On November 19, 2010, the Securities and Exchange Commission proposed a new rule, based on requirements under the Dodd-Frank Wall Street Reform and Consumer Protection Act, or the Financial Reform Act, defining “venture capital funds” for purposes of exempting advisers to these funds from registering under the Investment Advisers Act of 1940. In the past, advisers to venture capital funds have not been required to register with the SEC under the Investment Advisers Act so long as they had fewer than 15 clients and were not holding themselves out to the public as investment advisers. The Financial Reform Act will eliminate this “private adviser exemption” effective July 21, 2011, but it also provides for certain limited exemptions, including one for advisers that exclusively advise “venture capital funds.” Qualifying for the exemption will enable advisers to venture capital funds to avoid some of the more onerous compliance requirements of the Investment Advisers Act, but these advisers will still be subject to significant reporting, recordkeeping and compliance obligations.
The SEC is proposing to define a “venture capital fund” as a private fund that
- invests in equity securities of “qualifying portfolio companies” in order to provide operating and business expansion capital;
- acquires at least 80% of each target’s securities directly from the qualifying portfolio company;
- offers, and if the offer is accepted provides, significant managerial assistance to, or controls, the qualifying portfolio company;
- does not borrow, provide guarantees or otherwise incur leverage (other than limited short-term borrowing);
- does not offer its investors redemption or other similar liquidity rights except in extraordinary circumstances;
- represents itself as a venture capital fund to investors; and
- is not registered under the Investment Company Act of 1940 and has not elected to be treated as a business development company under the Investment Company Act.
The proposed rule also contains a grandfathering provision that would apply to any private fund that
- represented to investors and potential investors at the time the fund offered its securities that it is a venture capital fund;
- has accepted capital commitments from one or more investors prior to December 31, 2010; and
- does not accept any capital commitments (including additional capital commitments) from any person after July 21, 2011.
Don't Delay the Initial Closing of a New Venture Capital Fund. The SEC is requesting comment regarding the dates specified in the grandfathering provision. However, based on the grandfathering provision as proposed, any sponsor who is in the process of forming a venture capital fund should seek, if practicable, to hold a first closing prior to December 31, 2010.
Qualifying Portfolio Companies
Under the proposed rule, a venture capital fund may invest only in equity securities of “qualifying portfolio companies.”
For purposes of this exemption, a “qualifying portfolio company”
- cannot have equity securities that are publicly traded at the time of any investment;
- cannot, directly or indirectly, borrow or issue debt obligations in connection with the venture capital fund’s investments (the portfolio company can incur financing for working capital);
- must use the capital provided by the venture capital fund for operating or business expansion purposes rather than to buy out other investors; and
- cannot itself be a fund (i.e., it is an operating company).
For purposes of the proposed rule, the definition of “equity security” is the same as that found in section 3(a)(11) of the Securities Exchange Act of 1934 and Rule 3a11-1 thereunder. This definition includes common stock, preferred stock, warrants and other securities convertible into common stock as well as limited partnership interests. This term would not include debt securities issued by, or loans made to, a portfolio company. A venture capital fund may also invest in cash and cash equivalents and U.S. Treasuries with a remaining maturity of 60 days or less.
To qualify as a “venture capital fund,” the fund or its adviser must either (i) have an arrangement under which it offers to provide significant guidance and counsel concerning the management, operations or business objectives and policies of the portfolio company (and, if accepted, actually provides the guidance and counsel) or (ii) control the portfolio company.
Limitation on Leverage
Under the proposed rule, a “venture capital fund” may not borrow, issue debt obligations, provide guarantees or otherwise incur leverage in excess of 15% of the fund’s aggregate capital contributions and uncalled committed capital. Further, any such borrowing, indebtedness, guarantee or leverage must be for a nonrenewable term of no longer than 120 calendar days.
No Redemption Rights
Investors in a “venture capital fund” cannot have redemption rights except in “extraordinary circumstances.” Examples of extraordinary circumstances for redemption rights would include foreseeable but unexpected circumstances due to regulatory or other legal requirements (e.g., tax and regulatory changes). Pro rata distributions of profits are permitted.
Represents Itself as a Venture Capital Fund
Under the proposed rule, a “venture capital fund” must represent itself as being a venture capital fund to its investors and potential investors (e.g., by describing its investment strategy as venture capital investing or itself as a fund that is managed in compliance with the elements of the SEC’s proposed rule).
Trap for the UnwaryExempt “Venture Capital Fund” Advisers Must Still Comply with Reporting Requirements. Under the proposed rule, advisers to a venture capital fund who meet the conditions of the Investment Advisers Act exemption would nonetheless be required to submit and periodically update reports to the SEC by completing a limited subset of items on Form ADV.
Deadline for Comments
Public comments on the proposed rule may be submitted to the SEC on or before January 3, 2011.
This update is only intended to provide a summary of the SEC's proposed rule. You can read the full text of the proposal at http://www.sec.gov/rules/proposed/2010/ia-3111.pdf.
© 2010 Perkins Coie LLP