Deciphering the SEC’s New Definition of a “Venture Capital Fund”: Part 1 – An Overview

This is the first post in a series exploring the recent SEC regulations which define the term "venture capital fund" for the purposes of determining whether a fund's manager is exempt from SEC registration requirements under Dodd-Frank.  

The Dodd-Frank Act excluded from its registration requirements those private fund managers who exclusively manage venture capital funds.[1]  However, Congress left it up to the SEC to define the term "venture capital fund."  In June, the SEC issued a final rule which provides a definition for the term.  Here is a brief overview of the requirements that a fund must meet, under SEC Rule 203(l)-1(a), in order for it to qualify as a "venture capital fund":

1. The fund must represent to its investors and potential investors that it pursues a venture capital strategy.  This can be problematic for some funds who identify themselves as pursuing a "multi-strategy" or "growth capital" model.
2. No more than 20% of the funds total committed capital can be invested in assets that are not "qualifying investments" or "short term holdings."  The definition of "qualifying investments" is quite complex, but essentially, they are traditional VC investments in privately held companies that actually carry on a business (i.e. are not other investment funds).  "Short term holdings" are essentially cash equivalents.  I'll flesh out each of these terms in future posts.
3. The fund cannot incur leverage in excess of 15 percent of the fund's total committed capital.  Even when it does incur leverage, it may only do so for a period of up to 120 days.  However, when a VC fund guarantees the debt of one of its portfolio companies, it may do so in an amount up to the total amount otherwise invested in the company, and such guarantee will not be subject to the 120 day limitation.  It will however, be subject to the 15% cap.
4. The investors will not be permitted to withdraw capital from the fund, except in two situations: (i) extraordinary circumstances (which the regulation leaves undefined) and (ii) when capital is distributed back to all holders of interests pro rata.  Essentially, investors must have next to no redemption rights.  This also has some rather complicated implications for general partners and managing members who wish to receive withdrawals of their incentive allocations/carried interests.
5. The fund cannot be registered as an "Investment Company" or a "Business Development Company" under the Investment Company Act of 1940. I've never seen a private VC fund do this (as by definition it would no longer be private), so this last condition will not present much of an issue for VC fund managers.

As you can see, these requirement will impose significant restrictions going forward on the activities of VC funds if they want to maintain an exemption from registration under the Investment Advisers Act.  Luckily many existing VC funds that have completed their capital raises are grandfathered under SEC Rule 203(l)-1(b).

This description is meant to be a broad overview of the topic.  Future posts will describe each of these provisions and discuss their implications in detail.  Stay tuned.

Footnotes

[1] A fund manager who is exempt under the venture capital exemption is still an exempt-reporting adviser, which means it will still be required to provide an abbreviated Form ADV to the SEC.  In addition, fund managers exempt from the SEC may also still nonetheless be subject to state registration requirements.

Read more articles by Alexander Davie at Strictly Business, a business law blog for entrepreneurs, emerging companies, and the investment management industry.

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