Advisers Act Registration Exemptions for July 20 , 2011 Venture - - PDF document

Advisers Act Registration Exemptions for Venture Capital Fund Advisers and Private Fund Advisers: The SEC Adopts Final Rules

On June 22, 2011, the Securities and Exchange Commission (“SEC”) issued a release adopting rules to implement and define the scope of two new exemptions from registration under the Investment Advisers Act of 1940 (“Advisers Act”).1 Congress created or directed the SEC to create these exemptions in Title IV of the Dodd-Frank Wall Street Reform and Consumer Protection Act, enacted

• n July 21, 2010 (“Dodd-Frank Act”). The Dodd-Frank Act exempts from registration, among others:
• advisers solely to one or more venture capital funds (“Venture Capital Advisers”), and
• advisers solely to one or more qualifying private funds with aggregate assets under management in

the United States of less than $150 million (“Private Fund Advisers”). The Release adopts rules and definitions that give substance to these exemptions and clarify the terms and methods of their application. Below we discuss each exemption and the rules in the Release relating to such exemptions. Exempted advisers do not avoid new regulation entirely. We discuss below reporting requirements that will be applicable to Venture Capital Advisers and Private Fund Advisers (referred to collectively in the Release as “Exempt Reporting Advisers”) that were simultaneously adopted in a separate release (the “Reporting Release”). The Reporting Release addresses a broad range of changes to investment adviser registration and regulation as a result of the Dodd-Frank Act.2 As also noted below, Exempt Reporting Advisers will be subject to inspections (generally only for cause) by the SEC staff.

• I. Venture Capital Advisers

Section 407 of the Dodd-Frank Act creates a new Section 203(l) of the Advisers Act, which exempts Venture Capital Advisers from registration. The Dodd-Frank Act charged the SEC with defining the term “venture capital fund” within one year of the Dodd-Frank Act’s enactment. The Release adopts a definition of “venture capital fund” and also a broad grandfathering provision that would permit existing funds that meet certain requirements to be treated as venture capital funds even if they do not meet the definition.

• A. The Definition. The Release adopts a new Rule 203(l)-1, which defines the term “venture capital

1 Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers with Less than $150 Million in Assets Under

Management, and Foreign Private Advisers, Investment Advisers Act Release No. 3222 (June 22, 2011) (the “Release”), available here. The rules adopted were initially proposed on November 19, 2010.

2 Rules Implementing Amendments to the Investment Advisers Act of 1940, Investment Advisers Act Release No. 3221

(June 22, 2011), available here. For a more detailed discussion of these additional changes to investment adviser registration and reporting, see K&L Gates’ alerts on the subject, available here and here, respectively.

July 20, 2011

Practice Groups: Investment Management Hedge Funds and Venture Funds Financial Services Reform Private Equity

2 fund” as a private fund that:

• represents to investors and potential investors that it pursues a venture capital strategy;
• immediately after acquisition of any asset (other than “qualifying investments” (as defined below)
• r “short-term holdings”3) holds no more than 20% of its aggregate capital contributions and

uncalled capital commitments in assets (other than short-term holdings) that are not qualifying investments, valued at cost or fair value, consistently applied by the fund;

• does not borrow, issue debt obligations, provide guarantees or otherwise incur leverage in excess
• f 15% of the fund’s aggregate capital contributions and uncalled capital (“Permitted Borrowing”),

and limits Permitted Borrowing arrangements to a non-renewable term of no longer than 120 calendar days (provided that the 120-day limit does not apply to guarantees of obligations of qualifying portfolio companies (as defined below) up to the value of the fund’s investment);

• does not provide investors with redemption, withdrawal or repurchase rights, except in

extraordinary circumstances;4 and

• is not registered under Section 8 of the Investment Company Act of 1940 (“1940 Act”) and has not

elected to be treated as a business development company. A “qualifying investment” means:

• an equity security:5
• issued by a “qualifying portfolio company” (as defined below) that has been acquired directly

by the fund from the company;

• issued by a qualifying portfolio company in exchange for an equity security issued by the

parent company or predecessor of the qualifying portfolio company; or

• issued by a company of which a qualifying portfolio company is a majority-owned subsidiary
• r a predecessor acquired in exchange for an equity security described in the two bullet points

above.

