Alert June 30, 2011

Advisers Act Alert Part 6: Registration Exemption for "Venture Capital Fund" Advisers

Includes selected updates as of November 1, 2011

As noted above, beginning July 21, 2011 the Venture Capital Exemption is available to advisers that manage only venture capital funds. Thus, a single adviser that manages both venture capital funds and other types of funds cannot qualify for the Venture Capital Exemption (although certain firms with multiple advisory entities may be able to use different exemptions for a different entities, as discussed below). The new rules provide a detailed definition of “venture capital fund” for this purpose, although a less restrictive definition applies to existing funds that qualify for a “Grandfather Rule.” Both definitions are described below.

Definition of “Venture Capital Fund.” Except as provided in the Grandfather Rule, a “venture capital fund” (or “VC fund”) is required to have all of the following attributes: (1) pursues a venture capital strategy; (2) makes qualifying investments; (3) limits leverage; (4) offers no broad redemption rights; (5) has not registered under the 1940 Act or elected to be a BDC6; and (6) is a “private fund.”

Venture Capital Strategy. The VC fund must represent to its investors and potential investors that it pursues a venture capital strategy. As described in the Exemptive Release, the determination of whether a VC fund makes such a representation is based upon all of the statements (and omissions) made by the fund to its investors and prospective investors. This would include statements made in marketing materials (such as a private placement memorandum or pitch deck) and governing agreements (such as a limited partnership or subscription agreement). It is not necessary for the fund to include the term “venture capital” in its name. It may even be possible for a VC fund to properly represent itself as pursuing a venture capital strategy without ever using the term, although such an effort generally would seem to create unnecessary risk.

The new rules do not expressly state that a VC fund must represent that it pursues a venture capital strategy to the exclusion of all other strategies. However, the Exemptive Release does state that it would not be acceptable for a VC fund to represent itself as a “multi-strategy” fund. This suggests it would be acceptable for a fund to represent itself as pursuing “principally” or “primarily” a venture capital strategy, with some degree of flexibility to make a modest number of purely opportunistic investments that do not rise to the level of a bona fide “strategy.”

Significantly, the Exemptive Release does not define the term “venture capital strategy,” although it notes that certain investment strategies (e.g., investments in oil and gas leases and short-term investments) are not venture capital strategies. In the absence of a definition, it would be advisable for funds seeking to qualify as VC funds to affirmatively use the term “venture capital strategy” in their marketing materials and governing agreements. The Exemptive Release suggests it should be acceptable for VC funds to indicate that they pursue a specific type of venture capital strategy (e.g., seed-stage, growth-stage, international, cleantech, etc.).

Finally, the Exemptive Release notes that it may be a violation of the Advisers Act (as well as other applicable securities laws) for a fund to falsely represent itself as pursuing a venture capital strategy while actually pursuing a different strategy. Especially in light of the new rules’ failure to define the term “venture capital strategy,” the obligation of VC funds to represent that they pursue such a strategy may create a new source of risk for advisers whose strategy is difficult to characterize.

Qualifying Investments. As of the time immediately after a VC fund’s acquisition of any asset other than a qualifying investment or short-term holding, not more than 20% of the fund’s capital may consist of assets other than qualifying investments or short-term holdings. This 20% “basket” is intended to allow a VC fund flexibility to engage in a variety of investments and activities outside the new rules’ strict notion of “venture capital” investing. The Exemptive Release expressly contemplates that, within this basket, qualifying VC funds may make investments more typically associated with hedge, private equity or other types of funds, as well as other investments that do not meet the strict “qualifying investment” tests for any reason.

