There is one question that often confronts venture capital firms
as they grow more successful and encounter new opportunities:
Should we register with the Securities and Exchange Commission
(SEC)? While there is no one-size-fits-all response, and each firm
will decide based on its own set of facts and circumstances, the
current regulatory environment and the SEC’s supercharged
agenda are key factors to consider in the face of this question
today. In this post, we briefly review the registration and
exemption analysis applicable to most of our VC clients and
highlight the key benefits and costs of becoming a registered
investment adviser (RIA).
A note to our non-US clients: The registration
and exemption analysis is different for managers that are based
outside the US. The application of the various regulatory
requirements also will depend on where your funds are organized.
Please contact us for more information.
Registration basics for VC firms
Under the Investment Advisers Act of 1940 (Advisers Act), an
investment adviser is any person who – for compensation
– engages in the business of providing advice to others
regarding securities. With the exception of family offices and
corporate venture capital firms (CVCs), most VC firms will meet the
definition of investment adviser. Anyone who falls within the
definition of investment adviser is required to register unless an
exemption applies. The main exemption for VC firms is the venture
capital adviser exemption, although smaller firms, especially when
first starting out, also may rely on the private fund adviser
exemption.
The venture capital adviser exemption exempts from registration
investment advisers that only advise one or more venture capital
funds. The Advisers Act defines a venture capital fund as a type of
private fund that represents to investors that it pursues a venture
capital strategy, provides redemption rights only in extraordinary
circumstances, does not borrow more than 15% of its aggregate
capital contributions and uncalled capital commitments, and holds
no more than 20% of its assets in nonqualifying investments (often
referred to as the 20% basket), with the remaining 80% limited to
investments in qualifying portfolio companies. Cash and cash
equivalents do not count toward the 20% basket. A private fund is
an investment vehicle that is not offered to the general public and
is limited either to 100 beneficial owners or to beneficial owners
that are qualified purchasers (which includes entities with $25
million in investments and individuals with $5 million in
investments).
The private fund adviser exemption exempts from registration
investment advisers that solely advise private funds and have less
than $150 million in gross assets under management – also
known as regulatory assets under management (RAUM) – across
all their funds. While subject to a cap on its RAUM, a private fund
adviser is not limited to advising venture capital funds and can
advise any type of private funds, including private equity, crypto,
hedge and others. A VC firm can rely on one or both of these
exemptions, although it will likely outgrow the private fund
adviser exemption over time. At that point, unless all of its
clients are private funds that meet the venture capital fund
definition, the adviser will need to register with the SEC. An
adviser that relies on either exemption is referred to as an exempt
reporting adviser (ERA). ERAs are required to file portions of the
Form ADV Part 1A with the SEC and comply with limited requirements
under the Advisers Act, and they are subject to examination by the
Division of Examinations. However, they are not
“registered” with the SEC.
What are the benefits of registering?
The biggest benefit of registering is flexibility. Advisers that
rely on the venture capital adviser exemption or the private fund
adviser exemption can find themselves forgoing certain
opportunities or investment structures, negotiating less favorable
terms, or taking on risk and dealing with uncertainties. They have
to make a choice between the expensive and time-consuming process
of registering and the regulatory burden that comes with it, or
limit themselves to ensuring all their funds – including any
special purpose vehicles (SPVs) they manage – meet the
venture capital fund definition (including with respect to the 20%
basket) or stay below $150 million of RAUM.
Perhaps the most significant limitation for venture capital
advisers is the cap on nonqualifying investments. In general,
qualifying investments are limited to equity investments acquired
directly from private operating companies. Debt securities,
securities acquired in secondary transactions (including from
founders and company employees), public company securities,
cryptocurrencies and interests in other venture capital funds are
among the common nonqualifying investments that need to fit in the
20% basket. By registering, a venture capital adviser would no
longer be constrained by the 20% basket, which, in addition to
freeing up capacity in its main funds for nonqualifying
investments, also can prove especially impactful on the use and
nature of SPVs that invest in such nonqualifying investments.
Registering also would mean that the adviser could advise funds
that borrow in excess of the 15% limit or permit investors to
redeem outside of extraordinary circumstances.
Registration also allows increased flexibility to take on
non-private fund clients, such as separately managed accounts,
family offices and employee funds that are not private funds. For
firms looking to explore new business lines and different asset
classes, or enter into joint ventures, registration may provide
much-needed latitude.
Finally, some firms may find that certain investors are more
willing to commit to a fund advised by a RIA than an ERA. While
registration does not impose a heightened standard of fiduciary
duty (ERAs are subject to the same standard of conduct as RIAs), it
does impose a host of additional rules and requirements on the
adviser that are designed to protect investors and provide
additional information to the SEC. For some investors, this may be
a factor they consider when choosing an investment adviser
firm.
What are the downsides of registering?
While registration opens up new opportunities by removing
regulatory constraints and offering flexibility in its place, it
also imposes significant time and money costs. One of the first
impositions of registration is the requirement to appoint a chief
compliance officer (CCO) and implement a compliance program
tailored to the RIA’s business. These days, there are a
plethora of compliance consultants who can assist with the
development of a compliance program and also can conduct training
sessions. There also are various compliance tools to assist with
the collection, approval and oversight functions. What is important
for firms to understand, however, is that the mere adoption of a
compliance program will not be adequate. RIAs are expected to have
a dynamic compliance program that adapts to changes in their
business and organization, as well as developments in the law and
market.
