Although advisers to venture capital funds are exempt from registering with the Securities and Exchange Commission under the new financial reform law, determining the definition of venture capital could generate controversy.
In an attempt to provide better monitoring of private pools of capital, the Dodd-Frank measure requires advisers to private equity and hedge funds to register with the SEC. Funds of less than $150 million as well as venture capital funds do not fall under the mandate.
At an SEC meeting on Friday, however, two commissioners — Kathleen Casey and Troy Paredes — raised concerns that venture capital funds nonetheless will be subject to burdensome regulations that will crimp the advent of new companies.
The SEC voted to propose regulations for the registration of private funds and for the transition of advisers with assets under management between $25 million and $100 million from SEC oversight to state supervision. The public will be able to comment on the rules for 45 days after they are published in the Federal Register, which should occur within days.
At the meeting, the SEC provided little for advisers on when and how to switch to state regulation. The move will send about 4,100 of the SEC’s 11,850 registered advisers to states to give the SEC more capacity to oversee private funds.
Under Dodd-Frank, private equity and hedge funds must supply to the SEC information about the amount of assets the hold, their investors and their advisers’ services to the fund. They also must identify five categories of “gatekeepers” – auditors, prime brokers, custodians, administrators and marketers.
Even funds that don’t have to register with the SEC must provide a range of record-keeping information about their owners and affiliates, potential conflicts of interest and the disciplinary history of their advisers.
Ms. Casey called the parallel reporting requirements “a distinction without a difference.”
Such reporting will place costly burdens on venture capital managers, erect barriers to entry to the sector and jeopardize capital formation that would catalyze business start ups, innovation and job creation, according to Mr. Paredes.
“Such an adverse outcome would not be good for the nation’s economy,” Mr. Paredes said.
The SEC indicated that a venture capital fund would be defined as one that represents itself as a venture capital fund, only invests in equity securities of private companies to provide operating or expansion capital, is not leveraged, provides a “significant degree of managerial assistance” and does not offer redemption rights to investors.
Timothy Clark, co-head of the hedge funds group at the law firm Proskauer in New York, anticipates that venture capital funds of funds will not be included in the SEC’s definition. It will only encompass funds that invest directly in a company.
“There will be many fewer venture capital managers who will be able to take advantage of the exemption,” Mr. Clark said.
SEC Chairman Mary Schapiro said that venture capital is focused on starting companies not buying them out. But she acknowledged that the SEC will have to wrestle a definition to the ground.
“This is a challenging line-drawing process,” she said.
Ms. Schapiro welcomed the addition of private funds to the SEC’s portfolio, saying that before Dodd-Frank was approved, they were “out of sight and unknown to regulators and the public.” The information required from private funds will serve as a “red flag” for potential investor fraud and systemic risk.
Very little was said at the meeting, however, about reallocating regulatory responsibility for “mid-sized advisers” from the SEC to the states. SEC staff told commissioners that advisers would have 30 days to file for state registration and 60 days to withdraw from SEC oversight. But they did not say when the windows would go into effect.
The staff also said that the agency would propose a uniform method to calculate assets under management.
That proposal was welcomed by Steve Thomas, director of Lexington Compliance and the former chief compliance examiner in South Dakota.
“Very rarely did any of the people that I examined have an accurate number for AUM,” Mr. Thomas said.
For instance, fixed-income products and annuities can create discrepancies in AUM, which is defined as assets that are continuously and regularly managed. Buying and selling bonds might qualify, but it’s unclear if buying and holding them does.
“A lot of people with fixed portfolios are counting a lot of AUM, and they technically should not be,” Mr. Thomas said.
Important questions about the switch continue to linger, according to Zachary Gronich, president of RIA in a Box, the sister firm of Lexington Compliance. For instance, it’s unclear whether advisers must have switch registration by July, the anniversary of Dodd-Frank becoming law, or whether it will be pushed back farther. The SEC also has not indicated how it wants states to handle the transition.
“We have no guidance right now,” Mr. Gronich said.