The Venture Capital Adviser Exemption Explained

The first condition a fund need to meet to qualify as a venture capital fund requires that the fund” [represent] to financiers and prospective investors that it pursues a venture capital strategy.” The requirement for identifying whether a fund is actually holding itself out as pursuing a “equity capital strategy” is a subjective one, depending upon particular truths and circumstances. A fund is not necessarily required to utilize the words “equity capital” in the name of the fund. Rather, the SEC takes a look at the private fund consultants declarations to financiers and prospective financiers as a whole. In order to have an affordable guarantee that a personal fund consultant is exempt from investment adviser registration, the offering materials of the fund should clearly and unambiguously state that the technique being pursued is an endeavor capital technique.

Section 203( l) of the Investment Advisers Act of 1940 (the “Advisers Act”), also known as the endeavor capital advisor exemption, supplies that an investment advisor that solely recommends equity capital funds is exempt from registration with the SEC under the Advisers Act. The term “equity capital fund” is not specified in the text of the Advisers Act; rather, the term is defined in SEC Rule 203( l) -1( a) as a personal fund that meets particular conditions. This post takes a look at each of these conditions and discusses what is needed to satisfy them.
Pursuing a Venture Capital Strategy

Investment Holding Limitation

The second condition needs that the fund:

To put it simply, the 2nd aspect needs that no more than 20% of the funds total properties (consisting of dedicated however not yet invested capital) can be invested in possessions that are not “qualifying financial investments” or “brief term holdings.” Both of these terms are defined in the guideline.

” Immediately after the acquisition of any asset, other than certifying investments or short-term holdings, holds no more than 20 percent of the quantity of the funds aggregate capital contributions and uncalled committed capital in assets (aside from short-term holdings) that are not certifying investments, valued at expense or reasonable worth, consistently used by the fund”

Qualifying Investments

There are two primary consequences to this definition. Qualifying investments need to be equity and not debt. The term equity security is, luckily, specified rather broadly and includes favored stock, warrants, securities convertible into typical stock, such as convertible financial obligation, and limited collaboration interests. Bridge loans that are not convertible would not be thought about a certifying financial investment.

A “certifying investment” is among 3 things: (i) an equity security released by a “qualifying portfolio company” that is acquired straight by the private fund from such qualifying portfolio company; (ii) any equity security that is released by a qualifying portfolio business in exchange for another equity security of such qualifying portfolio business; and (iii) any equity security released by a moms and dad of a certifying portfolio business in exchange for an equity security in that certifying portfolio business. Item (ii) enables the fund to maintain its interest in a certifying portfolio business after some other situation or a business reorganization where there is some sort of exchange of equity interests. Product (iii) allows the fund to maintain its interest in a certifying portfolio business after the qualifying portfolio business has actually been acquired by another company, including an openly traded company. Because instance, the qualifying portfolio business would end up being a majority-owned subsidiary of the brand-new parent company.

Second, they should be acquired by making a financial investment straight into a business and not gotten by purchasing them from a third celebration. So the equity capital fund would not be able to deal with as a certifying investment any interest in a company that it acquires on the secondary market or through buying out existing owners or management without treating that interest as part of its 20% non-qualifying basket. A qualifying investment maintains its status as such after a corporate reorganization or buyout where the certifying portfolio companys equity interests are exchanged for new equity interests in the same company or in another business which gets the qualifying portfolio business.

Qualifying Portfolio Companies

The final requirement of the meaning makes sure that the meaning of the term “equity capital fund” will not consist of any kind of fund of funds, even if the underlying funds are themselves equity capital funds. Naturally, an equity capital fund can invest in other funds as part of its non-qualifying basket.

The next essential question is: what is a “qualifying portfolio company?” A “certifying portfolio company” has 3 requirements: (i) at the time of the investment by the fund, the business should not be a reporting company under the Securities Exchange Act of 1934 nor be listed or traded on any foreign exchange and is not an affiliate of (i.e. directly or indirectly under common control with) an Exchange Act reporting business or an openly traded foreign business; (ii) the business might not obtain or release debt obligations in connection with the funds investment in the business and distribute to the fund the profits of such loaning or issuance in exchange for the private funds investment (i.e. no leveraged buyouts); and (iii) it can not be a shared fund, hedge fund, private equity fund, another venture capital fund, a commodity pool fund, or a company of property backed securities.

The first requirement of a “certifying portfolio company” makes sure that any business that a venture capital fund invests in (other than its 20% non-qualifying basket) is not a publicly traded business. The endeavor capital fund can retain this investment even after the business goes public as the test for whether a financial investment is a “qualifying financial investment” is applied at the time of preliminary investment by a fund. The 2nd requirement of the “qualifying portfolio company” meaning ensures that leveraged buyout funds or other private funds that fund their portfolio acquisitions by triggering their portfolio companies to incur insolvency will not fit within the meaning of an endeavor capital fund.

