Venture Capital Funds: Overcoming U.S. Regulatory Limitations on Dealmaking
Some early signs of deal making by private equity (PE) and venture capital (VC) firms are discernable amid the turbulence of the current economic crisis. If the 2008 credit crisis is any indication, today’s market environment might yield once-in-a-lifetime opportunities. Last time around, many PE firms took advantage of the situation, while most VCs were forced to sit it out. But times have changed and venture capital firms could now become very active, if they can overcome regulatory limitations to take advantage of the changes in the technical, social, and economic environment.
Signs of the Times
One of the largest global expert network firms is experiencing a surge in demand from PE and VC firms for its services. In a recent month, according to my colleague at the firm, research calls were coming in at over double the expected volume for subject matter experts to analyze potential investments. The demand was not just for research related to the impact of the coronavirus, but on a broad range of topics and industries.
This is a good sign for the economy. It’s also one of the signs we are seeing that, while the staffs of many firms are focused on supporting their existing portfolio companies, others are clearly beginning to build a plan for the next round of deals. And some that had passed on acquisitions are now coming back around for cheaper, “recycled” deals.
Dealmaking: Then …
It all reminds me of something I observed during the last credit crisis: that many PE firms were eager to expand their focus and strategies to take advantage of unique opportunities—eager, but unprepared. During that period, some private equity funds looked to expand into loans and other debt instruments, while private credit funds wanted to take on more equity and convertible securities. And even long-short equity funds sought loan and high-yield debt exposure at severely discounted valuations.
To do such deals, many of these funds had to seek limited partner (LP) and/or advisory board consent because the investments were outside the mandates set in their partnership agreement and offering documents. Or, even where the documents allowed for it, the investments were way outside normal investment guidelines. While firms often missed initial opportunities because of this protracted approval process, they were ultimately able to address some of their internal obstacles and do new types of deals.
… and Now
Unlike PE firms, VC funds were left supporting their existing portfolios during the last crisis, and waiting for the growth cycle to resume before investing. This time, however, the opportunity will be very different, since the influence of disruptive technology is now felt well beyond the startups and FinTech companies in which VC funds usually invest.
Well-established industries and the largest corporations are turning to emerging technology capabilities to reach both teleworking employees and customers stuck in their homes on their phones, laptops, and iPads. One only has to watch TV for a brief period to see the constant stream of new apps and software targeted at how we live our lives during and after the pandemic. This means increased demand for these products and services from tech startups and FinTechs. Sheldon Slimp, a manager with Treliant’s FinTech practice, noted that, “we have been working with and talking to an unusually large number of firms seeking to deploy new technologies faster and into larger organizations and clients. This growth is a huge opportunity for venture capital investors.”
VC Appetite for Dealmaking
Like PE firms in the last crisis, VCs will need to overcome obstacles to respond in the current environment. Not the least of these are the limitations placed on venture capital firms taking advantage of the Registered Investment Adviser (RIA) registration exemption, often referred to as the Venture Capital Exemption, contained in the Dodd-Frank Act. This article explains VCs’ circumstances, including:
- legal limitations:
- the practical implications of the restrictions;
- trends we were seeing before the pandemic;
- what VC firms can expect from the Securities and Exchange Commission (SEC) in the coming months; and
- what firms can do to get ahead of these issues.
When the Dodd-Frank Act of 2010 required private funds to file as RIAs, VCs were allowed to opt out of certain requirements in the Investment Advisers Act of 1940, with many becoming known as Exempt Reporting Advisers (ERAs).
Under the ERA approach, the Adviser’s Act definition of a venture capital fund can be found in SEC Rule 203 (I) 1 and requires that it be organized as a private fund pursuing a venture capital strategy. Additionally, the underlying funds may not be registered as an “investment company” or elected to be organized as a “business development company.” Additionally, under the fund’s structural requirements, LPs may not have redemption rights in the normal course of business.
Investment restrictions were also placed on fund activities including:
- prohibiting “fund of funds” investments into other PE, hedge funds, and investment companies;
- limiting investment to no more that 20 percent of the fund (called and uncalled capital) in non-qualified investments; and
- limiting the amount of fund leverage to no more than 15 percent of the fund on a short-term basis.
Qualifying investments generally include equity purchased from the company and issued by portfolio companies that at the time of purchase/investment:
- do not have listed/public securities;
- are not public reporting entities; and
- do not have outstanding debt or issue debt as part of the transaction (this is restricted to prevent PE-style leveraged buyout transactions).
While investments may mature and grow, including through an IPO or M&A transaction resulting in public, registered, or listed equity, these securities, if purchased after the fact, would be considered non-qualifying investments subject to the 20 percent cap.
