A major theme of this Blog has always been ongoing legislative, regulatory and market initiatives to reform capital markets by targeting unreasonable or outdated impediments to capital formation to make it easier for early-stage companies to raise capital. These impediments are not always obvious or direct. One such indirect impediment has been the venture capital adviser exemption under the Investment Advisors Act of 1940, the eligibility requirements of which disincentivize VC investment in secondary transactions and in other VC funds, thereby unnecessarily hampering liquidity in the innovation ecosystem. If a new piece of proposed legislation passed by the House Financial Services Committee becomes law, however, this impediment will be eliminated.
Before Dodd Frank, venture capital fund advisers didn’t have to worry seriously about Investment Advisors Act regulation. That’s because the Advisers Act exempted any investment advisor that had fewer than 15 clients and didn’t hold itself out to the public as an investment adviser. For the purpose of the 15-client cap, the SEC treated each fund as one client. As a result, investment advisers could advise up to 14 private funds, regardless of the total number of LPs investing in a fund or the amount of assets in the funds, without the need to register with the SEC.
But as part of Dodd Frank, Congress repealed the exemption for advisers with fewer than 15 clients and replaced it with three more limited exemptions under the Advisers Act, one of which is an exemption for investment advisers that solely advise “venture capital funds”. The SEC definition of “venture capital fund” contains five components, one of which is that the fund may not invest more than 20% of its aggregate capital contributions and uncalled committed capital in assets that are not “qualifying investments”. Qualifying investments are generally direct investments in qualifying portfolio companies, which exclude private funds or other pooled investment vehicles. Secondaries and fund-of-fund investments are considered non-qualifying investments because the assets obtained through such transactions are not acquired directly from a qualifying private company.
The “directly acquired” requirement means that secondary investments, i.e., purchases from non-issuers such as founders, employees and other investors, do not constitute qualifying investments. Also, investments in other VC funds are excluded from the definition of qualifying investments. That means VCs must carefully monitor their secondary and investment vehicle investments to make sure they don’t exceed 20% of committed capital, and I suspect some VCs as a matter of policy avoid these transactions entirely to avoid the compliance headache.
The SEC’s stated rationale for the direct investment rule is its desire to distinguish between VC funds, which are the subject of the investment advisor exemption, and other investment funds which are not. The SEC observes that one of the features of VC funds that distinguishes them from hedge funds and private equity funds is that they invest capital directly in portfolio companies for the purpose of funding expansion and development of a company’s business rather than buying out existing security holders.
The inclusion within non-qualifying investments of secondary and fund-of-funds investments, however, has been perceived by many in the VC space as contributing to an unnecessary impediment to liquidity in the innovation ecosystem.
Secondary transactions have become increasingly common in the venture capital industry. As companies remain private longer and defer exits, the desire for liquidity grows among founders and other shareholders. Founders and employees typically have most of their net worth tied up in their company’s shares and have an understandable desire to diversify and generate some liquidity currently. Angel investors seek liquidity to be able to fund new investment opportunities. Syndicate members often just get tired and want out.
VCs often make secondary purchases of shares from founders and other holders to increase their ownership. The additional shares purchased by VC funds in secondary transactions often serve as a critical bridge between the needs of a fund to obtain sufficient ownership in a portfolio company to generate enhanced returns for LPs and the concerns of entrepreneurs and angel investors over the dilution they would experience if such additional shares were purchased directly from the company. Without secondary transactions, many venture funds and prospective portfolio companies may be unable to bridge that gap, resulting in a decline in VC investing in early-stage companies. Secondary transactions also serve to align the goals of VC funds and founders to continue to grow the company rather than selling it early to achieve founder liquidity.
VC Investment in VC and Other Vehicles
It’s become common for VC funds to allocate some of their investment to other VC funds as well as other investment vehicles such as “feeder”, “incubator”, “accelerator” or “micro-VC” funds. These seed or seed-type funds in turn invest at the very earliest stages of a portfolio company’s life and then rely on larger VC funds to participate in follow-on Series A or other future rounds. Seed funds are a great asset to both startups and larger VCs, as they allow for a significantly larger pool of companies to receive seed funding and form a larger universe of investable companies for larger VCs.
Another group of VC funds that receives investment from larger VC funds is emerging funds. Emerging fund manager sponsored funds tend to invest in startups developing new disruptive technologies, and thus play an important role in the venture economy. Investing in these emerging VC funds is perceived by many asset managers as posing higher risk but offering greater upside potential than more established funds with track records.
Institutional LPs are often interested in higher risk, higher reward emerging funds but may be constrained by their own minimum investment requirements which typically exceed the round size of a typical emerging fund. Other interested institutional LPs may want to mitigate against the risk of investing in a smaller emerging fund by taking a diversified approach to their investment in the space. For such institutional LPs, it would make sense to allocate some investment to a fund-of-VC funds that invests partly in emerging VC funds and partly in traditional VC funds.
VCs make investments in still other types of investment vehicles. One example is technology incubators that create and spin out start-ups. Another is companies that are in the “invention business” whose assets consist almost entirely of patent portfolios. VCs also sometimes invest in investment vehicles whose other members are well-connected technology entrepreneurs who help VCs identify prospective portfolio companies and then invest in them side by side with the VCs through the vehicle.
All these indirect investments currently fall within the 20% limitation, resulting in impediments to both capital formation and liquidity in the innovation ecosystem.
The DEAL Act
Last month, the House Financial Services Committee passed and introduced to the full House of Representatives a focused piece of legislation to revise the definition of “qualifying investment” for purposes of the exemption from registration for venture capital fund advisers under the Investment Advisers Act. Called the Developing and Empowering our Aspiring Leaders Act of 2023 or the “DEAL Act of 2023” (Congress loves catchy acronyms), it specifically orders the SEC to revise the venture capital fund adviser exemption’s definition of a “qualifying investment” to include secondary acquisitions and investments in other venture capital funds. Under the new rule, shares purchased by VC funds in secondary transactions or in other venture capital funds will no longer be deemed non-qualifying investments and thus not included in the portion of a VC fund’s investment portfolio that may not exceed 20% of committed capital.
If passed by Congress and signed into law, this reform of the venture capital fund exemption could lead to greater investment in early-stage companies and significantly more liquidity for founders and other early investors. The bill is part of a larger piece of legislation called the Expanding Access to Capital Act of 2023 and now moves through the legislative process.