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A longstanding characteristic of private venture fund regulations is their swing set-like nature. Each time new regulations or laws are enacted, the pendulum swings in the direction of either less regulation in favor of the general partners or increased regulation in favor of the investors. With the newly enacted regulations in favor of the limited partners, the swinging pendulum is certainly moving in their favor.

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After a decade-plus of zero interest rate policy and corresponding elevated performance by private funds, the pendulum had swung too far with reduced regulation and general partners stretching just how much they could push their investors, and the Securities and Exchange Commission (SEC) has had enough. The SEC passed new private fund regulations on August 23, 2023 that went into effect on November 13, 2023. Given the sweeping nature of the rules, the SEC has granted venture funds an 18-month window to get their reporting and operational practices refined to increase the likelihood of proper compliance.

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While these regulations do not eliminate venture funds in any capacity, they do change how venture capital funds must operate and dramatically increase the level of reporting and decrease the number of side deals that could previously be cut with investors, which may, in turn, prevent or limit new entrants from getting a seat at the proverbial table. Because the compliance and reporting requirements materially alter what funds must do to be compliant with the new rules, funds’ costs for compliance professionals and legal counsel will naturally increase, as will the time spent on these matters (as opposed to time spent managing funds’ portfolios). And for new venture funds who often do not have the resources to pay for additional outside assistance or the internal team bandwidth to cover some of the requirements set out in the new rules, the new regulations may end up having a chilling effect on the formation of new venture funds led by emerging managers.

Two of the most significant (and costly) rules among those made effective this November applicable to venture capital funds include (i) regulations surrounding fees and borrowings and (ii) the required disclosure of preferential treatment of different investors.

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Previously, general partners (GPs) of funds could charge the funds for SEC investigations of the funds or the GPs themselves. However, with the new regulations, GPs are prohibited from charging for any investigation that results in regulators imposing sanctions. If an investigation does not result in sanctions, the GP must now acquire consent from a majority in interest of their limited partners (LPs) to charge for the fees, and the LPs could agree contractually in their limited partnership agreements to increase those approval thresholds. Additionally, where the GPs could previously charge for fees and expenses associated with regulatory or compliance matters (for the GP or related persons) or SEC examinations without disclosing such fees to LPs, the SEC now mandates that those fees and expenses be disclosed to the LPs within 45 days.

Prior to the new regulations, GPs could borrow from private fund clients without disclosing such arrangements to other LPs, which often created warped incentives for the GPs and the lending LP to ensure that the line of credit or other form of borrowing was placed ahead of the duties to the funds’ LPs. However, the pendulum has again swung in favor of the LPs, with the new regulations now preventing GPs from borrowing money or other assets or receiving a loan or line of credit from private fund clients unless the GP discloses the related material terms to its LPs and receives majority-in-interest consent (or greater if so required by the fund’s respective governing agreements).

While the rules mentioned above add some complexity to fee structures as well as expenses to the GP and fund management teams, the new rules also add another layer to the disclosure process. Gone, at least in this swing of the pendulum, are the days in which the GPs could do what they like without disclosing any related party arrangements or charging funds for fees and expenses of regulatory examinations.

Prior to the new regulations taking place, side letters were issued seemingly left and right to investors, with carve-outs in every possible direction to limit disclosure of the contents of such letters to LPs and prospective investors. Often, lead or large investors were receiving discounted fees, preferential reporting treatment, or special access to co-investment opportunities over other LPs, but not anymore. Under the new regulations, funds must disclose any material economic terms of a current side letter to&nbsp;prospective&nbsp;LPs as well as any side letter with preferential treatment to all&nbsp;current&nbsp;LPs on an annual basis.

The impacts of these regulations remain to be seen, but the frequency with which emerging managers are forced to grant special unit economics to investors to secure their investment occurs far more frequently than seen in larger, more established funds. This may have a chilling effect on the ability of new fund managers to secure larger investors for their earliest funds, or may result in all those managers providing all investors with those preferred economic terms, which will only serve to exacerbate the potential issues smaller funds have in maintaining sufficient resources to manage their portfolios.

What’s arguably more significant is that the SEC estimated the average compliance costs under the new rules will be as follows:

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Note that the above costs do not factor in the potential fees related to an investigation that the GP cannot charge without the LPs’ consent.

While these costs may seem low to venture capital funds that already have a seat on the private fund swing set, the burdens may weigh more heavily on emerging or smaller funds. One must wonder then, if these regulations and added costs, which are meant to protect investors, all of whom are accredited or qualified purchasers with ample knowledge of how to protect their interests, will reduce the number of new funds and further push the venture capital market toward larger, more established funds in the name of investor protection.

The pendulum has certainly swung, but has it already swung too far?

https://admin.thompsonhine.com/wp-content/uploads/2023/12/Thompson-Hine-Newsletter-Business-Law-Update-December-2023.pdf

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This newsletter may be reproduced, in whole or in part, with the prior permission of Thompson Hine LLP and acknowledgement of its source and copyright. This publication is intended to inform clients about legal matters of current interest. It is not intended as legal advice. Readers should not act upon the information contained in it without professional counsel. This document may be considered attorney advertising in some jurisdictions.

The Pendulum Rockets Back in Favor of Investors with New SEC Fund Regulations