PLANADVISER - November/December 2022 - 38

compliance consult
David Kaleda
The Value of a VCOC
Investing ERISA plan money via a venture capital operating company
ASSET MANAGERS will often pool capital
into private funds not registered with the
Securities and Exchange Commission for
purposes of making equity investments
in companies. A substantial source of the
capital is employee benefit plans subject
to the Employee Retirement Income
Security Act and accounts such as individual
retirement accounts whose assets
are subject to the prohibited transaction
provisions in Internal Revenue Code
Section 4975.
If a manager intends to invest these
... the ability
to receive
performance
fees, enter into
transactions
with affiliates
" plan assets, " it should understand
whether and how ERISA's fiduciary duty
and the prohibited transaction provisions
apply to managing the capital pool. One
way to avoid having to contend with ERISA
and the IRC is to establish a venture capital
operating company. The VCOC construct can work well for
private equity funds, though it may have other applications.
As a threshold matter, the manager should consider ERISA
or pay affiliates
for providing
services can
be very limited.
plan asset issues. When pooling investor assets into a fund
and one or more of the investors is covered by ERISA or is an
IRA, the manager must determine whether the fund assets
will be treated as plan assets for ERISA and IRC purposes. The
assets will be deemed plan assets pursuant to the Department
of Labor's Plan Asset Regulation if benefit plan investors-e.g.,
ERISA-covered plans or IRAs-own 25% or more of
any class of equity in the fund. If the fund's assets are plan
assets, anyone exercising discretion over their management,
including the fund manager, is thereby acting as a fiduciary.
So, the asset manager should consider at the time it
creates the fund whether it intends to, or would like to, leave
open the possibility that benefit plan investors may invest in
excess of this 25% threshold. If so, the manager must then
decide whether it can manage the fund in accordance with
the fiduciary and prohibited-transaction provisions.
This can be challenging but is possible if the manager
carefully operates the fund. For example, the manager
will likely need to rely on the qualified professional asset
manager exemption to avoid transactions with parties in
interest and disqualified persons with respect to all fund
investors that are ERISA plans or IRAs. Additionally, the
ability to receive performance fees, enter into transactions
with affiliates or pay affiliates for providing services can
be very limited. On the other hand, the
manager can still avoid plan asset status,
without placing limits on the amount of
benefit-plan-investor equity investments
by structuring the fund as a VCOC.
A VCOC, says the Plan Asset Regulation,
is an entity in which 50% or more of
the assets-other than short-term investments
pending long-term commitment-
valued at cost, are invested in " venture
capital investments. " The regulation
defines venture capital investment as an
investment in an " operating company, "
other than a VCOC, as to which the investor
has " management rights. " An operating
company is defined as " an entity that is
primarily engaged, directly or through a
majority owned subsidiary or subsidiaries,
in the production or sale of a product or
service other than the investment of capital. "
A key requirement for VCOC status is that the fund
manager must have management rights over the companies
it owns an equity interest in and must periodically exercise
those rights with regard to at least one of those companies.
In other words, the fund may not be a mere passive investor
but engage in the management of the target companies.
Besides management rights, the structuring of the fund is
important because the Plan Asset Regulation limits the use of
intermediary entities. Also, it is not possible to have a fundof-funds
that is a VCOC-of-VCOCs. Yet, the target company
may be a real estate operation company, or REOC (see " Real
Estate Fund Investments, " PLANADVISER May/June 2022).
ERISA-covered plans, IRAs and other benefit plan investors
can be an important source of capital for managers that
make equity investments in companies. But such managers
should be familiar with the Plan Asset Regulation and understand
the implications of plan asset status and possible
alternatives, including establishing a VCOC. In any case, a
manager should consider the implications of the regulation
at the time it forms the fund. It can be difficult to comply
with ERISA or VCOC requirements once the fund begins
accepting capital contributions and making investments.
David Kaleda is a principal in the fiduciary responsibility practice
group at Groom Law Group, Chartered, in Washington, D.C.
38 | planadviser.com November-December 2022
Art by Tim Bower
http://www.planadviser.com
PLANADVISER - November/December 2022

Table of Contents for the Digital Edition of PLANADVISER - November/December 2022
