The White House released its draft paper on proposed changes to U.S. financial regulation yesterday. Included on this list were many hopes and dreams -- it is the most wide-ranging proposed update to U.S. financial rule-making since the Depression -- but among among them was a change that could be unhappy for the beleaguered venture capital industry.
Here is the relevant section:
All advisers to hedge funds (and other private pools of capital, including private equity funds and venture capital funds) whose assets under management exceed some modest threshold should be required to register with the SEC under the Investment Advisers Act. The advisers should be required to report information on the funds they manage that is sufficient to assess whether any fund poses a threat to financial stability. [Emphasis added]
This is potentially worrisome. Depending on what is meant by "modest threshold" in the preceding, many or even most venture capital partnerships could be forced to register under the Investment Advisers Act. After all, average assets under management is not dissimilar to average assets at a typical private equity firm, so a new threshold that captured most private equity firms would, by definition, capture most venture firms as well.
The cost of complying with the Investment Advisers Act is usually advertised as trivial. Recent experience in the hedge fund industry has demonstrated that is not the case, however, with firms sometimes hiring full-time compliance officers and incurring other costs taking the total to $200,000 a year, and more. Even if costs are more typically half of that for venture firms, it is material.
This would be ill-timed and inappropriate. First, the industry seems wrongly targeted. It is not a source of systemic risk in the sense that other large financial firms can be, with no use of leverage, no off-balance sheet exposure, and a relatively small amount of assets under management. Granted, fund strategies can drift, and I would not want venture capital status to be an easy out for funds wishing to escape regulatory oversight, but the systemic risk from venture capital pales in comparison to that of other financial entities.
Second, the industry is currently, as I have argued elsewhere, in the process of shrinking to a size where it can once again deliver the kinds of returns it did a decade ago, and earlier. The future of the venture industry is likely one with many $70m to $120m funds, but very few mega-funds with hundreds of millions of dollars. While the performance incentive comes from successful investing, day-to-day viability of such small funds comes from management fees that typically start at 2% of assets and decline after four years. With salaries, overhead, travel, audit, rent and the many other costs in running a small business, a new compliance line item could make smaller venture funds uneconomic precisely when such funds are most needed.
We should scrutinize the financial industry carefully for new and emerging sources of systemic risk. In doing so, however, regulators must minimize costs while choosing the right targets and focusing on the causes of risk, like unmonitored leverage, which is nonexistent in venture capital. I would hate to see the trajectories of future entrepreneurs altered by an over-eager and indelicate registration process that made uneconomic the kinds of small, risk-taking venture funds our economy needs right now.