Home Business Law The Enterprise Capital Adviser Exemption Defined

The Enterprise Capital Adviser Exemption Defined


venture capitalPart 203(l) of the Funding Advisers Act of 1940 (the “Advisers Act”), often known as the enterprise capital adviser exemption, supplies that an funding adviser that solely advises enterprise capital funds is exempt from registration with the SEC below the Advisers Act. The time period “enterprise capital fund” just isn’t outlined within the textual content of the Advisers Act; as a substitute, the time period is outlined in SEC Rule 203(l)-1(a) as a personal fund that meets sure situations. This text appears at every of those situations and explains what is required to satisfy them.

Pursuing a Enterprise Capital Technique

The primary situation a fund should meet to qualify as a enterprise capital fund requires that the fund “[represent] to traders and potential traders that it pursues a enterprise capital technique.” The usual for figuring out whether or not a fund is definitely holding itself out as pursuing a “enterprise capital technique” is a subjective one, relying on specific details and circumstances. A fund just isn’t essentially required to make use of the phrases “enterprise capital” within the identify of the fund. Somewhat, the SEC appears on the non-public fund adviser’s statements to traders and potential traders as a complete. Nonetheless, with the intention to have an affordable assurance {that a} non-public fund adviser is exempt from funding adviser registration, the providing supplies of the fund ought to clearly and unambiguously state that the technique being pursued is a enterprise capital technique.

Funding Holding Limitation

The second situation requires that the fund:

“Instantly after the acquisition of any asset, apart from qualifying investments or short-term holdings, holds not more than 20 % of the quantity of the fund’s combination capital contributions and uncalled dedicated capital in belongings (apart from short-term holdings) that aren’t qualifying investments, valued at price or truthful worth, persistently utilized by the fund”

In different phrases, the second factor requires that not more than 20% of the fund’s whole belongings (together with dedicated however not but invested capital) could be invested in belongings that aren’t “qualifying investments” or “quick time period holdings.” Each of those phrases are outlined within the regulation.

Qualifying Investments

A “qualifying funding” is considered one of three issues: (i) an fairness safety issued by a “qualifying portfolio firm” that’s acquired immediately by the non-public fund from such qualifying portfolio firm; (ii) any fairness safety that’s issued by a qualifying portfolio firm in change for one more fairness safety of such qualifying portfolio firm; and (iii) any fairness safety issued by a mother or father of a qualifying portfolio firm in change for an fairness safety in that qualifying portfolio firm. Merchandise (ii) permits the fund to retain its curiosity in a qualifying portfolio firm after a company reorganization or another scenario the place there may be some form of change of fairness pursuits. Merchandise (iii) permits the fund to retain its curiosity in a qualifying portfolio firm after the qualifying portfolio firm has been acquired by one other firm, together with a publicly traded firm. In that occasion, the qualifying portfolio firm would change into a majority-owned subsidiary of the brand new mother or father firm.

There are two fundamental penalties to this definition. First, qualifying investments should be fairness and never debt. The time period fairness safety is, fortunately, outlined somewhat broadly and contains most well-liked inventory, warrants, securities convertible into widespread inventory, reminiscent of convertible debt, and restricted partnership pursuits. Nevertheless, bridge loans that aren’t convertible wouldn’t be thought of a qualifying funding.

Second, they should be acquired by investing immediately into an organization and never acquired by buying them from a 3rd occasion. So the enterprise capital fund wouldn’t be capable to deal with as a qualifying funding any curiosity in an organization that it acquires on the secondary market or via shopping for out present house owners or administration with out treating that curiosity as a part of its 20% non-qualifying basket. Nevertheless, a qualifying funding retains its standing as such after a company reorganization or buyout the place the qualifying portfolio firm’s fairness pursuits are exchanged for brand new fairness pursuits in the identical firm or in one other firm which acquires the qualifying portfolio firm.

