Why VC Firms Are Registering as Investment Advisers
What do venture capital firms Andreessen Horowitz, General Catalyst, Foundry Group, and our company Touchdown Ventures all have in common? All of these venture capital organizations have become Registered Investment Advisers (“RIAs”). Touchdown has been registered as an RIA since the inception of our firm, in 2014.
To explore this growing trend of venture capital firms registering as investment advisers, I sat down with Saleemah Ahamed of Adherence, a company that provides compliance services to investment firms.
Founded in 2011 by Saleemah and Jane Shahmanesh, Adherence provides regulatory compliance management services for asset managers and broker-dealers. Saleemah and Jane are each lawyers who have worked in the financial industry for a long time and wanted to create an efficient, affordable, and effective way to manage compliance for firms with complex or innovative investment strategies. Saleemah is also Touchdown’s Chief Compliance Officer.
David: What is an RIA or investment adviser?
Saleemah: A registered investment adviser is an investment adviser that has registered with the Securities and Exchange Commission (“SEC”) or a state securities regulator. Generally, an RIA is a firm that advises its clients on investments and manages their portfolios. RIAs have a fiduciary duty to their clients, which means they have a fundamental obligation to provide investment advice that always acts in their clients’ best interests and to put their client’s interest above their own.
David: Why are some venture firms registered and others are exempt?
Saleemah: Venture capital firms are investment advisers in that they advise the funds they manage on investments and then manage the portfolios. However, venture firms can be exempt from registering with the SEC as an RIA if they meet certain requirements. They must manage the investments by pursuing a venture capital strategy within a private fund structure only. At least 80% of the fund’s assets must be invested in the equity of a private portfolio company and that portfolio company may not borrow or issue debt in connection with the private fund’s investment (i.e. no leveraged buyouts). Firms that want to invest in secondary offerings, other venture funds or the pubic equity of companies they took public, are limited to do so with only 20% of the total assets of their fund.
While many venture firms are comfortable managing their fund’s assets within the parameters of the exemption, a growing number of firms like Touchdown, the Foundry Group, and Andreessen Horowitz realize that the venture capital business models of the past need to change to meet the current reality of a crowded venture capital landscape. For example, Touchdown partners with the venture capital groups housed within large companies to help them find and invest in up-and-coming companies and entrepreneurs that can help the large companies innovate within their own competitive landscapes.
David: What are the differences between an RIA and a broker dealer?
Saleemah: The main difference between an RIA and a broker dealer is the legal obligation each owes to its clients and how they are compensated. An RIA has a fiduciary duty to its clients while a broker dealer is held to a suitability standard, meaning that the broker dealer’s advice to its clients must be suitable for the client’s need at that particular time and not necessarily what is best for the client. The fiduciary duty which RIAs owe to their clients is a much higher standard than the suitability standard.
In terms of compensation, broker-dealers are typically compensated through commissions based on the investment products they recommend and sell. An RIA is compensated by charging its clients (or fund) a fee based on a percentage of assets under management, or a fixed or hourly fee, or an incentive fee if those assets rise in value.
Finally, RIAs are registered with the SEC or a state securities regulator, and broker dealers are members of the Financial and Regulatory Authority (“FINRA”), which is regulated by the SEC.
David: What are some RIA compliance obligations that exempt firms don’t have?
Saleemah: Upon registration with the SEC as an RIA, the firm must adopt a host of policies and procedures governing practically every aspect of the firm’s business and must review them periodically to make sure they are adequate. These obligations stem from rules and regulations the SEC has created under the Investment Advisers Act of 1940. Investment advisers who are exempt from registration do not have these obligations. A non-exhaustive list of that policy and procedure matters an RIA should address includes:
- portfolio management processes, including allocation of investment opportunities — especially if they are limited as venture capital investments tend to be
- insider trading
- safeguarding of client assets
- marketing activities
- valuation of investments
- client privacy
- business continuity plans
- disclosure to clients and regulators
- surfacing and managing conflicts of interests
In addition, the employees and certain consultants of the RIA must adhere to a code of ethics which govern certain behaviors outside of work such as personal trading, other business activities, gifts and entertainment, and conflicts of interest.
Finally, an RIA must have a dedicated Chief Compliance Officer who is responsible for administering the policies and procedures.
David: Tell us more about Adherence and how you work with investment firms like Touchdown.
Saleemah: The firms with whom we partner take compliance very seriously but have limited compliance expertise and time — therefore they cannot be burdened with superfluous tasks and procedures in running their compliance programs. They prefer to bring in highly experienced compliance professionals, who understand their business models and can practically manage their compliance programs.
As an example, Touchdown engaged Adherence a few years ago as you were growing and wanted to make sure that your unique business model and compliance program were meeting the requirements of the applicable regulatory rules. I took on the role of Touchdown’s outsourced Chief Compliance Officer and together we worked on making sure that Touchdown’s compliance program meets the high standards your management team and Adherence require. This meant reviewing every aspect of Touchdown’s business to ensure that its compliance policies and procedures meet or exceed regulatory requirements. At the same time, we did not want to overburden Touchdown with inefficient tasks and procedures. This is where Adherence’s experience in working with small and mid-sized firms really helped.
David: We know that there are companies providing investment advice for a fee that are not registered. Are there potential penalties?
Saleemah: The consequences of providing investment advice for a fee and failing to register as an RIA include ceasing operations, disgorgement of all fees the firm earned plus interest, and paying a penalty which can be 50% of fees earned. The SEC will typically bring an administrative action against an unregistered firm that it believes is engaging in activities requiring registration. The SEC findings of administrative actions are published on the SEC’s website and routinely picked up by major news media and other blogs. Therefore, the action can be widely publicized resulting in great reputational harm to the unregistered firm and its principals.
David: Any predictions on whether more venture capital firms will register?
Saleemah: I believe that we will continue to see more and more traditional venture capital firms decide to register because their business models will need to evolve as the overall venture capital industry continues to change and competition increases. As venture capital business models change, they will likely lose the benefit of the current exemption from registration unless Congress decides to expand the exemption, which I think is unlikely.
David: Thank you, Saleemah. I do agree we will likely see more firms become RIAs in the years to come.
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