SEC registration for venture capital managers – what late stage venture capital funds should consider

      Waystone and our colleagues at Titan, a Waystone Group Company review what late stage venture capital funds should consider when registering with the SEC when becoming an RIA, how to prepare for SEC examinations and what operational considerations need to be taken into account.

      Webinar Panelists:

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      Webinar Transcription

      Hello, everyone, and thank you for joining us today at today’s webinar, “SEC Registration for Venture Capital Managers: What should late-stage Venture Capital Funds consider?” We’ll just allow the audience a few more moments to finish their registration process, and I’ll hand you over to my colleague, Matthew Brown. Please stand by.

      Great, I think I’ve seen the last of the numbers registering now. So, without further ado, I’ll hand you over to Matthew Brown. Thanks, Matthew.

      Meet the Panelists

      Thank you, Annie. Good morning, everyone. Thank you very much for joining us today. I appreciate that everyone’s busy in the run-up to the holidays. So very much appreciate you taking the time to join us. My name is Matthew Brown. I’m the global head of business development here at Waystone, and I’m joined today by my colleague, Marc Leiding, who is a senior compliance consultant at Titan Regulation. They’re a Waystone group entity.

      Titan Regulation provides regulatory compliance consulting services to asset managers across the industry, ranging from hedge funds, private equity to venture capital and real estate fund managers. Marc, thanks very much for joining us today. We’re here to talk about a particularly hot topic, which is becoming more and more recently. And I know that you personally are working on a number of inquiries and ongoing projects, so I think a particularly relevant topic regarding SEC registration for venture capital managers.

      So maybe I might start with a quick question to yourself, Marc. In order to frame the context as to why this is unusual, I think it’s important to understand the exemption of which venture capital firms historically operated.

      Can you tell me what is the venture capital exemption and how is it typically utilized by these firms?

      Yeah. Thank you, Matt. Pleasure to be here. Yeah, so historically there’s what’s called the VC exemption, and it’s under SEC advisors Act rule 203(l). And so, I think understanding this exemption on a high level helps us to frame the issue. So I’m going to simplify the exemption, but I’m going to give you some of the basics that I think really hammer home this particular topic. The first of which is that, you know, you have to hold yourself out as a venture capital strategy in order to meet this exemption.

      Once you do that, you have to fit all of your investments within this qualifying investments framework. What does that mean? It means that only 20% of your investments can fall outside of what are referred to as qualifying investments. So that means 80% of your investments have to fit this particular type of investment. So it creates key limitations:

      • One, it has to be equity in company. So you’re prohibited from debt.
      • Two, purchases on the secondary market through buyouts of existing management or owners, they would fall within the 20% of the non-qualifying bucket.
      • Number three, qualifying investments, they don’t include listed companies. So that’s both domestic or foreign-listed companies. So investments in publicly traded companies cannot exceed this 20% of the nonqualifying bucket.

      And one of the things that that means for VCs, and I’m just going to focus on that for a second, if you have an existing investment that’s in a private company and it then goes public, it doesn’t change its qualification from one bucket of the 80% qualifying to the nonqualifying bucket. But the key thing that I think we’re going to focus on and we’re going to talk a little more about is that it’s hard to build a meaningful position around that private company that’s then gone public because all subsequent purchases of that company on the open market, once it becomes public, those have to fall within your 20% nonqualifying bucket. So that creates a limitation there.

      And then there are strict limitations on the use of leverage at the portfolio company and the fund levels. So this would prevent, like, a private equity strategy. That would be something like a leveraged buyout. And then finally another key distinction in the exemption has to do with basically prohibitions on redemptions of investors. So what you think of a hedge fund or, like, some, sort of, evergreen-type structure that continuously accepts new investors and allows redemptions in a manner consistent with, you know, some of the other, like, private equity and hedge fund strategies—well, less private equity but more hedge fund strategies—you can’t do that in the current VC exemption rule.

      So, you know, this exemption, and that’s a very, you know, basic simplification of the rule, but I think it really helps to frame the issue that we’re discussing and why somebody would want to move away from that exemption.

      So the reality here, Marc, is whilst the venture capital exemption is useful, it’s quite restrictive in what you’re allowed to do.

      Yeah, correct. Correct. And I think there are some changes that are happening in certain parts of the market that, you know, maybe people want to move away from these restrictions and maybe people want to explore life without the limitations that this exemption provides and prohibits.


      And can you think of any recent case studies of managers that moved away from this exemption towards full registration?

      There’s a lot. So, I think there’s a certain tier. So, the largest of these types of VC advisors have moved and maybe started the revolution, if you will, as some pundits might call it. Andreessen Horowitz, they first registered in April of 2019, and then Sequoia most recently changed to an SEC registration in October of 2021, so just recently their registration went through. And then you could think of other examples might include like the Foundry Group or General Catalyst, a16z, Battery Ventures. These are just a few examples of big names that have moved over.

      So we can see that there’s a strong trend of tier-one names doing this. What are the potential regions… I think this goes back to our previous conversation, but…

      What are the potential reasons that the largest VC funds in the space are moving towards registration and away from this exemption?

