US Securities and Exchange Commission Issues Proposed Rule
22 November 10
Private Fund Adviser Exemptions - New Definitions
On November 19, 2010, the US Securities and Exchange Commission (the "SEC") issued Release IA-3111 (the "Proposing Release") setting forth proposed rules 203(l) and 203(m) (individually a "Proposed Rule" and collectively the "Proposed Rules") under the Investment Advisers Act of 1940 (the "Advisers Act") that will, when final, define and implement the private fund adviser exemptions. In this Briefing Note we will summarize the most significant aspects of these Proposed Rules. The Proposed Rules, which are not yet final, provide clarity for mid-sized investment advisers to private funds and advisers to venture capital funds as to their registration and reporting requirements under the Advisers Act. Those wishing to comment on either of the Proposed Rules should submit comments to the SEC by the first week of January 2011.
Background
On July 21, 2010, President Obama signed into law the Dodd-Frank Act, which amends the Advisers Act by, among other things, repealing the so called "Private Adviser Exemption" that currently exempts advisers with fewer than 15 clients from SEC registration and regulation. Repeal of the current Private Adviser Exemption becomes effective on July 21, 2011. In place of the Private Adviser Exemption, the Dodd-Frank Act creates several new exemptions, including an exemption for advisers solely to venture capital funds and an exemption for mid-sized investment advisers to private funds. The Proposed Rules define the term "venture capital fund" for purposes of the exemption for advisers solely to venture capital funds and provide a standard for determining what constitutes an adviser to a private fund with assets under management of less than $150 million in the US.
Proposed Rules
While the primary purpose of the Dodd-Frank Act was to require advisers to private funds (i.e. hedge funds, private equity funds and other pooled investment vehicles exempt under Section 3(c)(1) and/or Section 3(c)(7) of the Investment Company Act of 1940 (the "Company Act") from registration as investment companies) to register under the Advisers Act, it specifically identified certain fund advisers that it did not intend to subject to registration. Without defining the term, Section 407 of the Dodd-Frank Act exempted from registration advisers solely to "venture capital funds." Section 408 of the Dodd-Frank Act directed the SEC to exempt from Advisers Act registration private fund advisers with less than $150 million of assets under management in the US but provided no specificity either as to how to calculate assets under management or as to the definition of "in the United States." The Proposed Rules implement both exemptions by providing such definitions and guidance. However, these rules also require such exempt advisers to maintain such records and file such reports as determined by the SEC. Further, the Proposed Rules do not limit the SEC's authority to examine the books and records of any exempt reporting adviser.
Definition of Venture Capital Fund
The text of the Dodd-Frank Act clearly exempted venture capital fund advisers from registration under the Advisers Act, but did not make clear who would fall within the definition of venture capital fund. Proposed Rule 203(l) now provides such definition. The rule proposes to define a venture capital fund as a private fund that:
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Invests in (i) equity securities of "qualifying portfolio companies" ("QPCs") to provide operating and growth capital, at least 80% of which securities must be acquired directly from the issuer, (ii) cash and cash equivalents and (iii) US Treasuries maturing within 60 days;
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(i) Offers or provides significant managerial assistance to or (ii) controls the QPC;
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Does not use leverage in connection with its investment activities (other than providing loans to QPCs maturing in less than 120 days);
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Does not provide its investors with the right to redeem their interests in the fund except under extraordinary circumstances;
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Represents itself as a venture capital fund to investors; AND
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Is not registered under the Company Act and has not elected to be treated as a business development company.
The Proposed Rule also provides a grandfathering provision to include existing funds within the definition of venture capital fund for purposes of the venture capital fund adviser exemption. To be grandfathered, a fund must (i) have represented to investors at the time it offered securities that it was a venture capital fund (either by describing its investment strategy or describing itself in a manner consistent with funds who would comply with the venture capital fund adviser exemption set forth in the Proposed Rules), (ii) have sold securities to investors prior to December 31, 2010 and (iii) not have sold securities to or accepted capital commitments from any investor after July 21, 2011.