Qualifying Portfolio Firms

The following essential query is: what’s a “qualifying portfolio firm?” A “qualifying portfolio firm” has three necessities: (i) on the time of the funding by the fund, the corporate should not be a reporting firm below the Securities Trade Act of 1934 nor be listed or traded on any international change and isn’t an affiliate of (i.e. immediately or not directly below widespread management with) an Trade Act reporting firm or a publicly traded international firm; (ii) the corporate might not borrow or concern debt obligations in reference to the fund’s funding within the firm and distribute to the fund the proceeds of such borrowing or issuance in change for the non-public fund’s funding (i.e. no leveraged buyouts); and (iii) it can’t be a mutual fund, hedge fund, non-public fairness fund, one other enterprise capital fund, a commodity pool fund, or an issuer of asset backed securities.

The primary requirement of a “qualifying portfolio firm” ensures that any firm {that a} enterprise capital fund invests in (apart from its 20% non-qualifying basket) just isn’t a publicly traded firm. This isn’t a controversial requirement on condition that a vital factor of a enterprise capital technique is to spend money on a younger firm and doubtlessly take it public. The enterprise capital fund can retain this funding even after the corporate goes public because the check for whether or not an funding is a “qualifying funding” is utilized on the time of preliminary funding by a fund. Nevertheless, if the fund acquires further shares of a portfolio firm after it goes public, then that funding wouldn’t be thought of a “qualifying funding.” Due to this fact, if a enterprise capital fund is requested to enter into an settlement to take part in all future rounds of financing of a portfolio firm, that any such requirement carves out shares offered in an IPO. Such an settlement might inadvertently require them to buy non-qualifying investments, which might consequence within the enterprise capital fund’s funding adviser being required to register with the SEC below the Advisers Act. The second requirement of the “qualifying portfolio firm” definition ensures that leveraged buyout funds or different non-public funds that finance their portfolio acquisitions by inflicting their portfolio corporations to incur indebtedness is not going to match throughout the definition of a enterprise capital fund. Along with the requirement {that a} “qualifying funding” should be an fairness safety acquired immediately from the portfolio firm, this requirement successfully limits the number of transactions that enterprise capital funds can enter into whereas nonetheless sustaining an exemption for its funding adviser.

The ultimate requirement of the definition ensures that the definition of the time period “enterprise capital fund” is not going to embody any form of fund of funds, even when the underlying funds are themselves enterprise capital funds. In fact, a enterprise capital fund can spend money on different funds as a part of its non-qualifying basket.

Quick-Time period Holdings

Recall that no less than 80% of the fund’s investments should be in “qualifying investments” or “short-term holdings.” The definition of “short-term holdings” is restricted to the next: (i) financial institution deposits, certificates of deposit, bankers acceptances, and comparable financial institution devices; (ii) U.S. Treasuries with a remaining maturity of 60 days or much less; and (iii) cash market funds. This definition could be very restrictive. Whereas some funds might need to park their belongings in comparatively low-risk liquid investments reminiscent of business paper, municipal bonds, international debt, and repurchase agreements, none of those belongings would qualify. A enterprise capital fund might definitely spend money on these belongings as a part of its 20% non-qualifying basket however should keep away from them as a common money administration device.

The Non-Qualifying Basket

The “non-qualifying basket” refers back to the portfolio of investments which aren’t “qualifying investments” or “short-term holdings.” Not more than 20% of a enterprise capital fund’s whole belongings, together with dedicated however not but invested capital, could be invested within the non-qualifying basket.

The fund should make the calculation as as to whether it exceeds the 20% restrict on the time every funding is made. Nevertheless, the check just isn’t utilized repeatedly, so if sure qualifying investments subsequently decline in worth or if non-qualifying investments enhance in worth, the fund will nonetheless be in compliance with rules even when valuation modifications would trigger the non-qualifying basket to exceed the 20% restrict. Nonetheless, the fund could be unable to accumulate any non-qualifying funding till the proportion of non-qualifying investments fell again under the 20% threshold.

One other wrinkle is that every one capital commitments should be bona fide; that’s, a fund can’t have “traders” decide to present capital with the understanding that the capital would by no means be referred to as. The SEC has taken the place that any such association would scale back the quantity of dedicated capital utilized in calculating the ratio. Nevertheless, if an investor by no means supplies the capital regardless of the bona fide intent by the fund adviser to name it, the dedicated capital nonetheless counts in calculating the ratio.

