Better be a VC

In an effort to better regulate hedge fund advisors, The California Department of Corporations is reviewing a 2002 law that exempted certain investment advisors from registering with the department. It has also unveiled language that may affect private equity firms.
According to the proposed amendment, buyout firms will need to register as hedge funds with the CDC unless they prove themselves to be a “venture capital company.”
The proposed amendment would require any other advisor that meets California’s definition of an investment advisor to register with the department, which includes anyone who has a place of business or more than six clients in the state of California and is exempt from registration with the Securities and Exchange Commission by virtue of the “de minimis exemption” contained in Section 203(b)(3) of the Investment Advisors Act of 1940.
The proposal for this revision cites only an SEC hedge fund study from 2003 and language from the SEC’s 2004 failed bid to require hedge fund registration in justifying such an action given hedge fund growth, an upswing in hedge fund related fraud and retail investors’ involvement in the asset class. The 2002 law was worded vaguely enough that many hedge funds could still be exempted from registering. Under the new language, plenty of private equity funds could be forced to register unless they can qualify for the venture capital company exemption.
In order to qualify as a venture capital company, a buyout firm will have to have at least one half its long-term assets invested in “venture capital investments” or “derivative investments.” A venture capital investment is defined as “an acquisition of securities in an operating company as to which the [investor]… has… management rights,” which means that the investor has the right to substantially influence, or provide significant guidance and counsel “concerning
the management, operations or business objectives of the operating company in which the investment is made.” To qualify as such an “operating company” – the entity the GP owns – must be “primarily engaged… in the production or sale… of a product or service other than the management or investment of capital.”
Consortium deals that don’t list the private equity firm as the lead investors or later stage investments without sufficient board seats or other management rights won’t count as venture capital investments for purposes of the exemption. Should the amendment force a wave of hedge funds to register, private equity firms will have more reason to tout their operational focus.