3 “Short-term holdings” are defined as cash and cash equivalents (meaning bank deposits, certificates of deposit, bankers

acceptances and similar bank instruments), U.S. Treasuries with a remaining maturity of 60 days or less and registered money market mutual funds. This definition broadens the proposed definition by adding registered money market funds as a cash management option.

4 The Release provides examples of “extraordinary circumstances,” including “a material change in tax law after an

investor invests in the fund” or “the enactment of laws that may prohibit an investor’s participation in the fund’s investment in particular countries or industries.” See Release at 62. The touchstone of “extraordinary circumstances” appears to be that “the trigger events.. are typically beyond the control of the adviser and fund investor (e.g., tax and regulatory changes).”

5 “Equity security” is defined in the rules by reference to Section 3(a)(11) of the Securities Exchange Act of 1934 (the

“Exchange Act”) and Rule 3a11-1 thereunder to include “any stock or similar security, certificate of interest or participation in any profit sharing agreement, preorganization certificate or subscription, transferable share, voting trust certificate or certificate of deposit for an equity security, limited partnership interest, interest in a joint venture, or certificate of interest in a business trust; any security future on any such security; or any security convertible, with or without consideration into such a security, or carrying any warrant or right to subscribe to or purchase such a security; or any such warrant or right;

• r any put, call, straddle, or other option or privilege of buying such a security from or selling such a security to another

without being bound to do so.”

3 A “qualifying portfolio company” is a company that:

• is not a reporting company or foreign traded6 and does not control, is not controlled by, and is not

under common control with a reporting or foreign traded company, either directly or indirectly (but private companies that begin reporting or become foreign traded will continue to qualify);

• does not borrow or issue debt obligations in connection with the venture capital fund’s investment

and distribute to the fund the proceeds of such borrowing or issuance in exchange for the fund’s investment; and

• is not an investment company, a private fund, an issuer of asset-backed securities or a commodity

pool. Under the adopted definition, a qualifying portfolio company must not be reporting or foreign traded at the time of each investment made by the venture capital fund; however, a venture capital fund can continue to hold a qualifying portfolio company’s securities once the company begins reporting, becomes foreign traded or otherwise subsequently fails to satisfy the definition.

• B. Grandfathering Provision. The Release adopts a broad grandfathering provision for existing

funds that do not meet the criteria of the venture capital fund definition. The grandfathering provision includes as an exempt venture capital fund an existing fund that:

• represented to investors and potential investors at the time of offering its securities that it pursues a

venture capital strategy;

• prior to December 31, 2010, sold securities to one or more investors that are not “related persons”
• f any adviser to the private fund; and
• does not sell securities to any person after July 21, 2011.

Given the broad scope of the grandfathering relief, the Venture Capital Advisers exemption is primarily forward-looking in application.

• C. Key Issues.
• 1. 20% Non-Qualifying Asset Basket. Under the exemption as originally proposed, a venture

capital fund was only permitted to hold equity securities of qualifying portfolio companies and short-term holdings. As adopted, the exemption provides venture capital funds with greater flexibility by permitting a fund to hold 20% of its aggregate capital contributions and outstanding capital commitments (measured at the time of the investment) in other types of investments. This gives a venture capital fund manager the ability (albeit limited) to pursue attractive investment

• pportunities that may not fall within the parameters of a qualifying portfolio company (such as

securities acquired in a leveraged buyout or of publicly reporting companies) and to make non- equity investments related to its qualifying portfolio company investments, such as short-term loans for bridge financing or other purposes that may take the form of pure debt, rather than a convertible equity security. In addition, a venture capital fund is not required to sell assets from its 20% non-qualifying assets because of changes in the relative values of the fund’s assets. If the non-qualifying assets increase

6 “Reporting” is defined in the rule to mean a company that is subject to the reporting requirements under Sections 13 or

15(d) of the Exchange Act. “Foreign traded” means a company having a security listed or traded on any exchange or

• rganized market operating in a non-U.S. jurisdiction.

4 to more than 20% of aggregate capital contributions and capital commitments after purchase, the fund is simply unable to purchase additional non-qualifying assets until the overage is remedied.