Short-Term Holdings

Remember that at least 80% of the funds financial investments need to remain in “qualifying financial investments” or “short-term holdings.” The meaning of “short-term holdings” is restricted to the following: (i) bank deposits, certificates of deposit, lenders approvals, and comparable bank instruments; (ii) U.S. Treasuries with a staying maturity of 60 days or less; and (iii) money market funds. This definition is very limiting. While some funds may wish to park their assets in relatively low-risk liquid financial investments such as business paper, community bonds, foreign debt, and repurchase arrangements, none of these possessions would qualify. An equity capital fund may definitely invest in these possessions as part of its 20% non-qualifying basket but should avoid them as a basic cash management tool.

The Non-Qualifying Basket

The fund needs to make the calculation as to whether it surpasses the 20% limit at the time each financial investment is made. The test is not used continuously, so if specific certifying investments subsequently decrease in worth or if non-qualifying investments increase in value, the fund will still be in compliance with regulations even if evaluation changes would trigger the non-qualifying basket to exceed the 20% limitation. The fund would be unable to get any non-qualifying investment until the percentage of non-qualifying financial investments fell back listed below the 20% limit.

In addition, endeavor capital funds might pick one of 2 methods in its ongoing computations utilized to verify compliance with the limits on non-qualifying investments. A fund might select to value each financial investment at its fair value, which essentially is a “mark to market” approach. So, if the worth of a funds non-qualifying basket declined due to market variations, the fund would be permitted to purchase additional non-qualifying financial investments if they did not cause the fund to surpass the 20% limitation when all assets are valued at reasonable market value. This might get pricey, as numerous of the funds financial investments are likely to be hence tough and illiquid to value, demanding regular appraisals. The other method a fund might take is to value all financial investments at their historical cost so that the value of an investment never changes regardless of market fluctuations. This method avoids the frequent appraisals that would be necessary if the fund chose to use fair value in its calculations. A fund consultant might be lured to utilize one approach on some occasions and another method on other celebrations, however the SEC has actually taken the view that this is not allowed. The exact same method must be utilized to value all financial investments continually throughout the life of the fund.

Another wrinkle is that all capital dedications should be bona fide; that is, a fund can not have “financiers” commit to provide capital with the understanding that the capital would never be called. The SEC has taken the position that any such plan would minimize the quantity of dedicated capital used in calculating the ratio. However, if a financier never provides the capital in spite of the authentic intent by the fund adviser to call it, the dedicated capital still counts in calculating the ratio.

The non-qualifying basket is a beneficial tool for equity capital funds to get in into non-qualifying deals, such as swing loans to portfolio business or potential portfolio companies or purchases of publicly traded securities, without losing their status as an equity capital fund.

The “non-qualifying basket” describes the portfolio of investments which are not “qualifying investments” or “short-term holdings.” No greater than 20% of an endeavor capital funds total assets, consisting of committed but not yet invested capital, can be purchased the non-qualifying basket.

Limitations on Leverage

The third condition of a “endeavor capital fund” requires that the fund:

As a result of these two requirements, the take advantage of restrictions contained in the SECs meaning of a portfolio company are extremely restricting, effectively avoiding any funds that use significant take advantage of from making use of the equity capital exception to financial investment advisor registration.

The second requirement is that any borrowing (including the borrowing sustained in compliance with the 15% limit) must be for a non-renewable term of no longer than 120 calendar days, except for guarantees of portfolio business financial obligation. In addition, if the fund does guarantee portfolio business financial obligation for a period greater than 120 days, the overall debt ensured can not be larger than the funds investment in that portfolio business. Beyond that exception, any borrowing that does happen by a fund should be brief term.

” Does not obtain, release financial obligation obligations, provide warranties or otherwise incur take advantage of, in excess of 15 percent of the personal funds aggregate capital contributions and uncalled dedicated capital, and any such loaning, insolvency, warranty or take advantage of is for a non-renewable regard to no longer than 120 calendar days, except that any assurance by the private fund of a qualifying portfolio companys commitments up to the quantity of the value of the personal funds financial investment in the qualifying portfolio company is not subject to the 120 calendar day limit”

An endeavor capital fund may not obtain, incur insolvency, or assurance debts of portfolio companies in an overall quantity in excess of 15% of the funds aggregate capital contributions and uncalled dedicated capital. If a fund has total capital dedications of $10 million, but only $2 million has actually been called therefore far, the fund might in theory incur utilize of up to $1.5 million since the 15% estimation is made using the total aggregate number.