      And I mean, we’ve seen examples of tier-one venture capital managers doing this, but why register if you qualify for the exemption?

      Yeah, that’s a good question. This is my opinion. I think there are three contributing factors to this.

      1. Market Dynamic Shifts

      I think one of them has to do with market dynamic shifts. So, if we just look at market dynamic shifts, I pulled, you know, basic data from FactSet around the number of IPOs between 2019 and 2020. And in 2019, there were 242 IPOs. And that number more than doubled to 494 IPOs in 2020. So this market shift in itself and the faster growth towards that IPO stage and towards that publicly-traded company is one of the things that I think is one of the first contributing factors.

      Why? Because once you have that publicly traded company, it becomes difficult to fit within the VC exemption if you want to meaningfully hedge that position, let’s say, buying dips or, you know, using other instruments to put on as hedges for that publicly-traded company. It’s kind of like, you bought it, you have to hold it, you can trade around it within the 20% of the nonqualifying bucket if you have, you know, room within that fund. And that’s it. That can be limiting especially if you have a lot of these coming public.

      2. Restrictions on Redemption Rights

      The second thing, I think, and this is a big issue, has to do with restrictions on redemption rights. So if you think about the typical life of a VC fund, you’re talking about a historic lifespan of say 8 to 12 years. And when you look at the growth trajectory, especially in the last few years of some of these funds that have had companies go public, you know, they’ve really grown and they’ve really taken off. And you miss out on a lot of that compound growth if you can no longer meaningfully stay in that position because your fund has to close because your investors want liquidity. And they want liquidity because the fund has a finite lifespan, and there’s no other ways to get it. They can’t pull their money in and out on a regular basis. And so I think this is a big deal because, first of all, the VC managers and their investors want to get deeper into the lifecycle of some of those companies and stay with those companies longer.

      3. Competition

      And the third thing I think that might be driving this has a lot to do with competition. I think we’re seeing a lot more hedge fund players launching PE and VC-style crossover funds. And I think that these crossover funds are maybe eating VC’s lunch. I don’t know if that’s the best way to put it. But they’re competing with these pooled investment vehicles for the same opportunities and they don’t have the limitations that the VC funds do.

      So I think you’re starting to see bidding up of prices. You’re starting to see funds that have no timeline restrictions competing against funds that do have timeline restrictions. You know, and these VC funds can’t compete with the hedge fund in terms of the meaningful building of the position around these companies once they IPO. And I think that that is a contributing factor to why we’re seeing this registration.

      So I think we can safely say that the venture capital exemption is almost a restriction because these VC firms are having to leave a lot more growth on the table because they can’t participate post-IPO. And you’re right. You know, and we can refer to a previous webinar we did over the summer, that these hybrid funds from hedge funds are becoming ever more populous. There’s more competition for the same deals. And if these hybrid hedge funds have got the opportunity to invest in both the public equity and late stage venture growth, then they’re almost at an advantage to the traditional players in this industry, which are the venture capital managers. So I would tend to agree with those comments.

      What do you think are the significant compliance challenges that venture capital firms will face as it relates to a transition from the exemption to become fully registered?

      Yeah, absolutely. So, as you mentioned in the beginning, on an ongoing basis, I’m dealing with all kinds of exempt reporting advisor projects. I also have a lot of registration projects and things that I do for registered investment advisors. I’ve seen these crossover funds. I’ve seen the exempt reporting advisor funds, and it’s important to start with the concept that an exempt reporting advisor has a much lighter regime and that lighter regulatory regime… You know, if you just look at Form ADV, as an example, Form ADV has half of the parts for an exempt reporting advisor as it does for a fully registered investment advisor. Form ADV does not have a brochure, which is a narrative. you know, 20-page, roughly 20 plus page document that goes through extensive disclosures, which exempt reporting advisors don’t have to put out there.

      The Advisors Act in and of itself has a lot of language in there where it says if you are registered or required to register. So, a lot of those provisions just completely fall out because you’re an exempt reporting advisor. So, I mean, we’re talking about a whole host of things that exempt reporting advisors would need to implement. And some of these things… And I don’t want… You know, obviously it was not the purpose of this call to go into every single one of those, but for starters, you’re not required to archive all of your communications for an exempt reporting advisor. So right away, you know, when you switch, you’re going to need to implement something like a Global Relay, a Smarsh, or some similar solution to archive, you know, all of these communications.

      And then, I mean, we could go through a list of things that might be… You know, insider trading rules and regulations don’t really change, but you might need to strengthen them when you’re trading private and public equities safeguarding your client assets, such as the custody rule, might come into play. Marketing activities. Some of the marketing rules might need to be… The policies and procedures might need to be adjusted. These are just a few of the things that I can think of. And there are a lot of rules associated with a fully registered investment advisor that are more onerous, more expensive, and more time-consuming that an exempt reporting advisor would not necessarily have to consider.