  • 20% of Capital. For this purpose, a VC fund’s capital is deemed to consist of (1) capital contributed to the fund plus (2) uncalled capital commitments. This is not identical to the total capital commitments made by the fund’s equityholders. Principally, the rule appears to exclude capital that has been called, but not yet contributed (e.g., in the case of a pending capital call or a capital call default). Moreover, the Exemptive Release states that uncalled capital commitments may be counted only if they are bona fide commitments (i.e., there must be no understanding that such commitments will not be called and the adviser must have a reasonable belief that investors will be able to satisfy calls when issued (e.g. the investor is not known to be suffering significant financial distress)). This will require care in performing the calculation and may create difficult questions regarding the capital commitments of investors that the adviser believes to be in financial distress or otherwise subject to burdens (such as regulatory limitations) that may interfere with satisfaction of capital calls.
  • Valuation of Non-Qualifying Assets. For purposes of applying the 20% test, non-qualifying assets may be valued at cost or fair value, provided that the fund must apply the same method to all non-qualifying assets in a consistent manner throughout the fund’s term. Alternating between valuation methodologies is not permitted. Because the fair value of most VC fund assets is difficult to determine with precision, and can vary on a highly unpredictable basis, we anticipate that most funds will elect to value non-qualifying assets at cost for purposes of the 20% test.
  • Immediately After Acquisition of Any Asset. The 20% test is applied only immediately after the VC fund’s acquisition of an asset (other than a qualifying investment or short-term holding). Thus, a subsequent change in the value of non-qualifying assets, or the amount of the VC fund’s capital, will not result in failure to satisfy the 20% test (unless yet another such asset is acquired, in which case the 20% test must be reapplied). While the new rules state that the 20% test must be applied immediate after the fund’s acquisition of any asset (other than a qualifying investment or short-term holding), the explanatory language in the Exemptive Release raises the possibility that the 20% test need not apply if the fund acquires an asset other than an investment asset (e.g., an interest in an escrow account upon the sale of a portfolio company, a debt security received pursuant to settlement of a dispute or an item of intellectual property received pursuant to the liquidation of a portfolio company). This reading would seem fair, since a fund should presumably not cease to be a VC fund simply because it received a non-qualifying asset outside the normal course of its investment activities. In any event, if a fund expects to acquire such a non-qualifying asset, it may be advisable to avoid acquisition by pre-selling the right to receive the asset or by other means.
  • Not a Percentage of Current Portfolio. Based on the rules described above, it is quite possible that a VC fund may, at multiple times during its term, hold a portfolio that consists substantially (or even entirely) of non-qualifying assets without violating the 20% test. For example, a VC fund’s initial investment (at the start of its term) or last remaining investment (at the conclusion of its term) might be a non-qualifying asset. In either such case, the portfolio would, at a specific point in time, consist entirely of non-qualifying assets. So long as those assets do not exceed 20% of the VC fund’s capital at the time of acquisition, the 20% test should be satisfied.
  • Short-Term Holdings. Short-term holdings generally include cash (including foreign currencies), cash equivalents (i.e., bank deposits, certificates of deposit, bankers acceptances and similar bank instruments held for investment purposes, as well as the net cash surrender value of an insurance policy), U.S. Treasury obligations with a remaining maturity of 60 days or less, and shares of a money market fund that is registered under the 1940 Act. As described in the Exemptive Release, short-term holdings do not include other common types of short-term investments such as U.S. Treasury obligations with longer maturities, debt issued by foreign governments, repurchase agreements and commercial paper.
  • Types of Qualifying Investments. In general, a “qualifying investment” is defined to mean: (1) an equity security issued by a qualifying portfolio company that has been acquired by the VC fund directly from such portfolio company (a “Directly Acquired Security”); (2) an equity security issued by a qualifying portfolio company in exchange for a Directly Acquired Security previously issued by the qualifying portfolio company (a “Recap Security”); and (3) an equity security issued by a company of which a qualifying portfolio company is a majority-owned subsidiary, or a predecessor, and that is acquired by the VC fund in exchange for a Directly Acquired Security or a Recap Security (an “M&A Security”).
    • Equity Security. The term “equity security” is defined very broadly (by reference to the definition under Section 3(a)(11) of the Securities Exchange Act of 1934) and includes: “any stock or similar security, certificate of interest or participation in any profit sharing agreement, preorganization certificate or subscription, transferable share, voting trust certificate or certificate of deposit for an equity security, limited partnership interest, interest in a joint venture, or certificate of interest in a business trust; any security future on any such security; or any security convertible, with or without consideration into such a security, or carrying any warrant or right to subscribe to or purchase such a security; or any such warrant or right; or any put, call, straddle, or other option or privilege of buying such a security from or selling such a security to another without being bound to do so.”

      Within the context of common VC fund investments, the term “equity security” includes typical forms of common and preferred stock, convertible debt (such as bridge loans), warrants, options, and limited partnership interests. Limited liability company (“LLC”) interests are not specifically addressed, although it seems likely that most typical LLC interests would be treated as equity securities for this purpose. The inclusion of preorganization certificates and subscriptions may be particularly helpful to seed-stage VC funds that acquire interests in companies which have not yet completed their formation process.