• 2. Opt-Outs and Other Non-Traditional Venture Fund Structures. The SEC’s definition of

“venture capital fund” envisions a traditional venture capital fund. The SEC intentionally chose not to include venture capital funds of funds within the definition. The Release does not indicate, however, how the SEC would treat less traditional venture fund structures, such as pledge funds

• r other vehicles in which investors have opt-out rights on an investment-by-investment basis,

stating for instance that the status of the latter depends on the facts and circumstances. It is possible that the SEC would look through these types of vehicles as facilitating individual investments and require the adviser to treat each investor as a client, making the exemption for Venture Capital Advisers unavailable.

• 3. Redemptions. The definition of venture capital fund does not define “extraordinary

circumstances” under which redemptions are permissible, but the Release provides some

• guidance. The Release states that the ability to withdraw or opt out of a particular investment

could be considered to occur under “extraordinary circumstances” if the withdrawal or opt out is triggered, for example, by a material change in law or the enactment of laws that may prohibit an investor’s participation in the fund’s investment in particular countries or industries. Such tax or regulatory changes would be considered extraordinary circumstances because they are “beyond the control of the adviser and fund investor[.]”7 The Release states, however, that “a fund that permits quarterly or other periodic withdrawals would be considered to have granted investors redemption rights in the ordinary course even if those rights may be subject to an initial lock-up or suspension or restrictions on redemption.”8 The SEC further notes that certain practices, such as the common practice of facilitating transfers

• f fund interests in secondary transactions, could result in de facto redemption rights. The SEC

states that a fund would not be able to rely on the venture capital fund exemption if it creates such de facto redemption options by, for example, “regularly identifying potential investors on behalf

• f fund investors seeking to transfer or redeem fund interests.”9
• 4. Representing or Holding Out a Fund as Pursuing a Venture Strategy. A venture capital fund

must represent to investors and potential investors that it pursues a venture capital strategy. Similarly, in order to qualify for the grandfathering relief, a fund must have made similar representations at the time it offered its securities. This express representation requirement is a key element of the rule’s attempt to distinguish private equity, hedge and other types of funds from venture capital funds; in the case of the grandfathering relief, a fund’s representation to investors that it pursues a venture capital strategy is the sole factor delineating grandfathered venture funds from other types of funds. Advisers may find it difficult in some cases, however, to determine whether it is representing or has represented its funds as pursuing a venture capital strategy.10 The Release states that the analysis is based on all relevant facts and circumstances, including “all of the statements (and omissions) made by the fund to its investors and prospective

7 Release at 62. 8 Id. at 63. 9 Id. at 64. 10 The Release states that the requirement is meant to capture “funds that do not significantly differ from the common

understanding of what a venture capital fund is[.]” Release at 65. The ambiguity inherent in the representation requirement is made evident, however, by the SEC’s difficulty in crafting a precise definition of a venture capital fund.

5 investors.”11 The name of a fund is not determinative, and a venture fund need not include any variation of “venture” or “venture capital” in its name.12 A fund that identifies itself as a hedge fund, private equity or multi-strategy fund (in which venture capital strategies are framed as only

• ne of a number of strategies), however, would not meet the requirement.13 An adviser should

take great care in crafting descriptions of its funds’ strategies and its marketing materials, and should promptly begin reviewing its past funds’ marketing materials to determine whether they would meet the representation requirement of the grandfathering relief.

• 5. Limitations on Leveraged Buyouts. The rule provides that a qualifying portfolio company may

not “borrow or issue debt obligations in connection with the [venture capital fund’s] investment in such company and distribute to the [venture capital fund] the proceeds of such borrowing or issuance in exchange for the private fund’s investment[.]”14 The Release states that a distinguishing feature of a venture capital fund, as opposed to a private equity buyout fund, is that venture funds “invest capital directly in portfolio companies for the purpose of funding the expansion and development of the company’s business, rather than buying out existing security holders [or] otherwise purchasing securities from other shareholders[.]”15 Although the SEC sought to limit a venture capital fund’s participation in buyouts to the 20% non-qualifying asset basket, the borrowing limitation in the definition of a “qualifying portfolio company” restricts a venture capital fund from participating in a leveraged recapitalization (which results in borrowed funds being distributed to portfolio company shareholders) but does not prevent many types of leveraged buyouts of a qualifying portfolio company. In a typical leveraged buyout, the borrowed funds would go to the selling shareholders, not to the venture capital fund. This may be an unintended loophole, or may be a point the SEC will clarify in later guidance.

