The SEC has proposed rules that would define “venture capital fund” for purposes of the new exemption for investment advisers that advise solely venture capital funds. From the proposed rules:
As described in more detail below, we propose to define a venture capital fund as a private fund that: (i) invests in equity securities of private companies in order to provide operating and business expansion capital (i.e., “qualifying portfolio companies,” which are discussed below) and at least 80 percent of each company’s securities owned by the fund were acquired directly from the qualifying portfolio company; (ii) directly, or through its investment advisers, offers or provides significant managerial assistance to, or controls, the qualifying portfolio company; (iii) does not borrow or otherwise incur leverage (other than limited short-term borrowing); (iv) does not offer its investors redemption or other similar liquidity rights except in extraordinary circumstances; (v) represents itself as a venture capital fund to investors; and (vi) is not registered under the Investment Company Act and has not elected to be treated as a BDC.
We propose to define a venture capital fund for the purposes of the exemption as a fund that invests in equity securities issued by “qualifying portfolio companies,” which we define generally as any company that: (i) is not publicly traded; (ii) does not incur leverage in connection with the investment by the private fund; (iii) uses the capital provided by the fund for operating or business expansion purposes rather than to buy out other investors; and (iv) is not itself a fund (i.e., is an operating company). In addition to equity securities, the venture capital fund may also hold cash (and cash equivalents) and U.S. Treasuries with a remaining maturity of 60 days or less.
More specifically, these requirements are too narrow:
- the requirement that a venture capital fund own “solely” equity securities issued by one or more “qualifying portfolio companies” and at least 80 percent of the equity securities of each qualifying portfolio company owned by the fund was acquired directly from the qualifying portfolio company; and (ii) cash and cash equivalents, as defined in § 270.2a51-1(b)(7)(i), and U.S. Treasuries with a remaining maturity of 60 days or less.
This would disallow non-registered funds from investing in early stage companies in exchange for certain types of debt instruments. Why would we want to crimp the flexibility venture funds currently have in this regard? Were any of these types of transactions identified as abusive or inappropriate or a threat to financial stability?
Similarly, why disallow venture funds from acquiring equity securities from other equity security holders? Why require them to acquire them directly from qualifying portfolio companies? There doesn’t, in my opinion, exist a valid and legitimate reason to crimp the behavior of non-registered funds in this way.
Actual Proposed Definition From The Proposed Rules:
(a) Venture capital fund defined. For purposes of section 203(l) of the Act (15 U.S.C. 80b-3(l)), a venture capital fund is any private fund that:(1) Represents to investors and potential investors that it is a venture capital fund;
(2) Owns solely:
(i) Equity securities issued by one or more qualifying portfolio companies, and at least 80 percent of the equity securities of each qualifying portfolio company owned by the fund was acquired directly from the qualifying portfolio company; and
(ii) Cash and cash equivalents, as defined in § 270.2a51-1(b)(7)(i), and U.S. Treasuries with a remaining maturity of 60 days or less;
(3) With respect to each qualifying portfolio company, either directly or indirectly through each investment adviser not registered under the Act in reliance on section 203(l) thereof:
(i) Has an arrangement whereby the fund or the investment adviser offers to provide, and if accepted, does so provide, significant guidance and counsel concerning the management, operations or business objectives and policies of the qualifying portfolio company; or
(ii) Controls the qualifying portfolio company;
(4) Does not borrow, issue debt obligations, provide guarantees or otherwise incur leverage, in excess of 15 percent of the private fund’s aggregate capital contributions and uncalled committed capital, and any such borrowing, indebtedness, guarantee or leverage is for a non-renewable term of no longer than 120 calendar days;
(5) Only issues securities the terms of which do not provide a holder with any right, except in extraordinary circumstances, to withdraw, redeem or require the repurchase of such securities but may entitle holders to receive distributions made to all holders pro rata; and
(6) Is not registered under section 8 of the Investment Company Act of 1940 (15 U.S.C. 80a-8), and has not elected to be treated as a business development company pursuant to section 54 of that Act (15 U.S.C. 80a-53).