On Wednesday, August 23, 2023, the SEC adopted new rules and amendments under the Investment Advisers Act of 1940 (the “Advisers Act”) that apply to all private fund managers. The rules will have a large effect on investor negotiations and the way in which venture fund managers plan for approaching anchor investors, as well as other new compliance obligations that will impact their future fund operations.
These rules are long and detailed—the adopting release is over 660 pages. A condensed overview of the rules can be found here, and the longer form version can be found here. AngelList legal and compliance teams have analyzed the impact of these rules and we anticipate further guidance on technical compliance requirements from the SEC in the coming months. While the narrative in the industry thus far has been that these rules are not as burdensome as anticipated, it’s worth noting that there are new and significant compliance obligations coming from these rules.
While the application of many of the more burdensome new rules will strictly apply to Registered Investment Advisers (“RIAs”), a number of key changes will apply to all advisers to private funds (including venture capital Exempt Reporting Advisers (“ERAs”)). Fund managers will have some time to adjust their operations and fundraising plans to comply with these obligations as the Restricted Activities Rule and Preferential Treatment Rule that are applicable to ERAs will not go into effect until at least 12 months from the date the rules are first published in the Federal Register.
We wanted to provide an overview of these rules with a clear breakdown on the impact and implications these impose on fund managers throughout the venture ecosystem. We’ve highlighted the key rules alongside some of the most common FAQs we’re receiving on this topic.
Rules Overview
Rules applicable to ALL private fund advisers (including venture capital ERAs)
1. Preferential Treatment Rule. Broadly prohibits all private fund advisers from engaging in certain types of preferential treatment of investors reasonably expected to have a “material negative effect” on other investors, unless certain conditions are met, and requires disclosure of other types of preferential treatment offered to investors. Specifically:
- Material Economic Terms (e.g., fee breaks). To provide preferential economic treatment to an LP, the terms of that preferential economic treatment must be disclosed to all other LPs before they close into the fund. The adviser must send routine updates on the preferential treatment moving forward. This will significantly impact the way in which side letters are used currently to enter into custom agreements with certain investors with respect to customized economic terms.
- Other Preferential Terms. To provide other types of preferential terms, the adviser must provide notice of such terms to current investors, generally within four weeks following the end of the fundraising period. E.g., Side letters and the terms within them will need to be disclosed to all investors if they include preferential treatment. In some cases, preferential treatment terms will be prohibited unless offered to all investors.
- Redemptions. To redeem an interest on terms that have a material negative impact on other investors, such redemptions must be required by law or the adviser must offer such rights to all other existing and future investors.
- Information Rights. To provide superior information about the fund’s holdings or exposures, the information may need to be offered to all investors.
2. Restricted Activities Rule. Restricts all private funds advisers from undertaking certain types of actions (listed below), unless the adviser discloses the activity and/or gets investor consent. Specifically:
- Disclosure. These activities are restricted unless disclosed to investors in connection with the requirements of the rule: 1) Charging the fund fees related to the adviser’s regulatory or compliance posture or examinations related to the adviser’s regulatory or compliance posture (e.g., Form ADV filing fees). 2) Reducing the amount of an adviser’s clawback by the amount of certain taxes. 3) Charging or allocating fees or expenses related to a portfolio investment on a non-pro rata basis when multiple funds have investments, unless such non-pro rata allocation is fair and equitable.
- Consent. These activities are restricted unless investors consent in connection with the requirements of the rule: 1) Charging fees related to regulatory investigations of the adviser to a fund. 2) Borrowing money/assets or receiving a loan or extension of credit from the fund.
Rules applicable only to Registered Investment Advisers
- Private Fund Audit Rule. Requires RIAs to obtain an annual audit by an independent public accountant for each private fund they manage (and cause audited financial statements to be delivered to investors), in compliance with the audit provision in the current custody rule. This effectively eliminates the “surprise examination option” under the custody rule for private fund advisers.
- Quarterly Statement Rule. Requires RIAs to prepare and distribute quarterly statements disclosing a multitude of information on fund performance, fees, expenses, and certain other adviser compensation.
- Adviser-Led Secondaries Rule. Requires RIAs to distribute a fairness opinion or valuation opinion in connection with adviser-led secondary transactions. Adviser-led secondary transactions are any transactions initiated by the adviser that gives investors the choice to sell all or a portion of their interests in the fund.
- Amended Advisers Act Compliance Rule. Requires all RIAs to prepare written documentation of their annual review of compliance policies and procedures under the so-called “Compliance Rule.”