No Redemption Rights for Investors

The fourth condition requires that the fund:

The limitations on redemptions are mainly in keeping with the venture capital fund markets practices. There will be some funds that will not certify under the SECs meaning as a result of this requirement. Funds that are “evergreen” (that continually accept new financiers and enable redemptions as hedge funds typically do) or funds that make use of a “special minimal partner” and mean to make circulations to the special restricted partner that are not pro rata with the investors might have difficulty qualifying under the definition.

The SEC has supplied some guidance regarding what “remarkable scenarios” suggests in its comments to the rule, where it states that the term would generally be restricted to occasions beyond the control of the fund consultant or the financier. The sole example the SEC gives is a material change in law or guideline. Plainly the SEC planned that this exception will be very restricted in scope.

One issue that could occur is whether the funds consultant would have the ability to take distributions from its brought interest without a pro rata circulation to financiers, as some fund advisors do. The commentary to the guideline suggests that it can. The reason for this is that the regulations provide that an equity capital fund can only provide securities that do not have redemption rights. The fund consultants carried interest is normally in the kind of a general partnership interest of a minimal partnership or a managing member interest of a limited liability company, which in the context of a fund development, would not be thought about a security. However, there are some possible problems. Some fund advisers structure their brought interest as a restricted partnership interest held by a “special minimal partner” that is an entity different from the fund consultant. Such a limited partnership interest may be deemed to be a security, and subsequently, a fund structured in this manner may not be able to make distributions of the fund advisers carried interest without a matching professional rata distribution to investors.

” Only issues securities the terms of which do not provide a holder with any right, except in amazing situations, to withdraw, need the repurchase or redeem of such securities however might entitle holders to receive distributions made to all holders professional rata.”

Another concern that this requirement raises is whether it restricts transfers of an investors interest in an endeavor capital fund. Fund offering files often supply that an owner of an interest in the fund might transfer its interest upon getting an opinion of counsel stating that a resale exemption applies. The commentary to the rule implies that the SECs viewpoint is that it does not, supplied that the fund adviser is not supplying de facto redemption rights by regularly helping the financiers in discovering prospective transferees.

Restriction Against Investment Company Act Registration

The final and fifth condition requires that the fund: (i) not be signed up under the Investment Company Act of 1940 and (ii) not elected to be treated as a business advancement company pursuant to the Investment Company Act. This requirement should not substantially impact the majority of equity capital funds.

Typically, funds that are registered as investment business are openly traded mutual funds. In contrast, many endeavor capital funds are personal funds, which are funds that are exempt from the registration provisions of the Investment Company Act. Almost speaking, this means that private funds, such as venture capital funds, are either (i) limited to 100 or less recognized investors or (ii) restricted to certified purchasers.

The equity capital exemption from investment advisor registration likewise does not use to consultants to a fund which has chosen to be treated as a business advancement business under the Investment Company Act. An organisation advancement company is a type of openly traded private equity fund developed to supply capital to small, establishing, and economically troubled companies. Advisers to such funds will be required to register as a financial investment advisor with the SEC, unless another exemption uses.


In contrast, many endeavor capital funds are personal funds, which are funds that are exempt from the registration arrangements of the Investment Company Act. It might appear simple to certify for the endeavor capital adviser exemption by limiting the consultants service to encouraging exclusively endeavor capital funds, whether a fund fulfills the complex conditions for being a “endeavor capital fund” can be rather complex.

It may appear basic to qualify for the endeavor capital consultant exemption by restricting the consultants service to recommending solely venture capital funds, whether a fund satisfies the intricate conditions for being a “venture capital fund” can be rather complicated. Likewise note that a personal fund adviser exempt under the venture capital exemption is still an exempt reporting adviser, which suggests it will still be required to provide an abbreviated Form ADV to the SEC. In addition, fund advisors exempt from the SEC might likewise still nevertheless go through state investment advisor registration requirements. You must speak with an attorney who recognizes with securities regulatory concerns in evaluating whether your particular fund management business is needed to sign up with the SEC or with state authorities and what filings are needed.

The 2nd requirement of the “certifying portfolio company” definition ensures that leveraged buyout funds or other private funds that fund their portfolio acquisitions by causing their portfolio companies to incur insolvency will not fit within the definition of an endeavor capital fund. If the value of a funds non-qualifying basket declined due to market fluctuations, the fund would be allowed to buy extra non-qualifying financial investments if they did not cause the fund to exceed the 20% limit when all assets are valued at reasonable market value. Funds that are “evergreen” (that continually accept new investors and permit redemptions as hedge funds typically do) or funds that use a “special limited partner” and mean to make distributions to the unique restricted partner that are not professional rata with the investors might have trouble qualifying under the meaning.

© 2018 Alexander J. Davie– This post is for general info only. The info presented should not be interpreted to be official legal guidance nor the formation of a lawyer/client relationship.


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