So how do these requirements limit venture funds, especially during the turbulent market conditions we are living through? Well, several transactions come to mind.
Public securities prohibitions. VCs cannot buy public securities (beyond the 20 percent cap), whether debt or equity. This means that an existing portfolio holding that has public securities as a result of a previous IPO could not be purchased in the open market, if it would result in more than 20 percent of the portfolio consisting of non-qualified assets. In a market that is falling significantly, a fund may desire to purchase the security at a deep discount or to help create a floor on the price through open market purchases. This strategy was often implemented by PE firms during the credit crisis, and generally will not be available to venture funds operating as ERAs.
Open market limitations. While hedge funds and PE funds can take advantage of lower market valuations to find “cheap” assets to purchase, venture funds (because of the cap) must purchase only from the issuer and not make open market or secondary purchases. Included here would be a limitation on transferring/selling a portfolio company from a fund without available capital to a newer vintage fund that may have uncalled capital. This type of “rescue” transaction, although possessing many conflict issues, would be available to a PE fund, but may not be available to the ERA venture fund operating under the exemption. Additionally, purchases of an asset from an unrelated fund sponsor would also be restricted, further limiting investment optics and opportunities.
Debt financing restrictions. The restrictions on debt and leverage can be limiting as well. Struggling portfolio companies may need additional capital, and the fund’s debt financing options can be more limited—therefore more expensive if it wants to help a struggling company. Clearly the PE fund has greater flexibility to help backstop a cash-strapped portfolio company.
Trends Before the Pandemic
Over the last two years I have spoken with several venture firms that have begun to explore whether the pain of registration is less than the restrictions they face when operating as an ERA. Some of them have seen their largest peers go through the registration process and wondered if they too should take the plunge. The majority of these conversations have occurred because a fund has had to pass on an opportunity that would have been in conflict with the regulatory investment restrictions on the fund.
While the process and ongoing requirements of registration as an RIA are not insignificant, the removal of the caps and limits can provide a growing venture firm greater flexibility, especially around investment restrictions. This can be seen in the small but growing number of registered venture firms operating broader and sometimes larger portfolios of growth companies.
While the registration route is not necessary for all firms and may, for some, be counter to the core mission, optionality is never to be underestimated. Several firms that I am aware of have recently conducted an analysis of what it would take to register and how it would change the existing firm program.
This analysis was typically done as part of a strategic look at the portfolio and specifically at deals they would be forced to pass on due to the ERA limitations. What they generally found was that although the registration made them more structured, the impact was largely in operations, finance, and marketing. (I would argue that the marketing impact should be insignificant, since anti-fraud rules already apply to venture funds operating as ERAs.) Critical to this analysis is a strong knowledge of the RIA rules and a balanced understanding of the venture firm culture and approach.
So, what does the SEC think about all of this? Frankly, over the last two years I have seen a growing interest in venture capital firms and other ERAs from the SEC.
Last year I was fortunate to be close to several exams of ERAs. While they mostly focused on compliance with the exemption and marketing/advertising issues under the anti-fraud rules, in at least one case the SEC examiners noted that exams were likely to expand, since the SEC was concerned with the lack of oversight and supervision in this area and the growing size and impact of the venture community.
If the examiners’ view is added to comments made by several pro-regulatory congressional representatives, I would expect to see more attention spent on VCs and even possible rulemaking. (And, depending on November’s election results, such rulemaking may become an even greater priority in Washington.) As one lawyer recently told me, we are always only one scandal away from rulemaking on a number of fronts, and the growing attention on FinTech and venture is not helping.
How VCs Can Prepare
There are a number of things venture firms can do to address the changing regulatory environment and mitigate some of the risk of these turbulent times.
First, conduct an analysis of what it would take to register as an RIA and the impact on day-to-day business. This is a short exercise that can be done remotely, so that you have a better understanding about the myths, realities, and costs of registration. Your findings should be mapped to the investment opportunities and revenue that could be pursued if registered. Critical to this whole exercise is understanding the planning and timing to complete the process of registration, if the “right” deal comes along.
The second activity would be to conduct a mock SEC exam. Whether or not you are registered, this would help prepare for an actual SEC exam, should you receive one, and identify control gaps in your infrastructure. Mock exams often provide a great deal of support during LP conversations focused on the quality of a firm’s infrastructure, culture, and controls. These mock exams often include not only the core SEC RIA requirements, but cyber and privacy issues as well.
Firms need to be thinking about how they will continue to grow and evolve in these turbulent times, based on a better understanding of the rules and limitations of the ERA status and what you can do to address them.