Venture fund as a form of attracting investments in Ukraine and the EU, by Yosyf Ivanyuk, Managing Partner

The main idea of this report is to convey the opinion that it is necessary to borrow and implement into Ukrainian legislation the rules of EU directives on simplified legal regulation of joint venture investments in small and medium-sized enterprises, as opposed to the ordinary legal regulation of venture investing in big business.

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To begin with, it is necessary to briefly summarise the legal framework and clarify the main terms that will be used in this report. Therefore, we should start with the special normative legal act regulating the activities of VFs, which is the Law of Ukraine “On Joint Investment Institutions” dated July 5, 2012 No. 5080-VI (hereinafter referred to as the “Law”).

Thus, pursuant to Part 10 of Article 7 of the Law, a venture fund is a non-diversified closed-end joint investment institution that carries out exclusively private placement of joint investment institution securities among legal entities and natural persons.

In Ukraine, a VF may be established as a corporate fund (hereinafter referred to as the “CF”) or a unit fund (hereinafter referred to as the “UF”). The key difference is that a CF is a legal entity established in the form of a joint-stock company and carries out exclusively joint investment activity (Part 1 of Article 8 of the Law), while a UF is a set of assets belonging to the participants of such a fund on the basis of common partial ownership, managed by an asset management company (hereinafter referred to as the “AMC”) and accounted for by it separately from the results of its economic activity (Part 1 of Article 41 of the Law). Thus, a CF is a full-fledged legal entity, whereas a UF is merely a set of assets managed by the AMC.

With regard to the European Union (hereinafter referred to as the “EU”), the following legal framework should be taken into account. The main legislative act of the EU regulating collective investment is Directive of the European Parliament and of the Council of the European Union No. 2009/65/EC of 13 July 2009 (hereinafter referred to as the “Directive”). Pursuant to Article 1 of this Directive, it regulates the activity of collective investment in transferable securities established in Member States (“UCITS”). Based on Part 2 of Article 1 of the Directive, such investment activity consists of:

- transferable securities or other liquid financial assets, capital raised from the public, operating on the principle of risk spreading; and

- units which, at the request of the holders, are repurchased or redeemed, directly or indirectly, out of the assets of the collective investments.

The above investment activity, pursuant to Part 3 of Article 1 of the Directive, may be carried out in the form of a common fund (as a fund managed by management companies), an investment trust fund (in accordance with trust law) or as an investment company (in accordance with its statute(s)).

Transferable securities, within the meaning of point (n) of Article 2 of the Directive, are: (i) shares in companies and other securities equivalent to shares in companies; (ii) bonds and other forms of securitised debt; (iii) any other transferable securities that can be obtained by purchase or exchange. Thus, the Directive does not provide a definition of the concept of VF as an independent subject of investment activity, nor of its types, but clearly defines what UCITS investment activity is and lists the legal forms in which it may be carried out.

By analogy, it can be said that the counterpart of UCITS in Ukraine is open-end JIIs. This conclusion follows from the provisions of the Directive that exclude its application to closed-end JIIs.

Simplified regulation of VF activities in the EU is provided by Directive No. 345/2013 on European Venture Capital Funds (hereinafter referred to as the “EuVECA Directive” or “EuVECA”), adopted on 17 April 2013.

Based on the content of the provisions of the EuVECA Directive, the primary reason for its adoption was the need to protect venture capital from certain rules of the AIFMD (hereinafter referred to as the “AIFMD Directive”) that are unsuitable for the sector of investments through VFs, such as excessively high capital requirements and the obligation to appoint a depositary. To solve this problem, European legislators adopted a Directive that allows venture capitalists to place their funds (invest) throughout the EU without having to comply with all the requirements of the AIFM Directive. Simply put, investments through VFs concern investing funds in small and medium-sized businesses (hereinafter referred to as “SMEs”). Therefore, this form of investing should be simplified, which is why the EuVECA Directive was adopted. At the same time, the activities of investment funds in the EU are also regulated by the AIFMD Directive. Thus, the AIFMD Directive establishes rules for the authorisation, ongoing operation and transparency of managers of alternative investment funds (AIFMs) that manage and/or market alternative investment funds (AIFs) in the EU. In turn, as stated in point (a) of Part 1 of Article 4 of the AIFMD Directive, alternative investment funds mean collective investment undertakings, including sub-funds of alternative investment funds (hereinafter referred to as “AIF”), which raise capital from a number of investors with a view to investing it in accordance with a defined investment policy for the benefit of those investors.

At the same time, based on recital 6 and Part 2 of Article 2 of the AIFMD Directive, it applies to the activities of:

- alternative investment funds of both open-end and closed-end type, which in particular include VFs in the EU pursuant to the provisions of the AIFMD and EuVECA Directives;

- common funds (contractual law), investment trust funds (trust law), investment companies (statutes) or funds established in any other forms.