In the Proposing Release, the SEC went to great lengths to distinguish venture capital funds from private equity funds and other types of pooled investment vehicles. The SEC determined that Congress intended venture capital funds - and not private equity or hedge funds - to fall outside the scope of the SEC's registration requirements. Some of the key features that distinguish venture capital funds from other private funds according to the SEC include:
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Venture capital funds generally avoid the use of leverage in connection with their investments, which was a systemic concern underlying the adoption of the Dodd-Frank Act;
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Venture capital funds generally require the majority of their investment capital to be used to operate and grow their portfolio companies and not to buy out the interests of their owners;
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Venture capital funds invest in operating companies not other pooled vehicles or funds; and
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Venture capital funds have longer investment periods than other funds and generally do not permit their investors to have their interests redeemed.
Incorporating these fundamental concepts, in order to qualify as a venture capital fund the Proposed Rules require investments by such funds be limited only to equity securities in QPCs (and, as noted above, cash, cash equivalents or US Treasuries maturing within 60 days). A QPC is defined under the Proposed Rules as any company that (i) is not publicly traded, (ii) does not incur leverage in connection with the investment in it made by the private fund, (iii) uses the capital received from a private fund for working capital or for expansion rather than to repurchase the interests of its existing owners; and (iv) is an operating company and not a fund. A company need not be a US company to qualify as a QPC. Further, a fund's status as a venture capital fund under the Proposed Rules is not affected if the securities of any of its QPCs become publicly traded following the date of the fund's investment.
Private Fund Adviser Exemption
As required by the Dodd-Frank Act, Proposed Rule 203(m) provides an exemption from Advisers Act registration for investment advisers who only advise private funds and who have less than $150 million in the aggregate under management in the US. This private fund adviser exemption permits an investment adviser to advise an unlimited number of private funds so long as the aggregate value of the adviser's private fund assets under management in the US is less than $150 million. Non-US advisers would not lose the availability of this exemption even if they had non-fund clients outside of the US so long as all of their US clients are private funds. The definition of US persons used in Regulation S is generally incorporated into the Proposed Rules for purposes of determining if a non-US adviser has advised any US client that is not a private fund. The definition of US Person used in Regulation S is discussed in detail in our separate Briefing Note devoted exclusively to the foreign private adviser exemption.
With respect to private fund advisers whose principal place of business and office is in the US, Proposed Rule 203(m)-1 would count all assets under management (even those attributable to persons residing outside of the US and serviced from offices outside of the US) by such private fund advisers as "assets under management in the United States." However, private fund advisers whose principal place of business and office is located outside the US would only be required to count those assets managed from a US location towards the $150 million threshold.
For purposes of satisfying the private fund adviser exemption, private fund assets will be calculated in accordance with the requirements of Form ADV, the registration statement filed with the SEC by investment advisers. The amount of these assets would be determined quarterly based on their fair value as of the end of such quarter and would include uncalled capital commitments.
Finally, we note that Proposed Rule 203(m)-1 provides a transition period of one calendar quarter for registration with the SEC by a private fund adviser who fails to satisfy the private fund adviser exemption in the future because its assets under management in the US exceed $150 million on a quarterly basis. To qualify for the three month transition period, the adviser must be in compliance with all applicable SEC reporting requirements.
Conclusion
The Proposed Rules provide some clarity for those advisers wondering whether they would qualify for an exemption from Advisers Act registration. We do think that some true venture capital fund advisers may be unintentionally omitted from the benefits of the proposed venture capital fund adviser exemption as a result of the way in which they structure their transactions. For example, some venture capital invests purchase separate debt and warrant instruments and some do not provide managerial assistance to every portfolio company but have observer rights and certain control rights through their preferred equity instruments. Additionally, even those advisers who satisfy the exemptions from registration provided by the Proposed Rules will need to comply with other applicable SEC requirements (such as reporting obligations) and may need to obtain a similar exemption from applicable state registration.
We urge all private fund managers that have their principal place of business in the US or are located outside of the US and accept investments from US investors to consult with counsel regarding the potential effects of the Dodd-Frank Act.