• 6. Expanded but Still Restricted Ability to Manage Cash. The rule, as adopted, gives venture

capital funds limited flexibility in holding short-term investments for cash management purposes. As adopted, the rule expands the types of permissible cash management investments by including registered money market funds. Although the addition of money market funds is an improvement

• ver the proposed rule, the rule nevertheless significantly limits the types of cash management

instruments an exempted venture capital fund may use. The rule fails to include a variety of liquid, conservative instruments venture capital funds currently use to invest cash temporarily.

• 7. Portfolio Company as Investment Company. The rule expressly requires that a qualifying

portfolio company not be an investment company or a “private fund,” meaning an entity that relies on the exemptions from investment company status in either Section 3(c)(1) or 3(c)(7) of the 1940 Act; the SEC thereby expressly intended to exclude funds of venture capital funds from the exception to registration. On occasion, a venture-stage company may inadvertently fall within the definition of an investment company by virtue of its cash management investments pending its use of capital in operations or for research and development. A venture capital fund should make certain that a potential portfolio company either is not within the definition of an investment

11 Id. at 67. 12 Id. at 66-67. 13 Id. The non-qualifying asset basket would allow a fund to pursue attractive strategies that may fall outside the SEC’s

conception of a venture fund strategy, but highlighting these strategies in marketing materials as a key component of a fund’s overall strategy could cause the fund to fail the venture fund representation requirement.

14 Rule 203(l)-1(c)(4)(ii). 15 Id. at 44.

6 company or can rely on an exemption from registration other than those in Section 3(c)(1) or 3(c)(7) (such as 1940 Act Rules 3a-1 and 3a-8).

• 8. Removal of Requirement for Managerial Assistance or Control. Under the proposed rules, a

venture capital fund would have been required to either (i) offer to provide to a portfolio company, and if the offer is accepted would have had to provide, “significant guidance and counsel concerning the operations or business objectives and policies” of the portfolio company,

• r (ii) control the portfolio company. In the Release, the SEC removed this condition, noting that

active involvement in a portfolio company’s business is not always a feature of venture capital investing and that the level of involvement would vary among advisers and even from investment to investment.16

• 9. Non-U.S. Advisers. The exemption for Private Fund Advisers, discussed below, treats non-U.S.

advisers differently than U.S. advisers. That is not the case with the exemption for Venture Capital Advisers. Thus, while an adviser with or without a U.S. place of business may rely on the exemption for Venture Capital Advisers, it must comply with the requirements of the exemption with respect to all of its clients, both in the U.S. and outside the U.S.17

• 10. VCOC Status under ERISA. The SEC’s definition of “venture capital fund” for purposes of the

Venture Capital Advisers exemption contrasts with that of a “venture capital operating company” (or “VCOC”) as defined in U.S. Department of Labor (“DOL”) regulations under the Employee Retirement Income Security Act of 1974 (“ERISA”).18 Both definitions contemplate an unregistered fund, but differ in certain other respects, a complete discussion of which is beyond the scope of this alert. A key difference, however, relates to portfolio content. As described above, at least 80% of the assets of a “venture capital fund” (valued at cost or fair value, excluding short-term investments) must consist of “qualifying investments” in “qualifying portfolio companies.” On the other hand, at least 50% of the assets of a VCOC (valued at cost, excluding short-term investments) must consist of “venture capital investments” in “operating companies.” “Qualifying investments” under the Venture Capital Advisers exemption include certain equity securities issued by a qualifying portfolio company. As discussed above, the requirement that the fund provide “significant guidance and counsel” concerning the operations or business objectives and policies of the portfolio company was removed in the final rule. A “venture capital investment” of a VCOC, in contrast, generally is an investment (equity or debt) that provides “management rights” to the VCOC, which in turn are defined as contractual rights to substantially participate in or influence the conduct of the management of the operating company. The Venture Capital Advisers exemption generally defines “qualifying portfolio company” in the negative by requiring in part that the company not be an investment company, private fund, issuer

• f asset-backed securities, or a commodity pool. DOL regulations on the other hand define

“operating company” affirmatively as an entity “primarily engaged, directly or through a majority

• wned subsidiary or subsidiaries, in the production or sale of a product or service other than the

investment of capital.” As a result, an adviser managing a venture capital fund that seeks to take advantage of the Venture Capital Advisers exemption and avoid the application of ERISA (while

16 Id. at 54. 17 Id. at 68 (“A non-U.S. adviser may rely on the venture capital exemption if all of its clients, whether U.S. or non-U.S., are

venture capital funds.”).

