Part 2: The Future of Fund Management - How the SEC's New Rules Affect EMVCs
Last quarter, the financial landscape for private fund managers witnessed a significant shift as the U.S. Securities and Exchange Commission (SEC) rolled out a new set of rules and amendments under the Investment Advisers Act of 1940. These regulatory changes are poised to reshape the dynamics of investor negotiations and strategy formulation for venture fund managers, particularly in their engagement with anchor investors. The amendments introduce additional compliance requirements that promise to redefine the operational playbook for future fund activities, marking some key changes for private fund governance. In the second of this two-part series on venture capital (VC) funds and compliance, we will discuss the impact of this new ruling for emerging managers in venture capital (EMVCs), the primary audience for The Venture Fund Blueprint with the knowledgeable minds at Cedar Mountain.
While there are several new rules that impact Registered Investment Advisers (RIAs), there are two key rules impacting EMVCs, particularly Exempt Reporting Advisers (ERAs) or funds under the $150mm threshold.
Preferential Treatment Rule
The SEC has introduced the Preferential Treatment Rule, a stringent regulation that significantly narrows the scope for private fund advisers to extend preferential treatment to any investor that could detrimentally affect other investors, unless they meet specific criteria. This rule demands that fee discounts be uniformly available to all investors, thereby altering the dynamics of side letter arrangements and negotiation practices. VC funds are now compelled to retroactively reveal any special terms previously granted to select investors to their entire investor base as soon as reasonably practical.
Furthermore, the SEC mandates that information rights must be equitably distributed. This means that no investor, regardless of their type or size, should receive material information about fund holdings or exposures that could lead to a material negative impact on other investors. Such consistency ensures that not even anchor investors or preferred partners receive any kind of advantageous information.
Quarterly reporting by RIAs has become more detailed and demanding, aiming to prevent any discrepancies in reporting and ensuring a level playing field. Additionally, the SEC rules stipulate that examination costs or government-imposed expenses cannot be passed onto the fund but should be covered by management fees. EMVC firms must be prepared to bear these expenses out-of-pocket if management fees fall short, which raises important considerations regarding the minimum fund size EMVCs can viably raise to cover such costs.
Lastly, with regards to sidecar funds, the SEC requires that all terms, including fees and expenses, be proportionate to those of the main fund. This ensures equitable treatment across the board, with the main fund bearing pro-rata charges, not to be unevenly shared with any sidecar fund. These comprehensive rules and amendments are set to reshape the landscape of private fund management, reinforcing fairness and transparency across investor relations.
Restricted Activities Rule
The SEC's new Restricted Activities Rule imposes stringent controls on private fund advisers by restricting their ability to engage in specific actions unless they achieve full disclosure or obtain explicit investor consent. Advisers must now transparently disclose certain activities if they are to remain compliant with the rule, including the allocation of fees tied to their regulatory compliance, such as costs for filing Form ADV, and any reductions in clawback amounts due to tax liabilities. Moreover, they are prohibited from imposing fees or expenses related to a portfolio investment on a non-pro rata basis across multiple funds, except in cases where such an allocation can be demonstrably fair and equitable.
In addition to these disclosure mandates, the rule stipulates that other activities necessitate direct investor consent. Private fund advisers must seek approval before passing on to the fund any fees associated with regulatory investigations into their practices. Furthermore, any form of borrowing or the receipt of loans and credit from a fund by advisers is also subject to the precondition of obtaining investor consent. These measures are part of the SEC's broader initiative to enhance the transparency and fairness of private fund management, ensuring that investors are fully informed and consenting participants in the financial activities of their fund advisers.
Additionally, it has been asserted that the private funds will have much more scrutiny and regulation in future. The following was included in the aforementioned announcement: “Private funds and their advisers play an important role in nearly every sector of the capital markets,” said SEC Chair Gary Gensler. “By enhancing advisers’ transparency and integrity, we will help promote greater competition and thereby efficiency. Consistent with our mission and Congressional mandate, we advance today’s rules on behalf of all investors — big or small, institutional or retail, sophisticated or not” (source: SEC Enhances the Regulation of Private Fund Advisers). According to SEC Chair Gensler, there is more to come for private funds, which will have a rippling effect in the venture industry particularly for EMVCs. For those interested in reading more, you can find the summary here and the full ruling here.
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More Articles in this Compliance Series
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Sincere appreciation to our contributing author Meher Haider , Co-Founder at Cedar Mountain, along with Shea Tate-Di Donna and Kaego Ogbechie Rust, authors of The Venture Fund Blueprint.
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