Thus, point (b) of Part 1 of Article 4 of the AIFMD Directive provides that AIF managers are legal entities that carry out economic activity in the management of alternative investment funds.

Therefore, a parallel can be drawn between asset management companies that manage venture funds and AIF managers in the EU. The common feature is that the asset management company is the analogue of the AIF manager in the EU; however, the exact definition of the legal form of the AIF manager is determined by the specific substantive law of the EU Member State where such manager carries out its economic activity (or on the territory of which, within the EU, a non-resident manager carries out its activity through a branch / subsidiary or fund).

The AIFMD Directive also defines that each alternative investment fund (the manager – the legal entity of such fund) must be authorised in accordance with the provisions of this AIFMD Directive and the national legislation of the state where it is established or carries out its investment economic activity.

Article 9 of the AIFMD Directive contains obligations of EU Member States regarding the capital of AIF managers. Thus, the standard requirement for the size of initial capital of internal AIFs is EUR 300,000, but Part 2 of this article provides an exception that the initial capital may be EUR 125,000 where the AIF manager is an external manager (i.e., an organisation that manages investments on a principle similar to that described in the Law regarding asset management companies). If the manager manages funds whose investment portfolio exceeds EUR 250 million, the manager must provide an additional amount of own capital equal to 0.02% of the excess amount, but not more than EUR 10 million.

Finally, the EuVECA Directive should be characterised, since it is specific to qualified venture funds in the EU and entered into force on 1 May 2018. Pursuant to Article 1 of the EuVECA Directive, it applies to managers of collective investments in relation to the marketing of venture capital in the EU, thereby contributing to the functioning of the internal market. At the same time, managers of collective investments under the EuVECA Directive must meet the following criteria:

- assets under management: (i) must not exceed EUR 100 million, or (ii) must not exceed EUR 500 million provided that within 5 years from the date of the first investment (first investments) there is no repayment thereof;

- they must be established and carry out activities within the EU;

- they must undergo authorisation (a form of licensing in the EU country of their registration);

- they must manage portfolios of qualified venture funds.

Within the meaning of the EuVECA Directive (Part 2 of Article 2), a qualified venture fund is a collective investment:

- of at least 70% of the aggregate capital contributions and non-targeted capital in assets that are qualified investments, calculated on the basis of amounts invested after deduction of all relevant expenses and monetary reserves and equivalents, which is intended to be carried out within the established terms in accordance with the rules or founding documents;

- which does not use more than 30% of its aggregate capital contributions and non-targeted invested capital for the acquisition of assets other than qualified investments, calculated on the basis of amounts that may be invested after deduction of all relevant expenses and monetary reserves and their equivalents;

- which is carried out on the territory of an EU Member State.

Where the above main criteria and restrictions are met, an AIF manager registered in one EU Member State may market qualified venture funds in all other EU Member States: (i) to professional clients (customers); (ii) to other investors who invest at least EUR 100,000 and who have confirmed that they are aware of the risks of such investment(s); (iii) to managers, directors and employees involved in the management of investment funds.

Thus, it can be concluded that an alternative investment fund in the EU may be a JII of both closed-end and open-end type if it meets the features and criteria for AIFs defined by the AIFMD Directive, and a qualified venture fund under EU law is a type of alternative investment fund managed by an authorised manager to which the provisions of the EuVECA Directive may apply.

The EuVECA Directive imposes additional restrictions and criteria on venture capitalists in order to simplify the conduct of activities and promote venture investments in EU Member States. Where a venture fund in the EU does not meet the requirements of the EuVECA Directive for the purposes of conducting investment activity in simplified form, it will be considered a full-fledged AIF and the provisions of the AIFMD Directive will apply to it.

At the same time, the AIFMD Directive does not apply to VFs that operate in accordance with the EuVECA Directive (except where this is expressly provided for in the EuVECA Directive). A similar rule applies to alternative investment funds that operate in accordance with the AIFMD Directive (except where this is expressly provided for in the Directive).

Summarising the above, the following differences regarding the regulation of VF activities in Ukraine and the EU are significant:

- in Ukraine there are no simplified conditions for the activities of venture funds in terms of investing in small and medium-sized businesses, whereas in the EU, for such purposes, the EuVECA Directive entered into force on 1 May 2018;

- in Ukraine the issue of marketing investment proposals is not regulated, while in the EU it is clearly regulated at the level of obligations of EU Member States that are assumed by them after the directives enter into force;

- the EuVECA Directive imposes special requirements on the structure of assets of a qualified venture fund; however, if a venture fund in the EU does not conduct activity in accordance with the EuVECA Directive, only the general rules of the AIFMD Directive and the national laws of the EU Member State where such VF is established will apply to it.

From the point of view of improving Ukraine’s investment climate, it would be advisable to borrow from the EU the conditions for simplifying the conduct of investment activity for venture funds in Ukraine.

