As the delayed JOBS Act rule changes become imminent, our firm has noticed a spike in inquiries related to small hedge funds and feeder funds.The JOBS Act is not the only recent congressional act to change the landscape of hedge funds; the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) made significant changes as well.
In particular, the Dodd-Frank Act eliminated the oft relied upon exemption from registration for private hedge fund advisors for those advisors with fewer than 15 clients.While eliminating the private advisor exemption, Dodd-Frank created three new exemptions, which are the operable hedge fund advisor exemptions today.These exemptions are for:
(1) Advisors solely to venture capital funds;
(2) Advisors solely to private funds with less than $150 million in assets under management in the U.S.; and
(3) Certain foreign advisers without a place of business in the U.S.
Moreover, the Dodd-Frank Private Fund Investment Advisers Registration Act of 2010 (the “Advisers Act“) imposed certain limited filing requirements for those advisers claiming one of the 3 new exemptions.
In this series of blogs I will provide an overview of each of these exemptions and of the form filing and limited reporting requirements for exempt advisors.This is Part II in the series and discusses the exemption for advisors solely to Venture Capital Funds.
Exemption for Advisers Solely to Venture Capital Funds
The first new exemption for hedge fund adviser registration implemented by the Advisers Act as part of the Dodd-Frank Act is that for advisers to venture capital funds.
Definition of Venture Capital Fund
Rule 203(I)-1 defines a venture capital fund as a private fund that:
(i) holds no more than 20% of the fund’s capital commitments in non-qualifying investments (qualifying investments consist of equity securities of “qualifying portfolio companies”);
(ii) does not borrow or otherwise incur leverage (other than limited short-term borrowing);
(iii) does not offer its investors redemption or similar liquidity rights;
(iv) represents itself as pursuing a venture capital strategy; and
(v) is not registered under the Investment Company Act and has not elected to be treated as a business development company (BDC).
Definition of Qualifying Investments
To meet the definition of venture capital fund, the fund must hold immediately after the acquisition of any asset (other than qualifying investments or short-term holdings) no more than 20 percent of the fund’s capital commitments in non-qualifying investments. A qualifying investment generally consists of any equity security issued by a qualifying portfolio company that is directly acquired by a qualifying fund and certain equity security exchanged for the directly acquired securities.
The definition of equity securities incorporates the definition found in the Securities Exchange Act of 1934 and generally includes common and preferred stock, securities convertible into either such as warrants or options, and limited partnership interests.
Under the rules, qualifying investments are generally equity securities that were acquired by the fund in a transaction such that the fund’s capital investment is being used to finance operations of businesses rather than for trading in secondary markets. In particular, Rule 203(I)-1 defines a “qualifying investment” as:
(i) any equity security issued by a qualifying portfolio company that is directly acquired by the private fund (the directly acquired criteria);
(ii) any equity security issued by a qualifying portfolio company in exchange for directly acquired equity issued by the same company (such as in a reorganization of the qualifying portfolio company);
(iii) any equity security issued by a company of which a qualifying portfolio company is a majority-owned subsidiary or predecessor and that is acquired by the fund in exchange for directly acquired equity (such as resulting from a reverse merger).
One of the features that distinguishes a venture capital fund from other funds is that venture capital is used to fund business operations and growth, as opposed to, for example, a buyout of existing shareholders, a leveraged buyout by management, or a takeover of control—thus the “directly acquired” requirement to utilize this exemption.
Operation of the 20% Limit
The 20% rule is calculated immediately after the purchase of an investment. Under the rule, if a non-qualifying investment increases in value such that the non-qualifying investments exceed the 20% value, the fund does not need to liquidate such investment(s), but rather could not purchase additional non-qualifying investments until the total value of non-qualifying investments fell below the 20%.To determine the fund investment valuation for purposes of calculating the 20% figure, a fund may use either historical cost or fair value as long as they are consistent with the method throughout the term of the fund.
Short-Term Holdings
A qualifying fund may also invest in cash and cash equivalents with a maturity of 60 days or less and shares of registered market funds. These short-term investments need not be included in calculating the 20% limit on non-qualifying investments.
Qualifying Portfolio Company
Under the rule, qualifying investments consist of equity investment in qualifying portfolio companies. A “qualifying portfolio company” is defined as a company that (i) is not a reporting or foreign traded company and does not have a control relationship with a reporting or foreign traded company; (ii) does not incur leverage in connection with the investment by the private fund and distribute proceeds of any borrowing to the private fund in exchange for the investment; and (iii) is not itself a fund (i.e., cannot be a private fund or other pooled investment vehicle).The rule requires the analysis as of the time of an investment, so if a qualifying portfolio company were to go public and become a reporting company, the investment would still be qualifying.
Limitation on Leverage
Under Rule 203(I)-1 a venture capital fund is a private fund that does not borrow, issue debt obligations, provide guarantees or otherwise incur leverage in excess of 15% of the fund’s capital contributions and uncalled capital, and that any such borrowing, indebtedness, guarantee or leverage is for a non-renewable term of no longer than 120 calendar days. For purposes of these leverage criteria, a guarantee by the private fund of a qualifying portfolio company’s obligations up to the value of the private fund’s investment is not subject to the 120-day limit.
No Redemption Rights
A venture capital fund cannot offer redemption rights except in extraordinary circumstances, but can offer pro rata distributions. That is, it is expected that rather than offer redemption during the life of the fund, a venture capital fund will distribute assets when such investment matures and the exit strategy criteria have occurred (generally the company invested in has either been sold or goes public). A redemption is any withdrawal of investment.
Represents Itself as Pursuing a Venture Capital Strategy
A qualifying venture capital fund must represent itself as pursuing a venture capital strategy. This rule is to ensure that funds do not exemption shop after the fact, just because they happen to meet the other criteria for a venture capital fund exemption.
Is a Private Fund
A venture capital fund, for purposes of the exemption, must be a private fund, and therefore excludes funds that are registered investment companies (e.g., mutual funds) or have elected to be regulated business development companies (BDC).
Application to Non-U.S. Advisor
The venture capital fund exemption is available to both U.S. and non-U.S. advisors.
The Author
Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com
Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.
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