The Changing Compliance Landscape for Venture Capital & Other Private Markets Fund Managers
ACA’s Vivek Pingili, Director, recently joined the National Venture Capital Association (NVCA) and Northgate Capital in a webcast providing considerations for building and implementing an effective compliance program for venture capital and other types of private markets fund managers.
Increasing Regulatory Pressures
Although many venture capital firms in the U.S. today are exempt reporting advisers (ERAs), scrutiny of these firms has increased.
While today there are very few venture capital firms that operate as investment advisers registered with the U.S. Securities and Exchange Commission (SEC)(RIAs), that number is increasing due to pressure from prospective limited partners (LPs), or because firms want to diversify their investment strategies in a manner that would require them to abandon the SEC registration exemption available for venture capital fund managers and register with the SEC.
In part due to the significant growth in venture capital funds in the past 5 years, the current SEC administration wants to examine these firms more closely (irrespective of their SEC registration status) to better understand how venture capital fund managers are growing and how their risk profiles may change as their businesses evolve.
As a purely technical matter, various compliance obligations an RIA is subject to don’t apply to a venture capital fund manager operating as an ERA. The examinations of venture capital ERAs, as well as enforcement actions involving venture capital ERAs, have focused on virtually all of the key risk areas that also apply to venture capital fund managers that are RIAs. As such, through pressure from both investors and the SEC, the compliance program differences between being a registered or unregistered venture capital fund manager is increasingly shrinking.
Despite COVID-19, the SEC has been very active in examining venture capital firms and other types of private markets fund managers. ACA is seeing trends of SEC exams increasing in scope – including longer request lists and longer time-periods covered. In some instances, SEC-registered firms are even being examined on matters that occurred prior to when they registered with the SEC. Additionally, the SEC has been actively trying to educate the marketplace about their expectations by publishing guidance about lessons learned from exams, and the guidance being provided increasingly covers topics of unique or particular relevance to venture capital firms and other types of private markets fund managers (e.g., conflicts relating to co-investments and the use of operating partners and senior advisers).
ACA is also seeing venture capital ERAs increasingly adopt RIA-like written policies, even prior to SEC-registration, both to demonstrate to their current and prospective investors their compliance programs are as robust as those of their SEC-registered counterparts, as well as to prepare them for transitioning to RIA status in the future.
SEC Focus Areas
The SEC views contractual arrangements between general partners (GPs) and LPs as a key mechanism to sharing risk in light of the complicated, long-term, and closed-end nature of venture capital fund businesses. Over the years, the SEC has increasingly stepped in to ensure GPs are complying with their contractual obligations to their LPs (via limited partner agreements (LPAs) and side letters). As a result, it is not surprising that a fair number of SEC enforcement actions and exam deficiency letters have involved some type of a failure by a GP to comply with one or more side-letters and/or LPA provisions.
Given the increasing importance of LPA and side letter compliance (including being able to evidence such compliance), you should seriously consider a technological solution to efficiently and effectively manage these obligations to your investors.
Conflicts of interest
Conflicts of interest have always been a focus area for the SEC. In the initial years since the implementation of the Dodd-Frank Act, the SEC was primarily concerned with ensuring that GPs were notifying and/or receiving the consent of their funds’ respective limited partner advisory committees where such notification or consent was required under a fund’s LPA. More recently, the SEC is now increasingly focused on ensuring the quality of disclosures being made to fund limited partner advisory committees are robust enough to provide meaningful information to such independent committees regarding a host of conflicts. For example, we have seen the SEC recently scrutinize whether venture capital and other private markets fund managers are disclosing sufficient conflicts-related and other material information to LPs in connection with seeking their consent for warehousing and other types of principal transactions.
Historically, the SEC focused on how operating partners, senior advisors, and strategic advisors are compensated. In recent years, as these consultants increasingly work with multiple private markets fund managers simultaneously (including those competing with one another), the SEC has expanded its scrutiny of these relationships to ensure conflicts and other risks (such as misuse of sensitive information) are being properly managed (e.g., through robust contractual undertakings in confidentiality agreements).
Fees and expenses
Transparency around fees and expenses have been a top priority for the SEC since the early days of Dodd Frank. More recently under the Gensler administration, we have seen the SEC increasingly remark on the marked variations in fees and expenses an investor pays across the investor’s private markets fund investments. The SEC is focused on ensuring investors are able to better compare fee and expense terms from one fund to another to be able to make informed decisions about which fund investments are optimal for their investment objectives and risk/return profiles. Very recently, dovetailing with multiple proposals from the Institutional Limited Partners Association (ILPA) and other LP-side organizations, the SEC has indicated it will consider whether to adopt a principal-based rule designed to provide consistency across how fund managers disclose fees and expenses. Irrespective of whether such a rule will ultimately materialize, it is reasonable to expect additional formal guidance from the SEC on these matters (e.g., via risk alerts).
