The past several years have brought significant evolution for the venture capital industry, from updated regulatory frameworks, the explosion of venture capital, and a decades-long bull market followed by a meaningful downturn. Now, even more changes are afoot — this time, in the form of regulatory shifts. In what has been called the biggest rule-making event in venture capital (VC) since Dodd-Frank, the SEC recently passed a series of rules that have significant implications for any private fund managers, including venture capitalists. 

The five new rules passed by the SEC cover a range of issues under the Advisers Act. This Act, which was passed in 1940, regulates anyone who receives compensation for advising others on buying or selling securities. The law requires all advisers (GPs) to either register with the SEC, making them a Registered Investment Adviser (RIA), or qualify for an exemption. One avenue for exemption is by qualifying as an Exempt Reporting Adviser (ERA), which is the path taken by most VCs. As an ERA, you can pursue a venture capital strategy (meaning that 80% of your investments are made directly into private companies) and raise capital from accredited investors while avoiding formal registration with the SEC. Instead, ERAs file a truncated Form ADV. 

An overview of the rules

Keep in mind that these rules have changed slightly from the proposed versions that we highlighted in our Sydeletter on August 22, 2023. Overall, most of the rules were adjusted to restrict certain behaviors rather than prohibit them altogether.

Out of the five rules that were passed, two directly impact ERAs, while the rest will only impact RIAs. The rules that are most relevant for VCs who are registered as ERAs are: 

Advisers (GPs) are prohibited from offering preferential redemption or information rights to a subset of investors unless such rights are offered to all investors at the same time. Any preferential treatment relating to material economic terms offered to a subset of investors (e.g. via side letters) must be disclosed to all current and prospective fund investors (Rule 211(h)(2)-3).

Advisers who engage in certain sales practices, conflicts of interest, and compensation schemes must disclose (and get consent for certain activities) from all fund investors (Rule 211(h)(2)-1). Those restricted practices include: 

• Non-Pro Rata Fee & Expense Allocations: Generally, advisers cannot charge fees related to a portfolio investment on a non-pro rata basis when multiple funds managed by the adviser are participating – unless the adviser distributes advance written notice of the charge with a description of how the allocation approach is fair and equitable under the circumstances.

  • E.g., if your primary fund is investing in a company and you’re also launching an SPV for co-investors, you will have to share legal and other expenses that benefit the fund and SPV pro rata across both vehicles.

• Certain Regulatory Fees & Expenses: Advisers are prohibited from expensing fees to the fund that are associated with any regulatory, examination, or compliance fees related to the adviser unless the fees are disclosed in advance. Expensing fees to the fund that are associated with an investigation of the adviser is prohibited unless there is written disclosure to and consent from all investors. If an investigation results in adviser sanctions, the adviser may not expense such investigation fees.

  • E.g., you cannot expense fees for your annual Form ADV filing to your primary fund or SPVs, as this is an expense that benefits you as the adviser to these entities rather than the fund or SPVs directly.

• Reducing Clawbacks for Taxes: Advisers are prohibited from reducing the amount of a clawback obligation by actual, potential, or hypothetical taxes applicable to the adviser unless they disclose the pre-tax and post-tax amount to investors within 45 days of the end of the fiscal quarter.

  • E.g., if your fund has an American waterfall and, at the end of the fund, you determine that received more carry than you should have – because earlier liquidity events were more successful than later ones and you received more carry across all investments than what you agreed to receive – then when your excess carry is “clawed back”, you can no longer reduce the amount you give back to the fund by taxes you paid on the earlier pay–outs without appropriate disclosure. 

• Borrowing: Advisers are prohibited from borrowing money, securities, or other fund assets, or receiving a loan or an extension of credit from a fund unless they provide written notice of the borrowing terms and obtain consent from a majority of the fund’s investors.

The three additional rules are specific to RIAs: 

• 211(h)(2)-2: Fairness opinion or valuation opinion are now required for private fund adviser-led secondary transactions.

• 206(4)-10: A mandatory audit of private fund financial statements to, among other things, serve as a check against misappropriation of assets and calculation of adviser fees is now required. 

• 211(h)(1)-2: RIAs must deliver fund quarterly statements with certain specific information, including uniformity in fee presentation. 

The intention of the rules is clear: to increase the level of transparency between fund managers (GPs) and their investors (LPs). If you are at all familiar with the lengthy document called the Limited Partnership Agreement, or LPA, that is signed by all investors in a fund, you might be surprised to hear that the SEC feels like there isn’t enough transparency between GPs and LPs. LPAs are typically several hundred pages long and include a huge number of requirements and disclosures between the two parties. The document limits everything from what the GP can invest in, how long they can invest for, and even how they spend their time outside of investing. However, given that venture capital is still, relatively, a cottage industry, there is a lot of grey area around what is or is not allowed. Because most venture capital investors benefit from the Venture Capital Exemption and are considered Exempt Reporting Advisers, they have relatively limited compliance or regulatory obligations to the SEC or to their investors (outside of what is explicitly laid out in their LPA). This gives VCs, who operate in an industry that moves quickly and is largely based on relationships, a fair bit of flexibility with how they operate their businesses. 

