CHALLENGE: Venture capital registration
VC funds and their sponsors should be exempt from the Investment Company Act and Advisers Act
The SEC recently proposed raising the venture capital fund exemption from Investment Company Act registration from $10 Million to $12 Million. Under current laws and rules, a “qualifying venture capital fund” need not register with the SEC as an investment company if such fund has less than $10 Million in assets (committed and deployed) and has fewer than 250 investors. The SEC has also proposed a new rule that would ensure automatic inflation adjustments. If a VC fund cannot stay under these thresholds, it must limit itself to qualified purchasers or 100 investors or register under the Investment Company Act, thereby subjecting such fund to all the laws and rules applicable to mutual funds.
The real legal bite, however, comes under the Investment Advisers Act. VC advisers can claim exemption from the Advisers Act only if the fund sells itself specifically as a venture capital fund, invests 80% of its assets in equity securities of non-traded private companies, is unlevered, and does not permit any investor preferential rights. If a VC fund can’t meet all these requirements, the sponsor must register as an investment adviser, file a form ADV, prepare a disclosure document, adopt a compliance manual, and get ready for a SEC exam. Even if a VC sponsor can claim the exemption, if the sponsor manages over $100 Million, it still must register as an exempt reporting adviser and file a slimmed-down Form ADV and satisfy annual information filing requirements.
How about some statistics? The SEC reports that there are 2,022 venture capital exempt reporting advisers, managing about $1.2 Trillion in assets across 33,000 VC funds. Of course, we don’t know how many funds contort their structures to stay below the $10 Million or $100 Million thresholds.
The Dodd-Frank Act swept VC funds and their sponsors into the newly-created private funds registration regime. The SEC had for years attempted to exert its authority over hedge and private equity funds. Following the financial crisis, the regulator and its allies appealed to Congress, arguing that the SEC’s inability to have transparency into private funds caused or exacerbated the crisis. Venture capital funds were an inconvenient category because they were private funds but had nothing to do with the financial crisis. Also, nobody in Congress wants to be against capital formation that creates jobs. As a result, Congress created these unwieldy definitions and thresholds to exempt what they determined to be “good” venture capital funds.
MY TAKE: Venture capital funds and their sponsors should be exempt from both the Investment Company Act and the Investment Advisers Act. They pose no systemic risk. They serve an important capital markets function. Their regulation has served no public interest.
Nobody took issue with VC funds following the financial crisis. Those pushing Congress and the SEC took broad swipes at the private fund industry, and VC funds were swept up into an overbroad definition. The proponents first went after levered hedge funds, for which there was at least a legitimate argument about their volatility and potential contribution to exacerbating the financial crisis (with which I disagree). Rather than limit regulation to levered hedge funds, the drafters went after all private funds, which included private equity and venture capital funds. In the post-2008 climate, nobody could raise effective opposition to this overreach. However, there was never any basis for arguing that private equity or venture capital funds contributed to the financial crisis or market volatility. Private equity has its critics who argue that they exert too much influence on the economy or hurt small business, etc. While I fundamentally disagree with those criticisms, they have no application to VC funds.
My preference would be to exempt all unlevered funds that invest in private operating companies. If there is a fear about large PE funds, limit the exemption to sponsors who manage less than $5 Billion, an amount that is far below any potential systemic risk. Regardless, the SEC should not require VC only managers to file as exempt reporting advisers, thereby adding significant legal, compliance, and operational expenses that limits funds available to seed emerging firms. Another helpful reform would be to exempt all VC funds (or unlevered funds below $5 Billion) from the Investment Company Act so long as they only allow accredited investors. I never understood why the 100 investor limit makes sense when all investors must be financially sophisticated. Congress and the SEC could always tighten the rules around the definition of “accredited investor.”
Given the importance of VC funds to the growth of small companies and our economy, it’s time to re-think the laws and regulations that were never intended to regulate this industry.