      The term “equity security” includes many typical forms of hedges (e.g., puts, calls and straddles relating to common or preferred stock). However, it also appears to exclude many typical forms of hedges (e.g., currency and interest rate swaps). As with other types of non-qualifying investments, a qualifying VC fund may enter into non-qualifying hedges within its 20% basket.
    • Qualifying Portfolio Company. In general, a “qualifying portfolio company” is any company that: (1) at the time of the VC fund’s investment, is not publicly traded and is not controlled, controlling or under common control with respect to a publicly traded company; (2) does not borrow and distribute the proceeds of such borrowing to the VC fund in exchange for the fund’s investment; and (3) is not an investment company, investment fund or commodity pool.

      In this context, publicly traded means subject to the reporting requirements of the Securities Exchange Act of 1934 or having a security listed or traded on any exchange or organized market operating in a foreign jurisdiction. This rule may be particularly problematic for VC funds that invest outside the U.S., where many companies become publicly traded while still in early stages of development.7

      Because the publicly traded status of a portfolio company is determined only at the time of the VC fund’s investment, an otherwise qualifying investment in a portfolio company will not cease to qualify when the company conducts an IPO or otherwise becomes publicly traded (although a new investment in the company after it has become publicly traded generally would not be a qualifying investment). The new rules are not explicit with respect to the status of equity securities acquired from a publicly traded portfolio company via the conversion or exercise of qualifying investments that consist of convertible debt, options or warrants acquired by the VC fund before the portfolio company became publicly traded, but it would be logically consistent with other parts of the new rules for such newly acquired securities to be treated as qualifying investments.

      The limitation on borrowing and distribution of proceeds to the VC fund is quite narrow. The Exemptive Release clearly states that the limitation applies only to borrowings in which proceeds are actually distributed to the VC fund in exchange for the fund’s investment. In essence, the limitation applies when, as part of an integrated transaction, a portfolio company borrows and then distributes proceeds in order to repay all or a portion of the fund’s investment. Thus, a qualifying portfolio company may borrow for general business purposes and, it appears, may even borrow to redeem securities held by third parties. Moreover, the Exemptive Release states that subsequent distributions by the portfolio company to the VC fund solely in respect of the fund’s status as an investor would not be subject to the limitation.

      As described in the Exemptive Release, a qualifying portfolio company generally must be an operating company, rather than an investment company, investment fund or commodity pool. The Exemptive Release expressly allows a VC fund to hold the fund’s investment in a qualifying portfolio company through a wholly owned intermediate holding company formed solely for tax, legal or regulatory reasons. However, the Exemptive Release does not expressly contemplate the use of a single holding company that is jointly owned by two or more affiliated VC funds (a structure that would seem quite consistent with the purposes of the new rules). If the new rules are interpreted to preclude the use of jointly owned holding companies, it would be particularly burdensome in the context of parallel fund structures. Often, in these structures, several parallel funds (e.g., a main VC fund, a “principals VC fund” for members of the General Partner and an “affiliates VC fund” for a broader group of strategic persons) have used jointly owned holding companies to facilitate the periodic rebalancing of their ownership interests in portfolio companies without the need to formally transfer ownership of portfolio company shares.8

      In general, VC funds cannot themselves be qualifying portfolio companies, with the result that funds-of-venture-capital-funds cannot qualify for the Venture Capital Exemption.
    • Directly Acquired and Recap Securities. Except in the context of an M&A transaction, a qualifying investment for a VC fund generally must be acquired directly from the issuer, which means that equity securities acquired on a secondary basis (e.g., from pre-existing investors directly or via a secondary market mechanism) cannot be qualifying investments. The Exemptive Release does not specifically address the treatment of equity securities issued by a company to a VC fund that was not previously an investor in connection with the company’s redemption of equity securities from pre-existing investors (i.e., a transaction that might be considered an indirect secondary mediated by the company). In the context of a recapitalization, the Exemptive Release acknowledges that Recap Securities can be qualifying investments when “the [VC] fund, along with other existing security holders, [accepts] newly issued equity securities in exchange for previously issued equity securities.” The Exemptive Release does not specifically address a recapitalization in which some stakeholders are redeemed or washed-out, but it would seem consistent with other provisions of the new rules, and common practice relating to recapitalizations, to conclude that such redemptions or wash-outs generally should not disqualify equity securities issued in the recapitalization.
    • M&A Securities. As stated in the Exemptive Release, a VC fund generally may “acquire securities in connection with the acquisition (or merger) of a qualifying portfolio company by another company, without jeopardizing the fund’s ability to satisfy the definition of a venture capital fund.”