      A Shift in Approach

      I guess none of these are insurmountable challenges, Marc. Titan work with hundreds of registered investment advisors. It’s just a significant shift in approach, I’m assuming.

      Yeah, that’s it, that’s it. I mean, obviously these large-tier VC funds are doing this because they believe that that burden is not overwhelming. You know that burden is not so restrictive, but, you know, what does it really mean? It means something like you add a compliance body for personal trading restrictions, right? And whereas those personal trading restrictions weren’t applicable before, now you have the process of monitoring, you know, something like limitations and controls around personal trading where you weren’t trading in public equities before and you are now, or, you know, another thing I just thought of while we were talking about some of these complexities, and I don’t mean to digress, but it makes sense.

      I think that volatility and risk management might be a change that is something to consider as well. You know, you weren’t dealing with publicly traded companies and the changes in the market. And we’ve seen a lot of volatility over the last year and last few years. And so, you know, that might be something to consider as a change. Also, new asset classes as investments. So, you want to make sure that you’re competent in some of these and you might need to bring on somebody. But the thing that really struck me was you might be able to invest now in cryptocurrencies. I don’t know if that’s something that these larger VCs are really considering, but these would have been previously prohibited under the VC exemption. So, there’s a compliance challenge in and of itself if you do decide to go that route.

      But, yeah, I think that there are a lot of complexities but, you know, none of which can’t be, I guess, overcome. And, you know, yeah, maybe you have to translate for a stronger push towards MNPI restrictions and policies and procedures and information barriers, but I think that it’s well worth the risk if you’re the Sequoias of the world and you’re going after this long-term growth.

      That makes a lot of sense. So, in summary, there are a lot of changes but nothing that’s insurmountable and really those changes are relevant to the change in dealing with the liquid asset classes. The liquid asset classes, it seems particularly relevant to that. Okay.

      Obvious question here and probably why, you know, I invited you to the call today,

      Does Titan have experience in existing venture capital managers who are both relying on the exemption and registered investment advisors?

      Absolutely. Titan has experience from the registration process through, you know, advising on policies and procedures, mitigating conflicts of interest. And we do this for both the exempt reporting advisor side through… You know, we can manage through both registrations and policies and procedures for both. And Titan works with multiple VC clients, multiple private equity clients, multiple hedge fund clients. So we have the versatility to go between the different styles as these venture capitalists, you know, move away from the VC exemption and they go into the RIA world. We have a lot of policies and procedures to draw from to help them guide through any of these changes that they’re considering.

      Understood. I’m conscious of time, but…

      What would your final thoughts be for a venture capital firm who are considering their regulatory registration options?

      Yeah, that’s a good question. The first thing I think is just balance. You know, the exempt reporting advisor regime is available indefinitely when you meet the VC exemption. You know, obviously what we outlined above are serious restrictions, but you have to balance that between when you’re advising assets less than the threshold of 150 million with, you know, the benefits of, what do you get from not meeting this exemption? Do you have the capability to meet the, I don’t know, the compliance challenges that you’re going to face?

      And so, you know, firms starting below the threshold, I would say, stay with the exempt reporting advisor and you don’t even really need to think about it until you hit that 150 million. Once you hit that 150 million, then you’re, again, weighing those challenges of the compliance side of things and thinking through it. We can help anybody who’s looking to file the exempt reporting advisor and help you think through the challenges associated with changing the regime.

      And then I would say for an existing exempt reporting advisor who’s considering registration as an RIA, again, is the flexibility that you’re going to receive as a registered investment advisor, does the benefit, I guess, outweigh the costs associated with the compliance challenges, the code of ethics changes? Would you need to hire somebody? Can you bring on a company Tian Regulation to help you manage those challenges? These are things that we would suggest you consider.

      But Titan has the experience, and I think that we can add a lot of value for a company in, you know, providing additional resources at a lower cost. We have people who are on our team, who have been across the different lifecycles, who have dealt with different types of asset classes. And I think that we’re a great source of information to, you know, bounce these ideas off of and consider, you know, what you would need to do to change. So, we’d love to talk to you about it, and we can certainly help you out from, as I say, soup to nuts.

      Marc, that’s great. I think today’s been really helpful in understanding the exemption, understanding who it applies to, understanding any sort of restrictions of exemption, what the prospects of a registration might change from a business perspective of a venture capital manager considering that, and some of the thought processes and ways that Titan can assist.

      Webinar Conclusion

      I don’t think we’ve got a few minutes to run through some of the audience questions but, Marc, I very much appreciate your time today. That’s been a very useful insight into all of those topics that we ran through. To everyone that joined us today, we very much appreciate it. We understand it’s a busy run up to the holidays. So, thank you very much for taking the time, and we hope that you found it helpful. We do have a list of the registrants, so we’ll just be sharing our details. So, if you do have any direct questions, you can reach out to Marc, myself, or any of the team, and we’ll come back to you swiftly and look forward to engaging with you. Thank you, everyone. Have a great day, Marc. Thanks again for joining us.

      Thank you for having me.

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