18 DOL regulations provide that the assets of a VCOC are not considered “plan assets” of ERISA plans that may invest in

the VCOC. Consequently, the adviser of a VCOC is not required to conform to the fiduciary responsibility standards and prohibited transaction restrictions of ERISA in its management of the fund.

7 allowing ERISA plans as investors) must navigate separate, not entirely consistent, regulatory requirements.

• II. Private Fund Advisers

The Dodd-Frank Act creates a new Section 203(m) of the Advisers Act that exempts Private Fund Advisers from registration. As noted above, a Private Fund Adviser is one that (1) advises only qualifying private funds,19 and (2) has aggregate assets under management in the United States of less than $150 million. The Release adopts a rule that (1) defines when assets are deemed to be managed in the United States, and (2) provides a means for calculating assets under management for purposes

• f the exemption’s $150 million assets under management limitation (the “AUM Limit”).
• A. U.S. vs. Non-U.S. Advisers. As adopted, the Private Fund Adviser exemption applies

differently to an adviser with its principal office and place of business20 in the United States (“U.S. Fund Advisers”) than it does to an adviser with a principal office and place of business outside the United States (“Non-U.S. Fund Advisers”).

• B. Qualifying Private Fund Clients.
• 1. U.S. Fund Adviser. All of the clients of a U.S. Fund Adviser, regardless of whether the clients

are U.S. or non-U.S. clients, must be qualifying private funds.

• 2. Non-U.S. Fund Adviser. A Non-U.S. Fund Adviser cannot have clients that are “U.S. persons”

(as that term is defined in Regulation S under the Securities Act of 1933 (“1933 Act”)) other than qualifying private funds; however, a Non-U.S. Fund Adviser may have other types of clients that are not U.S. persons, so long as these clients’ assets are not managed from a U.S. place of

• business. (A “U.S. person” under Regulation S includes, among other persons, natural persons

resident in the United States and any partnership or corporation organized or incorporated under the laws of the United States.) For these purposes, U.S. investors in a fund would not be treated as clients; therefore, a Non-U.S. Fund Adviser could allow U.S. investors in an offshore fund without being deemed to have a client in the United States that is not a qualifying private fund. A Non-U.S. Fund Adviser must treat as a U.S. client, however, any discretionary account set up by

• r for the benefit of a U.S. person by the adviser or by an affiliate of the adviser.
• C. Assets Managed in the United States.
• 1. U.S. Fund Adviser. A U.S. Fund Adviser must include all of its qualifying private funds’ assets,

including the assets of non-U.S. private funds, in calculating its assets under management for purposes of the AUM Limit. All of these funds are deemed managed from the United States.

• 2. Non-U.S. Fund Adviser. A Non-U.S. Fund Adviser, however, only has to count in the AUM

Limit calculation the aggregate assets of its U.S. qualifying private funds and other qualifying

19 The rule uses the term “qualifying private funds,” which is broader than the term “private fund” as that term is otherwise

used in the Advisers Act (as a result of the amendments made by the Dodd-Frank Act). A “qualifying private fund” includes funds exempt from investment company registration under any of the exemptions in Section 3 of the 1940 Act, and thus is not restricted, as is the case with the term “private fund,” only to Section 3(c)(1) or 3(c)(7).

20 “Principal office and place of business” means the executive office of the investment adviser from which the officers,

partners, or managers of the investment adviser direct, control and coordinate the activities of the investment adviser. Rule 203(m)-1(d)(3).

8 private fund assets that it manages from a “place of business”21 in the United States (whether U.S.

• r non-U.S. clients). Thus, a Non-U.S. Adviser without a U.S. place of business can accept an

unlimited amount of U.S. investor investments into one or more non-U.S. funds without being deemed to manage any amount in the United States for purposes of the AUM Limit; this is a significant exception to the Rule.

• D. Calculating Assets under Management Annually; Undrawn Commitments Count.

