Now that you’ve seen what ACA Insight has to offer, don’t be without it. Subscribe now!

The weekly news source for investment management legal and compliance professionals

Current subscribers - please log in to the website in the upper right-hand corner

News February 21, 2011 Issue

What They’re Saying About The Proposed Registration Exemptions For Advisers To Venture Capital Funds and Certain Other Private Funds

As part of the Dodd-Frank Act mandates, back in November the SEC proposed three new definitions for advisers that would be exempt from registration with the SEC Ė venture capital funds, private fund advisers with less than $150 million in assets under management, and foreign private advisers.

The comments on that proposal are in, and here are some of the industryís observations for the staffís review in promulgating the final rule:

The venture capital fund grandfathering provision is overbroad.

The venture capital industry did not have much to say about the grandfathering provision. The North American Securities Administrators Association (NASAA), however, did. A private investment vehicle needs only to have offered investments during the relevant time period (up to the private fund adviser registration deadline) and called itself a "venture capital fund" to qualify for the relief, said NASAA president David Massey. "This approach seems overly expansive and we urge the Commission to consider imposing additional substantive requirements similar to those that will be in place after adoption of the definition of venture capital fund."

Certain definitions in the grandfathering provision may be limiting.

Industry terminology has evolved, and defined terms used fifteen years ago can have different meanings today, said the National Venture Capital Association (NVCA). For example, "private equity" was originally used to describe a variety of alternative asset segments that included venture capital as a subset. Excluding funds described in older offering documents as "private equity" would disqualify legitimate venture capital enterprises based on the outdated terminology alone. "The NVCA believes that prior use of the term "private equity" should not, in and of itself, be disqualifying for these funds."

"Multi-strategy," "growth capital," and "growth sector" are examples of other terms that should not be per se disqualifying, but rather limited in application. Multi-strategy, for example, often referred to early- or late-stage investing, a sector, or a geography, which should be permissible, urged the NVCA. Where multi-strategy indicates a venture capital strategy combined with buyout or hedge fund strategies, however, it should not.

The definition of venture capital fund should apply to all such funds, whether formed in the U.S. or not.

The final rule should apply equally to both U.S. and non-U.S. firms, and should not be limited to funds or advisers formed under the laws of the United States and/or funds investing exclusively or primarily in U.S. portfolio companies, said the European Private Equity & Venture Capital Association (EPEVCA).

The NVCA agreed that venture capital funds should be able to form as, and invest in, non-U.S. entities. Non-abusive tax considerations, increased globalization, and competition concerns make it important that venture funds be allowed to organize as and invest in companies worldwide, it said.

It is essential to allow venture capital funds to hold some non-conforming assets.

After extensive review, the NCVA determined it is "vital" that the venture capital fund exemption provide for a permissible level of non-qualifying activity. The NVCA suggested a 15 percent cap on such capital commitments, urging the allowance was necessary "for the exemption and definition to function as Congress intended."

Make the limit a range of 15-20 percent of a venture fundís capital commitments, said Oak Investment Partners COO Grace Ames. "By their nature, VCFs need to have flexibility in determining how best to achieve their investment objectives and the objectives of financing their portfolio companies, particularly as venture capital financing practices continue to evolve." That flexibility will not change the venture fundís approach to investing or give rise to systemic risk, she said.

Follow-on investments in portfolio companies that are publicly traded should be permitted.

"Provided the venture capital fund continues to hold at least a majority of its original investments made earlier in privately acquired equity securities," follow-on investments in portfolio companies after they become public should be permitted, said the NVCA. "Because these public company investments would be limited to those in which the venture capital fund already holds privately acquired equity securities, Öand based on the limited life of a venture capital fund, investor protection and systemic risk concerns should not be implicated by such investments," it said.

The NVCA also urged the SEC not to limit a venture capital fundís holdings in the public securities of formerly private portfolio companies, either by time or amount, under the same rationale.

The American Bar Associationís Committee on the Federal Regulation of Securities (ABA Committee) also supported follow-on investments in public portfolio companies. The ABA Committee suggested that the SEC permit at least 20 percent of a venture capital fundís total investment in any one portfolio company to be made after that company becomes publicly traded.

Venture capital fund-of-funds should be permitted, provided the underlying funds are also venture capital funds.

The varying tax situations of U.S. and international investors have given rise to parallel investment entities and intermediate holding vehicles used by the venture capital industry, said the NVCA. Permitting these practices to continue, so long as each entity in the chain of ownership also qualifies as a venture capital fund, would not expand the scope of the exemption. Concerns of exceeding certain investment limitations could be addressed by requiring aggregation for certain purposes throughout the enterprise, or with a parallel investment vehicle. Qualifying the investments in this way would avoid fund-of-funds concerns and "allow the normal business practices of the venture capital industry to continue."

Law firm Dechert found no indication in the legislative history of the Dodd-Frank Act that Congress would be opposed to a private fund solely invested in venture capital funds. If the SEC prohibits venture capital funds from investing in other private funds and vehicles, the firm said "[w]e Öbelieve the Commission is limiting the Venture Capital Fund Adviser Exemption without the Congressional mandate to support such limitations."