As an example: there is a long history of GPs negotiation special LP arrangements outside of their LPA through side letters (or secondary agreements used to create bespoke terms between two parties). The primary purpose of a side letter is to give an investor (either a VC or LP) some special or additional rights that are not granted to all of the other investors involved in a transaction. In almost all cases, these additional rights are advantageous to the investor. Venture fund managers use side letters to grant preferable terms to specific investors, oftentimes in order to secure their anchor or an otherwise large or strategic investor. Under most LPAs, the fund manager is not required to disclose any side letters to their other investors. 

Organizations like the Institutional Limited Partner Association (ILPA) have expressed their support for these rules, highlighting that additional regulation would help to level the playing field for all parties and ultimately increase the efficiency of private markets. They also point out that close to 97% of LPAs are initially drafted by the GP’s external counsel, and that the terms have become increasingly GP-friendly, especially with the consolidation of law firms leveraged by VC firms. Given that a fund investment is typically a 10+ year commitment, having terms that align the interests of GPs and LPs is crucial to a healthy ecosystem. 

Additional scrutiny of private markets can be attributed to the increase in private market participation over the past few years. In the past five years alone, there has been an 80% increase in the gross assets of private funds. Despite popular narratives, this growth has not been significantly hindered by the current market downturn: private markets are expected to hit $13 trillion by 2027. As attorney Chris Harvey points out: 

“Several years ago, private markets started outpacing public markets in terms of financing volume for private deals. Even with a down market in 2023, private markets still eclipse public markets in terms of total amount raised for equity financing. In fact, just the private funds industry alone has eclipsed the U.S. banking industry since 2021.”

What does this mean for emerging fund managers?

Many VCs are discouraged, rightfully so, by the push for tighter regulation; meanwhile, proposed rules that could decrease barriers for fund managers (like increasing investor limits or granting accredited investor status via a knowledge-based test) have fallen by the wayside.

However, don't despair just yet. Because emerging managers are already starting with limited leverage and bargaining power, these changes may have less of an impact if you are raising your first fund versus your fourth, fifth, or tenth. The biggest hit will likely be to mega funds, many of which have existed on the cusp between true VC funds and private funds for years. Funds like Andreessen, Bessemer, and Sequoia became Registered Investment Advisers over the past few years, largely driven by the desire to invest more into non-VC-qualifying assets like crypto, secondaries, and public companies during the bull market.

Maybe it’s not all bad 

The increased scrutiny isn't necessarily bad for emerging managers. The lack of clear guidance for early-stage VC leaves a lot of ambiguity over questions like how management fees can be charged or what constitutes a reasonable amount. SEC guidelines might prove to be a valuable compass for new entrants looking to better understand how to negotiate with LPs. Such rules could help answer questions and prevent abuses, creating safe harbors for legitimate activities. Good business can thrive in a clearer landscape.

And, in the meantime, if you’re looking for guidance on standard fees, check out our recently published report on Standard Terms for Emerging Managers.

What’s next? 

Now that the rules have been passed, the SEC will move forward to publish the final versions in the Federal Register. The date for this publication is still to be determined. Once the final rules are published, the clock will start on a 12-month period for advisers with >$1.5B AUM or an 18-month period for advisers with <$1.5B AUM, which will dictate the applicable compliance date. RIAs have two months to comply with the "Compliance Rule Amendments," which require a written annual review of their compliance policies. TDLR: VCs and other private advisers will not have to comply with these rules until late 2024 or early 2025. 

Importantly, the SEC is also providing legacy status for existing vehicles, meaning that any governing agreements (such as LPAs or side letters) that are executed prior to the compliance date will not be expected to comply with the Preferential Treatment or Restricted Activities Rules.

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Continued reading:

• From the horse’s mouth: check out the SEC’s own press release about the passage of the new rules. 

• It’s no surprise that the Institutional Limited Partners Association (ILPA) is in favor of the rules. Read their statement and check out the helpful chart on Page 6 of their report.

• What does this mean for emerging VC fund managers? Hear what Nik Talreja, CEO of Sydecar, has to say.

• Emerging Fund Lawyer Chris Harvey breaks down what the rules mean and where the biggest impact will be felt.

• A group of VC, PE, and hedge funds are threatening a lawsuit against the SEC. Among them is VC darling Andreessen Horowitz. Read more about their complaints here, and check out a16z’s specific comments on the SEC’s website.

• The Wall Street Journal calls the proposed rules a complete “overhaul.”