The Value of a VCOC

Art by Tim Bower

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 “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 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.

… the ability to receive performance fees, enter into transactions with affiliates or pay affiliates for providing services can be very limited.  

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 fund-of-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.