Becoming a RIA will mean greater scrutiny by the SEC. While ERAs
are subject to examination and do get examined, RIAs are much more
likely to undergo an examination. As a rule of thumb, RIAs should
expect to be examined within their first year of registration and
approximately once every seven years thereafter. During an
examination, SEC staff will rigorously evaluate an adviser’s
compliance with the myriad of legal and regulatory requirements,
including many that are based on fiduciary duty principles and
disclosures to investors regarding conflicts of interest. Most
examinations will result in the adviser receiving a deficiency
letter that lists the areas where the adviser falls short, although
some can and do get referred to the Division of Enforcement.
A firm that registers will become subject to various new rules
under the Advisers Act, including the code of ethics rule, custody
rule, marketing rule and recordkeeping rule. Each of these rules
involves pain points that a new RIA will need to cope with. For
example, the code of ethics rule requires senior executives and
certain other personnel to submit quarterly transaction reports and
annual holdings reports for their personal securities accounts and
to preclear transactions in private placements and initial public
offerings. The marketing rule requires deal-level net returns to be
shown with equal prominence when deal-level gross returns are shown
(something firms typically do not do and find meaningless), places
limitations on the ability to use a track record achieved at a
prior firm, and triggers disclosure and oversight requirements when
engaging a placement agent. The custody rule requires stub year
audits for funds that launch at the end of the year, irrespective
of costs and investors’ consent to extended audits, while the
recordkeeping rule requires RIAs to manage how employees use
off-channel communications like text messages, WhatsApp and other
direct messaging applications. (Please note that the above is not
intended to summarize these rules or their numerous challenges,
which is beyond the scope of this post.)
In addition, RIAs are subject to statutory requirements under
the Advisers Act, pursuant to which they may be required to obtain
investor consent when there are changes to their ownership
structure. The addition or removal of a person who owns more than
25% of a RIA’s voting stock can result in a deemed assignment
of an advisory contract requiring consent. Moreover, for RIAs to
receive performance-based compensation, their investors must be
qualified clients (which may require investors to satisfy a net
worth standard that is more than double what they need to satisfy
for a fund managed by an ERA).
RIAs also are subject to additional reporting requirements.
First, rather than completing just portions of Part 1A of the Form
ADV as ERAs do, RIAs must complete the entire Part 1A, as well as
Part 2A (the brochure) and Part 2B (the brochure supplement). While
these additional sections require more time and attention to
complete, once prepared, they are typically not as time-consuming
to update and keep current. Second, RIAs must file a Form PF with
the SEC, a confidential filing that collects information about the
private funds they advise. Although Form PF can be heavily
burdensome for large hedge fund and private equity fund managers
who may need to file the form quarterly, most registered VC firms
only need to make the filing annually, and their costs for the
reporting are typically not significant.
In considering the overall cost of registering, firms should
note that in the past couple of years, the SEC has had an unusually
active rulemaking agenda. Under current Chair Gary Gensler, the SEC
has proposed a long list of rules, many of which are slated to be
adopted in the coming months. Although some of these rules also
would apply to ERAs, RIAs would be subject to significantly more,
and the cumulative burden of the new rules may be prohibitive for a
smaller firm newly registering. Among other requirements, if the
proposed rules are adopted, RIAs would be required to send
quarterly statements to fund investors detailing various fees and
expenses, obtain fairness opinions prior to closing on adviser-led
secondary transactions, adopt cybersecurity policies and
procedures, disclose environmental, social and governance (ESG)
practices and cybersecurity incidents and risks in their Form ADV,
custody all client assets – not just funds or securities
– with a qualified custodian, and conduct due diligence on
outsourced service providers.
In addition, both RIAs and ERAs would be subject to new rules
that, if adopted, would prohibit certain activities with respect to
their private funds and place limitations on side letters. Among
other things, the prohibited activities rule would prohibit an
adviser from charging a fund fees or expenses associated with SEC
exams and any compliance expenses incurred by the adviser,
including registration expenses.
Should I register?
Given the number of variables that go into deciding whether to
register, it can be a complicated decision. There is no
one-size-fits-all answer. With that said, prior to the current
administration at the SEC, an important aspect that a firm might
have considered is the amount of resources – time and money
– that registration requires. While compliance with
additional requirements was an important consideration, it likely
was not a determinative factor. Today, however, firms might
consider not just the time and money that would be required to
register but also the likelihood that they would be able to comply
with all the requirements applicable to a RIA, especially if the
proposed rules also are adopted. Dedicating a certain level of
resources is one thing; inability to operate a business under the
burden of compliance is another. For an established VC firm with
ample personnel exploring new opportunities, registration may
provide freedom from the 20% basket and flexibility to expand its
business. But for a smaller firm with limited resources, would that
flexibility be crushed by new restrictions and prohibitions that
its own team and compliance program might not be able to handle?
The answer here is entirely situational, and we are here to guide
firms through the various considerations in answering this
difficult question.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