Under the rule as adopted, a Private Fund Adviser must aggregate the value of all of its funds (or, in the case of a Non-U.S. Fund Adviser, all of its U.S. funds managed from a place of business in the United States) in determining whether it crosses the AUM Limit. In valuing assets of its qualifying private funds, the Private Fund Adviser has to apply a market value standard of measurement (or, where market value is not available, a “fair value” standard). In addition to actual assets, a Private Fund Adviser also must include the amount of any outstanding but uncalled capital commitments and must include proprietary assets and assets managed without compensation. The Private Fund Adviser is not permitted to subtract outstanding indebtedness or other liabilities; thus, an adviser would not be able to deduct accrued fees, incentive allocations or expenses or the amount of any borrowing. A Private Fund Adviser is required to calculate and report its assets under management to the SEC on an annual basis on the Amended ADV Part 1 (as defined and discussed below in Section III).22

• E. Transition to Registration. If a Private Fund Adviser were to exceed the AUM Limit for a

year, the adviser would have up to 180 days from the end of the year to register (an additional 90 days after the date the Amended ADV Part 1 is due). This additional 90-day period is only available to a Private Fund Adviser that is in compliance with applicable reporting requirements, as discussed below in Section III.

• F. Key Issues.
• 1. State Registration. A Private Fund Adviser is exempt from federal registration, but still could be

subject to registration in one or more states. Some states appear to be contemplating exempting Private Fund Advisers from state registration, but it is unclear whether such an exemption will be widely adopted. If a Private Fund Adviser were subject to registration in a state, it would be subject to regulation and inspection by state authorities as well as the reporting obligations and SEC inspections to which Exempt Reporting Advisers will be subject (discussed below in Section III). The North American Securities Administrators Association (“NASAA”) proposed and has since revised and re-proposed a model exemption from state registration for certain Private Fund Advisers.23 It is unclear, however, how widely this model exemption will be adopted by the states, if at all.

21 “Place of business” means (a) an office at which the investment adviser regularly provides investment advisory

services, solicits, meets with, or otherwise communicates with clients, and (b) any other location that is held out to the general public as a location at which the investment adviser provides investment advisory services, solicits, meets with, or

• therwise communicates with clients. See Rule 222-1(a).

22 The original proposed rules provided for annual reporting of assets under management but required that this calculation

be conducted quarterly.

23 This model exemption is narrower than the exemption for Private Fund Advisers adopted by the SEC. The model

exemption imposes additional requirements upon advisers to funds that rely on the exemption from investment company registration in Section 3(c)(1) of the 1940 Act. Such advisers would only qualify for the model exemption if the Section 3(c)(1) funds they manage accept only “qualified clients” as defined in Rule 205-3 of the Advisers Act (a more stringent standard than the “accredited investor” requirement normally applied to Section 3(c)(1) fund investors), and the funds would have to provide investors with certain additional disclosures.

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• 2. Uncalled Commitments in Calculating Assets under Management. In calculating its assets

under management in the United States, a Private Fund Adviser must include the aggregate amount of any uncalled capital commitments. The rule assumes that these commitments are fully committed and that investors are contractually obligated to provide the funds upon request, subject to the terms of the fund’s governing documents. The rule and the Release do not definitively address commitments that are conditional or that are not immediately callable. The Release also does not address commitments that are excused in whole or in part, although it would make sense for these to be deducted from assets under management once excused, if the excuse is legally binding and irrevocable. In addition, some funds give investors opt-out rights for certain investments or may allow investors to determine individually whether to participate in a specific investment, as in the case of pledge funds and similar flexible structures that are growing in popularity, or may allow investors to opt out of an investment for regulatory or investor-specific reasons (such as pension funds with socially responsible or other mandates or Sharia’a compliant investors). Thus, it is unclear how or when these types of less than fully committed capital would be included for purposes of the AUM Limit.

• 3. Single Member Funds. The SEC notes that an adviser could attempt to circumvent the

requirement that it advise only “private funds” by creating single-member funds for individual clients that would be “tantamount to separately managed accounts.”24 The Release states that whether such a fund would be treated as a qualifying private fund for purposes of the exemption “depends on the facts and circumstances.” The SEC would not treat as a private fund an entity that is “nominally a ‘private fund’ but that in fact operates as a means for providing individualized investment advice directly to the investors in the ‘private fund.’”25 The Release recognizes that there are circumstances where a single-investor fund could justifiably be treated as a private fund, such as situations in which all but one investor in a fund have redeemed their investment or when a fund is in its initial start-up period and has only one investor. But, it is unclear whether a single- investor vehicle created at the request of an investor for liability insulation or other legitimate business purposes would be recognized by the SEC and its staff as a qualifying private fund for purposes of the Private Fund Adviser exemption.