What does this all mean?
These rules will alter the current landscape of how managers fundraise and operate their funds. Venture fund managers are often formed as ERAs and have more limited compliance obligations relative to RIAs. The rules will impact how venture fund managers will need to operate their funds when considering how to apportion certain expenses between related funds.
Most importantly, fundraising may be more complicated and may involve strategic decisions on when to engage and close certain anchor investors given the requirement of disclosing material economic terms to all investors prior to closing. Later investors will likely condition their investment on obtaining the same such terms, and this, overall, may result in less incentives to offer to anchor investors in order to ensure a fund manager’s economic ability to operate the fund. This is most likely to impact more seasoned managers with institutional investors who are well-represented by counsel, than emerging managers focused on their first or second fund.
Given that these new rules were just approved by the SEC, it’s likely that additional guidance by the SEC and its staff will be provided in the future. As AngelList continues to analyze the rules, and as more guidance is provided by the SEC, we will aim to provide more comprehensive updates in the future.
Have additional questions? We've included a list of FAQs below.
Frequently Asked Questions
Q: Am I an ERA or RIA?
A: While AngelList cannot advise you on the proper registration filing for your advisory status under the Advisers Act, an overwhelming majority of fund managers in the venture and private fund space are ERAs. If you have any questions about your registration status under the Advisers Act, we would recommend that you seek outside counsel.
Q: I only syndicate deals through stand-alone SPVs on the AngelList platform; I do not run a traditional VC fund. Do these changes apply to me?
A: Yes! These rules apply broadly to investment advisers to private funds under the Advisers Act. Please consult with your counsel if you have any questions.
Q: I see that “fee breaks” are meant to be disclosed to an investor before closing into the Fund/SPV. What does this disclosure look like? Do I have to disclose the particular names of the investors receiving fee breaks?
A: All Investment Advisers to private funds must provide advance, written notice that the Adviser is providing preferential “material economic terms” to certain investors, which includes such terms as fee breaks, liquidity rights, and co-investment rights. In terms of the form of the disclosure, the SEC noted that the Adviser could provide “a written summary of the preferential terms … provided the summary specifically describes the preferential treatment.” In the context of material economic terms (like fee breaks), this would mean disclosing the lower fee terms, including the applicable rate. The SEC did note that an Adviser is not required to disclose the identity of the specific investor that is receiving preferential treatment.
Q: What about preferential treatment that does not pertain to “material economic terms”?
A: All other preferential treatment needs to be disclosed, in writing, to current investors as soon as reasonably practicable following the end of the fund’s fundraising period. An example of a right that is not a “material economic term,” and therefore only needs to be disclosed post–fundraising period would be an “excuse right” (i.e., granting an investor the right to refrain from participating in a particular investment of the fund).
Q: For the Preferential Treatment Rule, is there an annual compliance requirement?
A: Yes! Annual, written notice must be provided to the current investors in a private fund, and such notice must include specific information about any preferential treatment being provided to other investors in such fund since the last written notice.
Q: What does this mean for side letters? Do I have to disclose all my side letters?
A: The SEC specifically noted that compliance with the disclosure requirements can be satisfied by providing copies of side letters (with identifying investor information redacted). As noted above, an Adviser could alternatively provide a summary of the preferential terms, provided it describes the preferential treatment specifically. Thus, while actual disclosure of each side letter is not an explicit requirement, it may prove to be the simplest way to comply with the disclosure requirements.
Q: What about side letters that were executed last month or last year? Do I need to disclose preferential treatment that was agreed to with an investor prior to the adoption of the new rules?
A: Yes, while the SEC has provided “Legacy” status to certain elements of the new rules, the disclosure provisions of the Preferential Treatment Rule will be applicable for any preferential treatment that existed before the compliance date (see below), and such treatment will need to be disclosed to investors that participate in the fund post-compliance date.
Q: When do these rules become effective?
A: For the Restricted Activities Rule and Preferential Treatment Rule, the SEC adopted staggered compliance dates for advisers based on the amount of assets under management (“AUM”). For advisers with $1.5 billion or more in AUM, there is a 12-month transition period. For advisers with less than $1.5 billion in AUM, there is an 18-month transition period.
Q: Will AngelList assist funds or SPVs launched on the AngelList platform to ensure they are in compliance with these new rules?
A: AngelList will continue to analyze the rules and seek to improve our platform overall in light of these new rules and regulations. As more information and SEC guidance becomes available, and we continue to build out and upgrade the functionality of our platform, we will update our customers with any relevant improvements.