As well as, enterprise capital funds might select considered one of two strategies in its ongoing calculations used to confirm compliance with the bounds on non-qualifying investments. A fund might select to worth every funding at its truthful worth, which primarily is a “mark to market” method. So, if the worth of a fund’s non-qualifying basket declined resulting from market fluctuations, the fund could be permitted to buy further non-qualifying investments if they didn’t trigger the fund to exceed the 20% restrict when all belongings are valued at truthful market worth. Nevertheless, this might get costly, as lots of the fund’s investments are prone to be illiquid and thus troublesome to worth, necessitating frequent value determinations. The opposite method a fund might take is to worth all investments at their historic price in order that the worth of an funding by no means modifications no matter market fluctuations. This method avoids the frequent value determinations that might be vital if the fund selected to make use of truthful worth in its calculations. A fund adviser could also be tempted to make use of one technique on some events and one other technique on different events, however the SEC has taken the view that this isn’t permitted. The identical technique should be used to worth all investments repeatedly all through the lifetime of the fund.

The non-qualifying basket is a great tool for enterprise capital funds to enter into non-qualifying transactions, reminiscent of bridge loans to portfolio corporations or potential portfolio corporations or purchases of publicly traded securities, with out dropping their standing as a enterprise capital fund.

Limits on Leverage

The third situation of a “enterprise capital fund” requires that the fund:

“Doesn’t borrow, concern debt obligations, present ensures or in any other case incur leverage, in extra of 15 % of the non-public fund’s combination capital contributions and uncalled dedicated capital, and any such borrowing, indebtedness, assure or leverage is for a non-renewable time period of now not than 120 calendar days, besides that any assure by the non-public fund of a qualifying portfolio firm’s obligations as much as the quantity of the worth of the non-public fund’s funding within the qualifying portfolio firm just isn’t topic to the 120 calendar day restrict”

The leverage restriction consists of two fundamental necessities. First, a enterprise capital fund might not borrow, incur indebtedness, or assure money owed of portfolio corporations in a complete quantity in extra of 15% of the fund’s combination capital contributions and uncalled dedicated capital. Which means that throughout early durations within the lifespan of a fund, earlier than it has referred to as all its capital, it could possibly incur important leverage. For instance, if a fund has whole capital commitments of $10 million, however solely $2 million has been referred to as to date, the fund might theoretically incur leverage of as much as $1.5 million as a result of the 15% calculation is made utilizing the full combination quantity.

The second requirement is that any borrowing (together with the borrowing incurred in compliance with the 15% restrict) should be for a non-renewable time period of now not than 120 calendar days, aside from ensures of portfolio firm debt. As well as, if the fund does assure portfolio firm debt for a interval better than 120 days, the full debt assured can’t be bigger than the fund’s funding in that portfolio firm. Exterior of that exception, any borrowing that does happen by a fund should be quick time period.

On account of these two necessities, the leverage restrictions contained within the SEC’s definition of a portfolio firm are very limiting, successfully stopping any funds that use important leverage from using the enterprise capital exception to funding adviser registration.

No Redemption Rights for Buyers

The fourth situation requires that the fund:

“Solely points securities the phrases of which don’t present a holder with any proper, besides in extraordinary circumstances, to withdraw, redeem or require the repurchase of such securities however might entitle holders to obtain distributions made to all holders professional rata.”

The SEC has offered some steering as to what “extraordinary circumstances” means in its feedback to the rule, the place it states that the time period would usually be restricted to occasions past the management of the fund adviser or the investor. The only real instance the SEC provides is a fabric change in legislation or regulation. Clearly the SEC supposed that this exception will likely be extraordinarily restricted in scope.

One concern that would come up is whether or not the fund’s adviser would be capable to take distributions from its carried curiosity with out a professional rata distribution to traders, as some fund advisers do. The commentary to the rule implies that it could possibly. The rationale for that is that the rules present {that a} enterprise capital fund can solely concern securities that wouldn’t have redemption rights. The fund adviser’s carried curiosity is often within the type of a common partnership curiosity of a restricted partnership or a managing member curiosity of a restricted legal responsibility firm, which within the context of a fund formation, wouldn’t be thought of a safety. Nevertheless, there are some potential issues. Some fund advisers construction their carried curiosity as a restricted partnership curiosity held by a “particular restricted associate” that’s an entity separate from the fund adviser. Such a restricted partnership curiosity could also be deemed to be a safety, and consequently, a fund structured on this method might not be capable to make distributions of the fund adviser’s carried curiosity with out a corresponding professional rata distribution to traders.