There has been an increased focus on performance presentations in SEC enforcement and examination activity because these presentations are crucial to an investor’s or a prospective investor’s evaluation of a private markets fund manager. Not surprisingly, under the new Marketing Rule, which will only apply to RIAs, at least 50% of the focus is on performance reporting matters.
Even if the Marketing Rule is not applicable to your firm, as in the past, if you do comply with it voluntarily, it can be a safe harbor to rely on should you face an allegation that you misled investors.
Additionally, while historically, the SEC has not focused on Regulation D compliance in the private fund space, this is an area that has seen a steady increase in SEC scrutiny over the past few years. Particularly as more and more fund managers opt for general solicitation via Rule 506(c) offerings, the SEC is examining whether such firms are independently vetting the accredited investor status of prospects (as opposed to relying solely on self-representations these prospects provide in subscription documents). The SEC has also noticed that many firms that continue to rely on 506(b) offerings (where general solicitation is prohibited) have undertaken activities that the SEC believes amount to general solicitation (e.g., listing private funds on a website or publicly announcing they are in fundraising mode).
Historically, certain private markets fund managers have reviewed valuations once a year, except in the case of investments where material developments arose during the course of a year. Since the onset of COVID-19, the SEC and LPs have been putting pressure on these fund managers to review valuations more frequently and provide more timely information to their LPs on material developments involving portfolio companies.
ACA is also seeing an increased SEC push for lookback testing. When a private markets fund manager exited investments at lower valuations than what the manager marketed/reported to its investors during the holding period for an unrealized investment, the SEC is looking at what lessons the manager learned from this experience, and whether the manager appropriately modified its valuation processes to be more conservative to reduce the risk of such mis-matches in the future.
Many venture capital firms and other private markets fund managers are implementing increasingly ambitious environmental, social, and governance (ESG) policies (and expanding their disclosures in this area). This is at least in part due to a lot of pressure from LPs who want their GPs to formally articulate and implement a robust charitable and/or investment-related ESG footprint. However, due to the intense SEC focus and LPs increasingly probing how venture capital firms and other private markets fund managers are implementing ESG policies vis-à-vis their contractual undertakings and/or disclosures in this area, managers should not commit to aspirational policies unless they have a solid implementation game plan that is feasible. It is always better for a firm to, in practice, go above and beyond what they have committed to in writing. The same holds true for ESG-related undertaking a private markets fund manager seeks to provide in relation to its portfolio companies.
When creating an ESG policy, venture capital fund managers should consider:
- What do LPs really want to see in this area?
- How can the venture capital fund manager efficiently and pragmatically satisfy LP expectations relating to ESG matters (and document their accomplishments)?
- In relation to undertakings being made on behalf of portfolio companies, can these companies accomplish these tasks and provide evidence of such completion given their other constraints and challenges?
Since COVID-19, monitoring for how venture capital fund managers and their portfolio companies are managing risk in this area has become more common by the SEC. An increase in ransomware attacks and identity theft (including in the context of funding investments and receiving distributions) has resulted in portfolio companies and their venture capital fund owners putting capital at risk. Venture capital fund managers need to think about how they are managing enterprise level risks and the risk exposure and damage that can occur if they or one of their portfolio companies is subject to a ransomware attack.
Firms can combat cybersecurity risks by making sure:
- Employees are trained on proper cybersecurity etiquette and identity theft-prevention controls
- Systems are secure
- Passwords are routinely updated
- Infrastructure is secure
- Cybersecurity policies are actively monitoring for breaches
- Consistent testing to identify gaps in IT infrastructure
There is an increasing push by the SEC for venture capital firms to formalize their investment processes, from how they source investment opportunities to how they exit these opportunities – i.e., the full lifecycle of the investment process. The SEC is looking for consistency in due diligence processes from deal to deal on common denominator risks such as cybersecurity, background checks on senior management of portfolio companies, pending litigation (if any), and quality of financial accounting and reporting processes at portfolio companies.
It is also important that the investment process and how it is presented to the investment committee is accurately represented in the investment disclosures. The SEC doesn’t want to see procedures listed in disclosures that do not add value to the process.
Listen to the full webcast
Vivek Pingili, Director at ACA Group, and Larry Cowen, General Counsel & Chief Compliance Officer at Northgate Capital provide more details on all of these topics in the on-demand webcast and the corresponding presentation. Click below to listen to the full webcast and download the presentation.
How we help
Whether operating as an ERA or an RIA, ACA has a range of services that can help a venture capital firm develop and maintain an effective compliance program.
- Compliance Program Development and Enhancement
- Compliance Program Reviews, Mock Exams, and Gap Analysis
- SEC Registration, FCA Authorization, and Initial Filing Services
- Compliance Training and Education
If you have any questions about the SEC focus areas, or would like to speak with someone about developing and implementing an effective compliance program, please reach out to your ACA consultant or contact us here.