- Despite size, PE firms that use line of equity claim VC registration exemption
- Investment style is similar to VC investing
- Exempt advisers are still subject to SEC exams
I spent a few hours recently trying to track down information about EnCap Investments through its SEC filings. After coming up empty-handed, I came to learn that EnCap is an “exempt adviser,” meaning it doesn’t have to fill out Form ADV Part 2A, the detailed brochure that most registered advisers file with the SEC.
How is it possible that a private equity firm the size of EnCap, which has raised around $33 billion since inception, could be exempt? Let me explain.
It’s all about investment strategy: EnCap partners with executives and backs them with equity commitments to build their businesses. Earlier this month, for example, the firm said it would provide a $500 million equity commitment to Silverback Exploration II to develop oil and gas properties across the United States. EnCap won’t provide the full equity commitment up front to Silverback’s management team. Instead, it will release the equity incrementally each time the business achieves certain milestones.
The strategy is not too different from the way venture capital firms invest in startups, though it is on a much larger scale. Because the majority of EnCap’s investments follow this strategy, the firm is able to register with the SEC as an exempt adviser, claiming the VC exemption.
This means the firm does not have to file the detailed brochure that I enjoy reading, nor does it have to file a Form PF to report regulatory assets under management. It is still subject to SEC audits, although one attorney who works with private equity firms on compliance issues said exempt advisers are less likely to face SEC exams.
The VC exemption was one of two carved out of the rules in the Dodd-Frank Financial Reform Act. The other exemption is for firms with less than $150 million of assets under management to relieve them from the burden of complying with the rules.
Judith Burns, a spokeswoman for the SEC, declined to comment.
“Formally registering as investment advisers under the Advisers Act carries significant additional burdens, without providing additional relevant information about our industry,” Trevor Loy, managing partner of Flywheel Ventures, said in testimony before Congress in 2009.
“From preparing for SEC examinations, to establishing complex compliance programs overseen by a compliance officer, SEC registration will demand significant resources that promise to be costly from both a financial and a human resources perspective,” said Loy, who at the time was a board member for the National Venture Capital Association.
Another PE firm that claims the venture capital exemption is Pine Brook, which also uses a line-of-equity strategy. Pine Brook, formed in 2006, closed its second fund on $2.43 billion in 2014. It raised $1.4 billion for its debut fund.
Given their size, EnCap and Pine Brook hardly seem like the kind of shops the law was meant to relieve from the burdens of compliance costs. However, the law is meant to reflect concerns about leverage and systemic risk. The venture strategy laid out in the exemption excludes firms that mostly invest equity and don’t use leverage strategies, the PE attorney said.
A few specific factors allow these two firms to claim the exemption. For one, the fund can’t borrow or incur leverage of more than 15 percent of the fund’s aggregate capital contributions and uncalled commitments, and then only on a short-term basis, according to SEC guidance published in 2013. The fund is also restricted from holding more than 20 percent of aggregate capital in “non-qualifying” investments. This means 80 percent of the time, firms like EnCap and Pine Brook have to fund new businesses using equity strategies.
Rob Jackowitz, managing director and chief compliance officer at Pine Brook, said: “The reason the venture capital exemption works for us is that we do a lot of startup investments. Management teams come to us, looking for financial backing. We’ll help them start their companies and we’ll infuse various tranches of equity capital over time in the hope the management team hits their business plan. If they do, we give them more equity to invest.”
The crux of the exemption is that the equity remains in the portfolio company, Jackowitz said. Unlike a buyout, where equity trades from one party to another, these need to be primary investments of equity into the company, he said.
And while being exempt from registration sounds like a big relief, the reality is that exemption is more like “registration-light,” Jackowitz said. Exemption “doesn’t alleviate us from all the compliance functions a regular adviser would adhere to,” Jackowitz said.
Action Item: Read more about exempt advisers here: http://bit.ly/2vo4CVH
The U.S. Securities and Exchange Commission logo adorns an office door at headquarters in Washington on June 24, 2011. Photo courtesy Reuters/Jonathan Ernst