The ABA Committee also believes the ability of venture capital funds to invest in private funds and pooled investment vehicles should be preserved. "We do not believe that exempting the use of such special purpose vehicles would create loopholes or allow leveraged buyout funds, hedge funds or any other funds that pose systemic risks to take advantage of the venture fund exemption," it said.

Clarify certain points about managerial assistance and control.

The "offer only" proposal in the rule is the right way to go, said the NVCA. Portfolio companies have different needs over time and the provision of actual assistance or control is not appropriate or necessary. Also, the NVCA requested confirmation that a management rights letter received by a venture fund from a portfolio company for purposes of the Venture Capital Operating Company rules under ERISA would qualify as an offer of managerial assistance. This will prevent unnecessary duplication of effort and expense, said NVCA, and provide certainty to venture capital funds.

Contractual management rights, without more, should qualify as offering managerial assistance, said Oak Investment Partners. Adopting this "already established industry standard" would provide consistency and certainty for investors and portfolio companies alike.

Advisers should have some leeway in calculating "regulatory assets under management."

Let advisers decide whether to include the types of assets and advisory services that generally would not subject a firm to regulation under the Advisers Act, said the Managed Funds Association (MFA). Family accounts, proprietary accounts and non-compensated accounts are all examples of such assets.

Excluding proprietary accounts encourages managers to have "skin in the game," said the ABA Committee, which aligns management interests with the interests of investors. Including such assets in the regulatory AUM calculation would give managers an incentive to reduce their personal commitments to the private funds.

Regulatory assets under management should reflect net assets, not gross assets.

The SEC should adhere to a net assets calculation, said the MFA, as a gross assets calculation "is likely to be complex and could lead to significant uncertainty as to whether an adviser has to register with the SEC."

Dechert agreed that net assets calculations provide the most accurate representation of an adviserís assets under management (AUM) for regulatory purposes. Calculating gross AUM is confusing to industry participants because they are accustomed to a net assets industry standard, misrepresents the actual size of the adviserís business, and adds volatility to AUM, said the firm.

In support of a net asset standard, the ABA Committee observed that "[a]lthough total assets may be an appropriate measure to consider in terms of systemic risk, we believe it extremely unlikely that a net asset limit of $150,000,000 in private funds could be leveraged into total investments that would pose any systemic risk."

Persons advising their own employee securities companies should be exempt.

Although the proposed rule doesnít specifically address this matter, it should, said Goodwin Procter partner Elizabeth Fries. By the SECís own acknowledgement, she said, "the employer-employee relationship is unlike the commercial relationship between an investment adviser and its client that the Advisers Act was intended to regulate."

In an extensive analysis, Fries noted that employee securities companies and other employee funds are already subject to the regulatory protections of the Investment Company Act and ERISA. Employers have no profit motive in the management of employee funds, and through them "seek only to compensate and reward their own employees for their services," said Fries. Establishing a voluntary exemption for such employers would permit them to attract and retain employees while avoiding the unintended consequences, costs, and burdens of registration.

Raise the $25 million foreign private adviser registration threshold to $100 million (or more).

The $25 million threshold proposed is "effectively too low," said Dechert. One U.S. client could cause a foreign private adviser to cross the line under the lower standard. "We do not believe the Congressional intent behind the Dodd-Frank Act was to subject such foreign advisers to the U.S. regulatory scheme."

The ABA Committee believes relatively few offshore advisers will be able to qualify for the exemption as articulated. Raise the U.S. AUM threshold to $100 million, the ABA Committee suggested, and clarify that where a foreign private adviser fails to meet the statutory criteria for exemption, it may still rely on other exemptions that might be available.

"We believe that [the $25 million threshold] risks diverting Commission resources towards firms that are systemically insignificant," said EPEVCA. EPEVCA suggested the threshold be increased to $150 million, corresponding to the mid-size private fund advisers exemption, or to $100 million, corresponding to the mid-size adviser registration threshold set forth in Dodd-Frank Act Section 410.

The registration threshold "should probably be raised to $150 [m]illion" to match the private fund advisers exemption, said the Association FranÁaise de la Gestion financiere.

Clarify that back offices in the U.S. are not "places of business" that would require foreign private advisers to register here.

In practice, many foreign advisers or their affiliates have offices for research or administrative purposes, said the ABA Committee. It suggested that the SEC should clearly state that offices engaged in those activities should not be considered a place of business in the United States, provided that no advisory activities are carried out at such offices.

Foreign adviser offices in the U.S. that conduct only research and due diligence type activities should not be deemed a "place of business" for purposes of the rule, said Dechert. "As long as it does not Ďhold himself outí as an adviser by regularly meeting with clients, conducting marketing activities, or providing regular and continuous investment advice to a client from the United States from that office, it should not be considered, said the firm.

Other suggestions made by commenters included:

  • refine certain definitions to permit a wider variety of legitimate venture fund practices, such as bridge financing for qualifying portfolio companies;
  • permit venture capital fund redemptions under "extraordinary" circumstances generally not controllable by the investor;
  • preserve the "participating affiliate" doctrine, which permits large, international investment management groups to structure their businesses to comply with the multiple legal regimes to which they are subject, without the additional costs of infrastructure and regulatory duplication; and
  • clarify that the management of "single investor" private funds will not cause a qualifying adviser to otherwise lose exempt status.