      Under the specific provisions of the new rules, a qualifying investment will include equity securities issued by an acquiror (even though the acquiror is not a qualifying portfolio company) in a transaction pursuant to which the target portfolio company becomes a majority-owned subsidiary of the acquiror, so long as the securities surrendered by the VC fund in the transaction were themselves a qualifying investment. The new rules specify the same result if the target portfolio company is a “predecessor” of the acquiror.

      While these provisions would appear to cover most common M&A transactions involving acquirors that are not themselves qualifying portfolio companies, some types of transactions are not clearly addressed (e.g., an acquisition that is structured as an asset purchase). It would seem appropriate to provide the same treatment for those types of transactions, although additional guidance may be required to achieve clarity on this point.

    Limitation on Leverage. In general, the aggregate amount of a VC fund’s borrowing, issued debt obligations, guarantees of third-party obligations and other leverage must not exceed 15% of the VC fund’s capital (as defined above), and any such borrowing, obligations, guarantees and other leverage must have a non-renewable term of 120 days or less. However, the 120-day limit does not apply to the VC fund’s guarantee of a qualifying portfolio company’s obligations (but only up to the amount of the VC fund’s investment in such qualifying portfolio company).

    • Recycling the 15% Limit; When and How Tested. Although not expressly stated in the Exemptive Release, it appears that the 15% limit should be determined by reference to the amount of borrowing, obligations, guarantees and other leverage in effect at a specific time, rather than on a cumulative basis over the VC fund’s term. In this regard, the Exemptive Release leaves a number of open questions, such as (1) whether the 15% test is applied only immediately after each new borrowing, obligation, guarantee or other leverage transaction is entered into, and (2) whether accrued interest must be taken into account when determining the amount of a VC fund’s borrowing, obligations, guarantees and other leverage.
    • Changes to Common Borrowing Arrangements. Many VC funds establish lines of credit to bridge capital calls and provide for other short-term capital needs. Such lines of credit may still be used, but a number of previously common terms generally should be changed. For example, such lines of credit generally should no longer provide for terms longer than 120 days or for automatic renewals (although it is possible that such changes may not be required with regard to the use of lines of credit exclusively to bridge capital calls, so long as each draw-down to bridge a capital call is repaid within 120 days and each subsequent draw-down relates to a different capital call). It also would be advisable to carefully review loan agreements for cross-guarantee provisions. Many loan agreements require cross-guarantees by parallel or affiliated funds. Such cross-guarantees generally would count toward the 15% limit.
    • Traps for the Unwary. VC funds often engage in activities that may be deemed a borrowing, issuance of a debt obligation or other form of leverage for purposes of the new rules. For example, a VC fund’s General Partner may defer receipt of management fees in order to allow the fund to make additional investments. Unless properly structured, such a deferral may be deemed a borrowing or other use of leverage that counts toward the 15% limit. Similarly, many VC fund agreements provide for the redemption of an investor’s interest in exchange for a long-maturity promissory note (with or without interest or recourse) if the investor defaults on a capital call, fails to provide information needed by the VC fund to comply with applicable law, or would (by its continued participation as an investor) impose upon the VC fund substantial legal, tax or other burdens. Because such notes may count toward the 15% limit, it often may be advisable to seek alternative remedies.
    • Loans vs. Guarantees. Often, a guarantee of portfolio company indebtedness can be avoided by making a loan to the portfolio company. Loans to portfolio companies do not appear to count toward the 15% limit. In some circumstances, it may be possible to replace a guarantee with a commitment to make a loan upon the occurrence of certain events (although such an arrangement must be structured with care to prevent it from being deemed a de facto guarantee).

    No Broad Redemption Rights. A VC fund must not issue securities that grant investors a right (except in extraordinary circumstances) to withdraw, redeem or require the repurchase of such securities, although investors may be entitled to receive pro rata distributions from the fund. As described in the Exemptive Release, this rule is based upon a principal distinction between VC funds and hedge funds – specifically, broad redemption rights.

    • Most VC funds do not grant broad redemption rights because an investment strategy based upon investments in private companies makes it difficult, if not impossible, to generate the routine liquidity necessary to implement such rights.

      Notwithstanding that most venture capital funds do not grant broad redemption rights, it is fairly common for fund agreements to allow redemptions/withdrawals under specific, generally unlikely, circumstances. For example, many fund agreements allow investors regulated under ERISA or similar laws to withdraw if their continued participation would give rise to violation of such laws. The key issue is whether such circumstances rise to the level of “extraordinary circumstances.” Unfortunately, the language of the Exemptive Release is not particularly helpful, implying in some places that circumstances may be extraordinary if they are known to occur (e.g., corporate events such as mergers) but are unexpected in their timing or scope and implying in other places that circumstances based upon a legal requirement may be extraordinary only if they result from an actual change in the law and that the trigger for extraordinary circumstances should be outside the control of the parties. Ultimately, it appears that the rule is based upon an intention to allow redemption rights of the type historically common within the venture capital industry.