One other concern that this requirement raises is whether or not it prohibits transfers of an investor’s curiosity in a enterprise capital fund. The providing paperwork of personal funds should limit the transferability of pursuits within the fund as a situation to creating use of Regulation D; nonetheless, there are particular exemptions reminiscent of Rule 144, Part 4(a)(7) of the Securities Act of 1933, or the so-called “Part 4(1½) exemption” that let resale. Consequently, fund providing paperwork regularly present that an proprietor of an curiosity within the fund might switch its curiosity upon acquiring an opinion of counsel stating {that a} resale exemption applies. Does such a provision violate the redemption restriction? The commentary to the rule implies that the SEC’s opinion is that it doesn’t, offered that the fund adviser just isn’t offering de facto redemption rights by repeatedly aiding the traders find potential transferees. Due to this fact, it’s advisable that enterprise capital funds keep away from providing to assist their traders discover potential transferees.

The restrictions on redemptions are largely in line with the enterprise capital fund business’s practices. Nevertheless, there will likely be some funds that won’t qualify below the SEC’s definition because of this requirement. Funds which can be “evergreen” (that regularly settle for new traders and permit redemptions as hedge funds often do) or funds that make the most of a “particular restricted associate” and intend to make distributions to the particular restricted associate that aren’t professional rata with the traders might have issue qualifying below the definition.

Prohibition In opposition to Funding Firm Act Registration

The fifth and closing situation requires that the fund: (i) not be registered below the Funding Firm Act of 1940 and (ii) not elected to be handled as a enterprise improvement firm pursuant to the Funding Firm Act. This requirement mustn’t considerably have an effect on most enterprise capital funds.

Sometimes, funds which can be registered as funding corporations are publicly traded mutual funds. In distinction, most enterprise capital funds are non-public funds, that are funds which can be exempt from the registration provisions of the Funding Firm Act. A enterprise capital fund sometimes makes use of considered one of two exemptions: the “3(c)(1)” exemption or the “3(c)(7)” exemption. The three(c)(1) exemption exempts from Funding Firm Act registration any fund with 100 or fewer traders. The three(c)(7) exemption exempts from Funding Firm Act registration any fund that’s offered solely to certified purchasers (which roughly talking, is an individual or entity with $5 Million or extra in funding belongings). Virtually talking, which means that non-public funds, reminiscent of enterprise capital funds, are both (i) restricted to 100 or much less accredited traders or (ii) restricted to qualified purchasers.

The enterprise capital exemption from funding adviser registration additionally doesn’t apply to advisers to a fund which has elected to be handled as a enterprise improvement firm below the Funding Firm Act. A enterprise improvement firm is a type of publicly traded non-public fairness fund designed to offer capital to small, creating, and financially troubled corporations. Advisers to such funds will likely be required to register as an funding adviser with the SEC, except one other exemption applies.


Though it might appear easy to qualify for the enterprise capital adviser exemption by limiting the adviser’s enterprise to advising solely enterprise capital funds, whether or not a fund meets the complicated situations for being a “enterprise capital fund” could be fairly complicated. Additionally word {that a} non-public fund adviser exempt below the enterprise capital exemption remains to be an exempt reporting adviser, which suggests it would nonetheless be required to offer an abbreviated Kind ADV to the SEC. As well as, fund advisers exempt from the SEC can also nonetheless nonetheless be topic to state investment adviser registration requirements. You must seek the advice of an legal professional who’s acquainted with securities regulatory points in assessing whether or not your specific fund administration enterprise is required to register with the SEC or with state authorities and what filings are required.

© 2018 Alexander J. Davie — This text is for common data solely. The data offered shouldn’t be construed to be formal authorized recommendation nor the formation of a lawyer/shopper relationship.


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