I never find it boring to review the investment adviser exemptions for private fund managers.  Apparently, I am not the only one since this is a question we frequently field.

Initially, private fund manager investment advisers, who are primarily regulated by the SEC, that is, large adviser firms with $100 million or more in assets under management (“AUM”), may claim federal exempt reporting status by relying on one of the statutory exemptions implemented under the Dodd-Frank Act of 2010 (“DFA”) amending the Investment Advisers Act of 1940 (“Advisers Act”).   Essentially, a party may be able to rely upon the private fund adviser exemption pursuant to Advisers Act Section 203(m), so as not to register fully as a registered investment adviser (“RIA”) .  This private fund adviser exemption for large advisers is the transition threshold from state to federal registration and from a federal exempt reporting adviser (“ERA”)– advisers relying upon either of the venture capital fund adviser exemption or the private fund adviser exemption — to a full-fledged RIA ($100 million AUM to $150 million AUM).

The large adviser may also advise non-venture capital funds, including, but not limited to, funds of funds and secondary funds, while saving money by avoiding the costs associated with registration.   This exemption is available to a U.S. based adviser of “private funds”–  an issuer of securities that would be an investment company but for the exceptions provided for in the Investment Company Act of 1940 (“ICA”) Sections 3(c)(1) or 3(c)(7)– with a combined AUM of less than $150 million.  Most private equity funds rely on the Securities Act of 1933 (“Securities Act”) Regulation D Rule 506– the private offering exemption as well the exemptions pursuant to ICA Sections 3(c)(1) or 3(c)(7).  In fact, ICA Section 3(c)(1) provides an exclusion from investment company registration for a fund that: (i) does not publicly offer its securities; and (ii) has 100 or fewer beneficial owners, while Section 3(c)(7) of the ICA provides an exclusion from investment company registration for a fund that: (i) does not publicly offer its securities; and (ii) limits its owners to qualified purchasers.   A large adviser, $100 million or more in AUM, advising funds that meet these qualifications may register with the SEC as a federally covered ERA, however, if the organizer advises any clients that are not private funds, then the adviser must register as an RIA with the SEC.

Additionally, there is another exemption called the venture capital adviser exemption pursuant to Advisers Act Section 203(l).   The large advisers venture capital adviser exemption also provides for an avenue to avoid RIA registration.  However, this exemption has many caveats, and is available to advisers of one or more “venture capital funds.”  Venture capital funds are private funds that: (1) pursue a venture capital strategy; and (2) hold no more than 20% of its total assets (including committed but not yet invested capital) in non-qualifying investments or short-term holdings (cash and cash equivalents, U.S. Treasuries with a remaining maturity of 60 days or less and certain money market funds).  A “qualifying investment” is an equity security purchased directly from a “qualifying portfolio company,” that is, at the time of the fund’s investment: (a) is not a reporting company, listed on a foreign exchange, and an affiliate of an Exchange Act reporting company, (b) does not borrow or issue debt obligations in connection with the fund investment and distribute proceeds in exchange for the investment, and (c) is not a mutual fund, hedge fund, private equity fund, venture capital fund, commodity pool fund, or an issuer of asset-backed.  The venture capital fund must also: (1) limit borrowing to 15% of the fund’s assets and only for a short-term (non-renewable term of 120 calendar days); (2) not provide redemption rights (except in extraordinary circumstances); and (3) is not ICA registered or a business development company.  For each investment fund, the investment manager has to ensure it meets the venture capital fund definition or the adviser cannot rely on the exemption.  So long as each fund advised by the organizer meets the definition then the adviser can remain an ERA indefinitely, while an adviser relying on the private fund adviser exemption may only do so until its AUM reaches $150 million.  Once reached, the adviser would be required to become a federally covered RIA.

Significantly, these parties also need to concern themselves with state ERA registration as well as small and mid-sized advisers (advisers with less than $100 million AUM) must also comply with applicable state law where it conducts its advisory business. These advisers are generally prohibited from registering with the SEC, and may not register as a federally covered ERA under one of the exemptions discussed above.  Some states have adopted the NASAA Registration Exemption for Investment Advisers to Private Funds Model Rule or some variation of it.  This Rule provides exemptions for state-regulated advisers from state RIA registration.  Further, states that provide either the model rule or a modified version of the rule, typically, track the federal exemptions discussed above, but a state may have modified or added requirements that organizers should take into consideration as part of their registration

For example, California adopted a modified version of the NASAA Model Rule, and parties, who are primarily regulated by the California Department of Business Oversight, may rely on the California private fund adviser exemption.   Pursuant to California law, the California private fund adviser exemption is the equivalent state ERA exemption.  See Cal. Code Regs. tit. 10, Section 260.204.9.   Pursuant to this Rule, a venture capital company (“VCC”) would include a fund that meets the federal venture capital fund definition as well as: (1) an entity that has 50% of its assets are in venture capital investments (investment in an operating company where the adviser obtains management rights); (2) an entity that is a “venture capital fund” as defined in Advisers Act Rule 203(l); and (3) an entity that is a “venture capital operating company” as defined in Employee Retirement Income Security Act of 1974 Rule 2510.3-101(d).   If the adviser advises funds that meet one of these definitions then it may claim the certificate exemption for investment advisers to private funds under California law, and it allows a California adviser to rely on the venture capital fund definition as defined by federal law for purposes of claiming the state exemption.  If the adviser meets this standard or one of the other definitions then it is a VCC and is only required to file a truncated Form ADV, pay the applicable state filing fee, and abide by the substantive requirements of state covered ERAs.  Further, if the organizer advises funds that do not meet one of the three statutory definitions of a VCC, then it still may rely on an exemption from state RIA registration but with additional considerations.  A private fund (excluding a fund that limits offerings to qualified purchasers) that does not qualify as a VCC is considered a “retail buyer fund” under California law, and an adviser to a retail buyer fund may still qualify for the certificate exemption for investment advisers to private funds but must provide audited financials to the fund’s beneficial owners within 120 days of the end of the fiscal year and may not charge performance fees to an investor that is not a “qualified client.”

Moreover, if the state does not have applicable exempt reporting adviser exemptions then the adviser must ensure that it complies with state RIA requirements.  Additionally,, there is nothing that would exempt these RIAs from taking a licensing test—Series 65.

Finally, given the complexity of state RIA and ERA requirements, fund organizers should consult counsel for the appropriate course of action to ensure full compliance.