      It is common for a hedge fund to prohibit redemptions and withdrawals during an initial two-year (or similar) lock-up period following investment in the fund. The Exemptive Release states that such initial period lock-ups do not rise to the level of extraordinary circumstances, and implies that other types of restrictions commonly imposed by hedge funds (e.g., caps on withdrawals that would represent too large a percentage of the fund’s total capital or otherwise impose an undue burden on the fund) also would not be deemed extraordinary circumstances.

      The Exemptive Release expressly states that an adviser could not rely upon the Venture Capital Exemption if it created de facto redemption or transfer rights by, for example, regularly identifying potential investors on behalf of fund investors seeking to transfer or redeem fund interests.
    • Carried Interest. The Exemptive Release indicates that the existence of a General Partner’s carried interest in the VC fund is not inconsistent with the requirement that distributions generally be pro rata so long as the General Partner’s carried interest in the VC fund is not a “security.” While the Exemptive Release notes that the treatment of the General Partner’s carried interest as a security must be based on the particular facts and circumstances, it is commonly believed that the typical carried interest is not a security.

    No Registration/Election Under the Investment Company Act. The VC fund must not be registered as an investment company under the 1940 Act (i.e., the fund must not be a mutual fund) or have elected to be a business development company under such Act.

    “Private Fund” Status; Special Rule. The VC fund must be a “private fund.”9 For this purpose, under the SEC’s prior interpretations of the 1940 Act, a fund generally can be a private fund only if it avails itself of U.S. jurisdictional means when fundraising or engaging in certain other activities, but the Venture Capital Exemption includes an additional special rule.

    • The special rule allows an adviser to treat certain funds as “private funds,” but only if the adviser is willing to treat the funds as private funds for all purposes under the Advisers Act. As stated in the Exemptive Release, this special rule is “designed to ensure that an adviser relying on the venture capital exemption by operation of [this special rule] is subject to the same Advisers Act requirements as other advisers relying on the venture capital exemption without use of [this special rule].”10

      Under this special rule, a non-U.S. fund that does not use U.S. jurisdictional means to conduct an offering (in particular, does not offer interests to U.S. persons) could be considered a “private fund” and, assuming it otherwise met the VC fund definition, could be a VC fund.

    Grandfather Rule. Under the Grandfather Rule, a fund will be deemed a VC fund, even if it does not satisfy the general definition, if it has all of the following attributes.

    • Venture Capital Strategy. A grandfathered VC fund must represent, and have represented, to its investors and potential investors at the time of the offering of its securities that it pursues a venture capital strategy. In general, the considerations applicable to this requirement are identical to those described above regarding the general definition although, in most cases, nothing can be done to alter communications that have already occurred. In particular, many existing funds that otherwise would appear to qualify under the Grandfather Rule may have used very different language (e.g., “growth”) to describe their strategy. This will place particular emphasis on carefully reviewing all of the fund’s communications to determine whether, taken as a whole, those communications effectively describe the fund’s pursuit of a venture capital strategy, regardless of the specific terminology used.
    • Initial Closing. A grandfathered VC fund must have sold (i.e., issued) securities, prior to December 31, 2010, to one or more investors that are unrelated to the fund’s adviser.
    • Final Closing. A grandfathered VC fund must not sell (i.e., issue) securities to any person (including by means of accepting a capital commitment from such person) after July 21, 2011. The Exemptive Release confirms that calling capital after July 21, 2011 in respect of commitments existing on July 21, 2011 will not violate this requirement.
    • Private Fund. A grandfathered VC fund must be a “private fund,” in the same manner as under the general VC definition.

    6 The VC fund must not be registered as an investment company under the 1940 Act (i.e., the fund must not be a mutual fund) or have elected to be a business development company under such Act.

    7 In practice, many multi-national venture firms have “siloed” their operations into different geographic regional organizations that function with significant independence. These firms may wish to consider whether each organization may be respected as a separate, non-integrated adviser for purposes of the Advisers Act based on the precedents discussed below.

    8 Note that jointly owned holding companies also may be problematic from an ERISA perspective if one or more of the funds seeks to qualify as a “venture capital operating company.”

    9 Please see Footnote 2 above in this Alert.

    10 Please see the discussion below regarding segregating adviser operations for Advisers Act purposes.