• 4. Integration of Separate Advisers’ AUM. The Release notes that the SEC could aggregate the

assets under management of two separate but affiliated legal entities each of which, individually, falls within the AUM Limit. The SEC states that “[t]he determination of whether the advisory businesses of two separately formed affiliates may be required to be integrated is based on the facts and circumstances” and cites the SEC staff’s previous guidance in the Richard Ellis, Inc. no- action letter setting forth the staff’s criteria for determining whether two related entities will be treated as operating independently.26

• III. Exempt Reporting Adviser Reporting Requirements; SEC

Inspections

Venture Capital Advisers and Private Fund Advisers, while exempt from Advisers Act registration, are nevertheless subject to certain reporting requirements. Section 204 of the Advisers Act sets forth

24 Release at 79. The SEC notes that “Section 208(d) of the Advisers Act anticipates these and other artifices and thus

prohibits a person from doing, indirectly or through or by another person, any act or thing which it would be unlawful for such person to do directly.”

25 See Release at n. 324. 26 See Release at n. 506. Richard Ellis, Inc., SEC No-Action Letter (pub. avail. Sept. 17, 1981).

10 the recordkeeping and reporting obligations of investment advisers and authorizes SEC inspections. The only advisers that are exempted from Section 204 are those “specifically exempted from registration pursuant to section 203(b) of [the Advisers Act.]” Because the Dodd-Frank Act exempts Exempt Reporting Advisers from registration under new Sections 203(m) and (l), the SEC takes the position that Exempt Reporting Advisers are subject to (and Congress intended them to be subject to) the reporting obligations of Section 204 and the provision authorizing SEC inspections. This is the major change wrought by the Dodd-Frank Act for advisers to smaller private equity and venture capital funds, the great majority of whom have not previously been subject to any such requirements.

• A. Reporting Requirements. In the Reporting Release, the SEC adopts new Rule 204-4, which

requires Exempt Reporting Advisers to complete and periodically update a limited subset of the items required on the Form ADV Part 1A, as it is amended by the Reporting Release (the “Amended ADV Part 1”). Exempt Reporting Advisers are not required to complete a Form ADV Part 2A or 2B. Exempt Reporting Advisers must file and update the relevant items on the Amended ADV Part 1 through the Investment Adviser Registration Depository (or “IARD”) system currently used to file and amend the Form ADV Part 1. This filed information will be publicly available on the IARD system.

• 1. Overview. The designated Items on Amended ADV Part 1 require an Exempt Reporting Adviser

to provide information regarding:

• basic identifying information, form and state of organization, location of its records, websites it

maintains, and any non-U.S. registrations (Items 1 and 3);

• the basis for the adviser’s ability to file as an exempt reporting adviser (Item 2.B);
• the name of its executive officers, direct owners and indirect owners (Item 10 and Schedules A

and B);

• other business activities of the adviser and its affiliates (Items 6 and 7.A);
• disciplinary history of the adviser and its employees (Item 11, including criminal, civil and

administrative disclosures); and

• the funds the Exempt Reporting Adviser manages (Item 7.B and related Section 7.B of

Schedule D).

• 2. Fund Information. Under Rule 204-4, an Exempt Reporting Adviser must provide information

about each fund it advises,27 including:

• identifying and other basic information about the fund, including its name, private fund

identification number, entity type and jurisdiction of formation, any foreign registrations and the 1940 Act exemption upon which it relies (i.e., Section 3(c)(1) or 3(c)(7) or another exemption in Section 3 of the 1940 Act);

• whether the fund is part of a master-feeder structure or is a fund-of-funds;
• which of seven enumerated strategies best describes the fund (e.g., hedge fund, liquidity fund,

private equity fund, real estate fund, securitized asset fund, venture capital fund or other);

27 An adviser with its principal office and place of business outside the United States is not required to provide information

regarding any private fund that, during the adviser’s last fiscal year, was not a U.S. person, was not offered in the United States and was not beneficially owned by any U.S. person. See Reporting Release at 58.

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• the gross asset value of the fund;28
• certain limited information about the fund’s investors, including:
• total number of beneficial owners,
• percentage of the investors that are adviser related persons, fund of funds and non-United

States persons,29 and

• the minimum investment commitment required of investors; and
• information about the five types of service providers to a fund deemed “gatekeepers” by the

SEC, including the fund’s auditor, prime broker, custodian, administrator and “marketers” (including, among others, placement agents and solicitors).

