The typical venture capital fund invests in small companies, with little or no profits, with a vision of selling the company for large multiples once it becomes profitable and/or its business scales up to size. As with all private funds, the venture cap fund is limited to raising money from accredited investors and qualified purchasers. Some may say that such investments are best suited to such investors but the retail market place is diverse and there is no doubt that a meaningful allocation of retail money is out there.
So, if retail money is available how does a manger access it? If a path to retail investors exists why wouldn’t a manager want to access it? Well, as with any great opportunity there are meaningful obstacles and risks. The price of accepting retail money in this case is complying with the rules and regulations surrounding business development companies or “BDCs”. BDCs have been around for over 30 years but haven’t been widely utilized to date. There were just four of them a decade ago. Now, there are nearly 30, with a total market capitalization of over $26 billion. The 3 largest BDCs account for over $12 billion market cap.
A BDC is a form of investment company that is subject to many but not all of the typical ’40 Act rules that affect mutual funds. The shares of a BDC are registered under the ’33 Act and are typically, but not necessarily, traded on an exchange and subject to ’34 Act regulation. And finally, a BDC will elect to be taxed as a regulated investment company or “RIC” for federal income tax purposes, the same as a mutual fund. A BDC is limited to investing in private or small (i.e., sub $250mm market cap) public companies – but this is the primary domain of venture cap funds anyway. Additionally, a BDC is subject to certain asset diversification and leverage limitations which is the key differentiator for managers electing an entity form.
A BDC must maintain an asset coverage ratio of 200% which limits the fund’s leverage ratio. Nevertheless, there are methods to increase gross leverage beyond this limit and there is no limit on the ability of portfolio companies to leverage themselves. For many venture capital funds that intend to run a diversified portfolio on a limited leveraged basis, a BDC form may be viable.
Running a venture cap fund in BDC format has considerable benefits. The key, obviously, is the ability to take retail money. However, the benefits continue. BDCs that trade on exchange maintain permanent capital akin to closed-end funds. Moreover, BDCs are able to charge private fund type fees including incentive compensation. BDCs are also able to publicly advertise themselves and their performance, a feature that is highly restricted (although evolving) among private funds. Moreover, many large BDCs have an affiliated company licensed as a small business investment company or SBIC which allows for a lower cost of capital.
Private venture capital funds and BDCs are not mutual exclusive creatures. A private venture cap fund could be a seed investor in a BDC. Alternatively, a BDC could be an investor in the private fund. Given the substantial benefits of raising permanent capital from retail investors any manager intent on raising a venture capital fund should consider whether the intended strategy could fit within, or alongside, a BDC.
If you have any questions regarding venture capital funds, BDCs, or SBICs please contact your regular WithumSmith+Brown partner.