value of assets under management, advisers cannot simply value the private fund’s assets at cost, but must use the market value of the assets, or the fair value of the assets in cases in which market value is unavailable.
The final rules require advisers to determine market value using the same method they used to report account values to clients or to calculate fees for investment advisory services. To reemphasize this point and to remind advisers of their obligation of good faith, in a footnote to the final rules release, the SEC stated that it expects advisers that calculate fair value in accordance with GAAP or another basis of accounting for financial reporting purposes will also use that same basis for purposes of determining the fair value of their regulatory assets under management.
Reporting by Exempt Reporting Advisers
In amending the Advisers Act to provide for the venture capital exemption and the private fund adviser exemption, Dodd-Frank gave the SEC authority to require investment advisers relying on these exemptions (we refer to such advisers as “exempt reporting advisers”) to maintain such records and to submit such reports as the SEC determines is necessary or appropriate in the public interest or for the protection of investors. There is no express threshold below which reporting by exempt reporting advisers is not applicable. Instead, the reporting obligation focuses on whether an investment adviser is relying on the venture capital exemption and the private fund adviser exemption.
Under the final rules, exempt reporting advisers must file reports with the SEC electronically on Form ADV through the IARD using the same process used by registered investment advisers. Generally, an exempt reporting adviser must submit its initial Form ADV within 60 days of relying on the exemption from registration provided by the venture capital exemption or the private fund adviser exemption. Under the final rules, exempt reporting advisers will need to file their initial Form ADV between January 1, 2012 and March 30, 2012.
In its filings, an exempt reporting adviser will need to disclose information about its assets under management, organization, ownership, control and disciplinary history about the adviser and its employees. An exempt reporting adviser must also provide basic information regarding the size and organizational, operational, and investment characteristics of each private fund it advises.
Once filed, any information disclosed by an exempt reporting adviser on its Form ADV (including any information about the private funds it manages) will be publicly available. As a result, such information will be available to prospective investors in private funds managed by an adviser and prospective investors will be able to compare Form ADV information to the information they have received in offering documents and due diligence.
With respect to the record keeping and reporting obligations of exempt reporting advisers, the final rules only address their reporting obligations. The SEC staff noted in a footnote to the final rules release that record keeping requirements for exempt reporting advisers will be addressed in a future release.
SEC Registration Deadline
As part of its rule-making initiative, the SEC adopted a transition rule10 that allows advisers that rely on, and were entitled to rely on, the private adviser exemption on July 20, 2011, to delay registering with the SEC until March 30, 2012. Advisers should seek to submit their complete Form ADV and compliance documents by no later than February 14, 2012 in order to allow for the normal SEC review and processing time and to ensure that they are in compliance by the March 30, 2012 deadline.
Transition to State Registration
Under Section 410 of Dodd-Frank, an investment adviser that is required to be registered as an investment adviser in the state in which it maintains its principal office and place of business and that has assets under management between $25 million and $100 million is not permitted to register with the SEC. As a result, Dodd-Frank created a new category of “mid-size advisers” and shifted the primary responsibility for their regulatory oversight to the states. However, there are, of course, exceptions: a mid-sized adviser must register with the SEC: (i) if the adviser is not required under the state’s rules to be registered as an investment adviser with the securities commissioner (or any agency or office performing like functions) of the state in which the adviser maintains its principal office and place of business; or (ii) if registered with that state, the adviser would not be subject to examination as an investment adviser by that securities commissioner. All state securities authorities other than Minnesota, New York and Wyoming have informed the SEC that advisers registered with them are subject to examination. In addition, the final rules permit any investment adviser who is required to register in 15 or more states to instead register with the SEC.
To implement Section 410 of Dodd-Frank, the SEC has adopted new Advisers Act Rule 203A-5 to provide for an orderly transition to state registration for mid-sized advisers that will no longer be eligible to register with the SEC.
- Existing Registrants – Under Rule 203A-5, each adviser registered with the SEC on January 1, 2012 must file an amendment to its Form ADV no later than March 30, 2012. These amendments will identify mid-sized advisers no longer eligible to remain registered with the SEC.
Mid-sized advisers that are no longer eligible for SEC registration must withdraw their SEC registrations by filing Form ADV-W no later than June 28, 2012. Mid-sized advisers registered with the SEC as of July 21, 2011 must remain registered with the SEC (unless an exemption from SEC registration is available) until January 1, 2012.
- New Applicants –Until July 21, 2011, advisers applying for registration with the SEC that qualify as mid-sized advisers may register with either the SEC or the appropriate state securities authority. Thereafter, all such advisers are prohibited from registering with the SEC and must register with the state securities authorities. Advisers with $100 million or more of assets under management will continue to register with the SEC (unless an exemption from registration with the SEC otherwise is available).
Any adviser that is not eligible to register with the SEC should consult state law in the states in which they are doing business to determine if they are required to register in those states.