• 3. Initial Filing Deadline and Updates. The Reporting Release provides that an Exempt Reporting

Adviser must file their first reports through IARD between January 1 and March 30, 2012.30 An Exempt Reporting Adviser initially must file the sections of the Amended ADV Part 1 no later than 60 days after the adviser begins to rely on the exemption.31 Thereafter, an adviser would have to update the information within 90 days of the adviser’s fiscal year end or “promptly” if responses to certain Items become inaccurate (or, in the case of information about an adviser’s control persons, materially inaccurate).

• B. Key Issues.
• 1. Disclosure Generally. As noted above, the information an Exempt Reporting Adviser files about

itself and its funds will be publicly available. These disclosures could bring public and perhaps unwanted attention to an Exempt Reporting Adviser and its listed control persons. Importantly, however, an Exempt Reporting Adviser will not need to disclose publicly the names or much identifying information regarding any of its fund investors. In addition, two Commissioners dissented from the SEC’s adoption of the disclosure rules based on concerns that the SEC’s disclosure requirements might evolve over time such that the reporting regime would come to resemble the regulatory regime for registered advisers. Time will tell whether the SEC will administer the disclosure regime in a way that minimizes regulatory burdens on Exempt Reporting Advisers and maintains the distinction between the registration and reporting regimes.

28 The rules as proposed would have required gross and net asset values, as well as a breakdown of a fund’s assets and

liabilities by class and categorization under the fair value hierarchy under GAAP. The SEC removed these requirements in response to comments that stated that disclosure of this information could give away sensitive proprietary information about funds’ use of leverage and, in the case of venture capital and similar funds, the value of underlying portfolio

• companies. See Reporting Release at 61.

29 The amendments to the Form ADV Part 1A as proposed would have required a more detailed breakdown of the types

• f investors in a fund. The SEC removed the obligation to report on many types of investors in response to comments

expressing concern that such information is proprietary and could be used in some cases to identify investors in a fund. See Reporting Release at 61.

30 The SEC initially intended to require Exempt Reporting Advisers to make their initial filing by August 20, 2011. The

SEC chose to extend the deadline for registration of advisers from July 21, 2011 to March 30, 2012, and also determined to extend the compliance date for Exempt Reporting Advisers filing obligations “to accommodate re-programming of the IARD system on which these reports will be filed” and “to address concerns raised by commenters that advisers will not have sufficient time to determine whether they qualify for the new exemptions, familiarize themselves with Form ADV and IARD, collect the data necessary to file an initial report, and to file the report.” Reporting Release at 95-96.

31 Reporting Release at 42.

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• 2. General Solicitation. Most advisers rely on Rule 506 of Regulation D under the 1933 Act in

selling interests or shares in private funds without registration of the offer and sale under the 1933

• Act. In order to rely on Rule 506, an adviser or fund must not offer or sell interests through a

“general solicitation.” Because the detailed information filed by Exempt Reporting Advisers regarding the private funds they manage would be publicly available, the SEC or state regulators might deem responses to Items on the Form ADV a general solicitation in certain circumstances. The SEC’s changes last year to the Form ADV Part 2 raised a similar issue; in the release adopting those changes, the SEC stated that disclosures on the new Part 2A could constitute a general solicitation if they went beyond what was required. However, the disclosure applicable to Exempt Reporting Advisers may raise less of a “general solicitation” concern than the Part 2A because the responses to Amended ADV Part 1 are not in narrative form and provide less of an

• pportunity to exceed the scope of the questions.
• 3. Limited SEC Inspections – Exempt Reporting Advisers Examined for Cause. As noted

above, Exempt Reporting Advisers are subject to inspection by the SEC staff. The SEC stated in the Reporting Release, however, that it will not routinely inspect Exempt Reporting Advisers, but instead will inspect these advisers only for cause, such as when prompted based on a tip, a complaint or a referral from another agency or self-regulatory organization.32 Authors:

Cary J. Meer cary.meer@klgates.com +1.202.778.9107 John W. Kaufmann john.kaufmann@klgates.com +1.212.536.4009 Jarrod R. Melson jarrod.melson@klgates.com +1.202.778.9349

32 Id. at 48.

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