For example, the implementation of the concept of the requirements of the EuVECA Directive would significantly simplify collective investments in so-called startups that belong to the SME sector and require investment inflows quickly and without excessive bureaucracy.

The implementation of the concept of simplified venture fund activity in Ukraine can be achieved by supplementing the Law with a new Section 4 “Specific Features of the Activity of Investment Funds”, in which norms should be provided regarding the activity of VFs under the concept of the EuVECA Directive.

Thus, the new section should specify the criteria under which a VF is entitled to conduct simplified activity; in this context, it is advisable to borrow the provisions of Article 1 of the EuVECA Directive referred to above.

A separate article should regulate the activities of the AMC of such “simplified” VFs. The general requirements imposed by the EuVECA Directive on such AMCs are set out in its Chapter II, including, inter alia, that no more than 30% of the aggregate contributions to the fund and uncalled capital may be used for asset acquisition, the fund’s exposure may not exceed the level of its committed capital, and debt obligations issued by the VF must be covered by uncalled commitments (Article 5 of the EuVECA Directive); investment in such a “simplified” VF is permitted in an amount of no less than EUR 100,000 (Article 6 of the EuVECA Directive).

At the same time, it should be borne in mind that the EuVECA Directive applies exclusively as a mechanism for imposing requirements on EU Member States; therefore, each state is entitled to supplement its national legislation in the field of collective investment. As a result, it would be advisable to supplement the new Section 4 of the Law with norms restricting the economic sectors in which a “simplified” VF may invest and to refer to a separate regulation of the National Securities and Stock Market Commission on the structure of assets of such a VF. Thus, it should be stated that this section of the Law applies exclusively to investments in SMEs in the information technology and construction sectors.

In addition to the above, the new Section 4 of the Law must clearly outline the rules on advertising investment objects and their marketing in the Ukrainian market. In particular, the Law should prohibit speculative marketing of investment objects and must impose requirements to provide information on investment objects in the volume provided for by the Law of Ukraine “On Protection of Consumer Rights”, since such investments will primarily be marketed to the public.

Finally, VFs that will carry out their investment activity in accordance with this section of the Law must be open-end funds, i.e., the issue prospectus must be public, the ownership structure and information on ultimate beneficial owners must be published, and consolidated financial statements must be published on the website of the group of this VF.

To prevent fraudulent transactions in the securities market, the subject composition of buyers of securities of such a “simplified” VF and the volume of securities that may be acquired should be restricted. Such a rule should be reflected in a separate article of the new Section 4 of the Law in order to prevent monopolistic acquisition of investment objects by giant companies in the relevant economic sectors.

It would be advisable to state in the norm that large enterprises may not own more than 30% of the securities of the VF (calculated from the assets of the VF), but no restrictions should be imposed on SME contributors, since they lack the resources to create a monopoly. Finally, the proportion of ownership of securities of such a VF by large enterprises should decrease in accordance with the number of large-enterprise contributors. As a result, it would be advisable to establish in the Law a restriction that where securities of the VF are owned by two or more large enterprises, their aggregate share may not exceed 40%, since the “simplified” VF is created and operates to promote investments in SMEs and, therefore, decisive influence on transactions concluded by this VF through the AMC must be prevented.

With regard to AMCs that manage “simplified” VFs, Section 6 of the Law should include an article establishing a prohibition on the presence of large enterprises in the ownership structure of the AMC; however, the most appropriate solution would be to introduce a norm requiring the registration of a new AMC together with the “simplified” VF, taking into account the said restriction. Such a concept would prevent influence on the VF’s activity through an AMC that may be owned by large companies or persons related to them.

At the same time, for giant companies that, for example, carry out construction activities through a VF, the ordinary requirements for VF activities (on the model of the AIFMD Directive and other norms of the Law rather than the new Section 4) may be applied as to enterprises in the big-business segment.

Finally, such differentiation will improve the existing legal regulation of venture investment activity, since it will establish clear criteria for investments in SMEs and investments in big business. In particular, this will significantly reduce various models of tax fraud currently used by construction companies that do not possess sufficient assets and funds to guarantee investment contributions by natural persons.

Originally published in 2020 in Ukrainian as follows:

Ivanyuk, Y. I. (November 4, 2020). Venture fund as a form of attracting investments in Ukraine and the EU [in Ukrainian]. Scientific seminar "Venture fund as a form of investment attraction in Ukraine and the EU."

Link to seminar's announcement: https://law.lnu.edu.ua/news/anons-04-11-2020-naukovyy-seminar-venchurnyy-fond-iak-forma-zaluchennia-investytsiy-v-ukraini-ta-yes

Link to article itself: https://law.lnu.edu.ua/wp-content/uploads/2020/11/Dopovid-_Ivaniuk.pdf