Venture Capital and Systemic Risk

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.

Comments

[Michael F. Martin]

I agree. Madoff was registered and what good did that do? If anything unregistered hedge funds whethered the crisis better than the rest of the financial industry. What's the point of requiring registration?

The larger problem with this white paper is that it provides no explanation for why these proposals are important. It's clear that they were shooting to put more and more detail into the report as it went on from its structure. But the effect is of repetition, not iteration into additional detail and explanation.

[Gregg]

“Venture Capitalists” The name alone sounds risky. Of course they caused the financial crisis. They invested a whole million dollars in JoesOnlinePoker.com and look what happened. These fat cats must pay. Hit them with regulation. Thank you SEC.

http://www.beaconintegration.com/

[Michael Turner]

"Madoff was registered and what good did that do?"

Under the previous regime -- i.e., absurdly lax oversight of dangerously loose rules -- registration naturally meant next to nothing. This discussion is about compliance costs in regulatory regimes where compliance will actually be demanded, and where the rules people have to comply with actually matter.

To an objection worth taking more seriously:

"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."

Yes, but to what extent are the costs of compliance adding mainly to transaction costs, and to what extent is the sheer scale of transaction flow the main dependent variable in costs? Also, the costs of full-time compliance in Manhattan are much higher than in Cupertino, just in cost-of-living terms for any in-house regulator.

If you're a major Silicon Valley VC and your firm's dealflow is, even in the good years, in the low double digits annually, the cost of compliance activity kicked off might not nearly as high as half that of some hedge fund with the same headcount. It might be more like 2%, and perhaps quite small compared to the checks you write to Wilson, Sonsini. Even if the costs of compliance per transaction are much higher for VCs than for hedge funds.

"'Venture Capitalist'. The name alone sounds risky."

Yes, they should adopt more conservative-sounding nomenclature. How about "tech-sector hedge funds"? Because hedging is, as you know, about reducing your risks, and VCs, by gathering knowledge about startups and spreading their risk among them ....

What? "Hedge Fund" now means "Financial Neutron Bomb"?

Never mind.

"Venture Capital" is truth in advertising, if there ever was such a thing. (Did you know it used to be called "Adventure Capital"? Nice! How 'bout we split the difference and go back to that?)

[Healy Jones]

The main cost of complying with these types of regulation is the time involved for the managing partner(s). While larger funds can afford to hire non-deal COO/CFO partners, financial administration at smaller funds falls onto the active deal partners. Since the limiting factor at most VCs is the investing professionals' time, anything that keeps them from investing or working with portfolio companies could be a real burden. Having been a junior VC at a larger firm & having helped with the silly exercise of annual portfolio valuations for the auditors, I can tell you that these sorts of low-value added administration are major time sucks - and did I mention that they don't really add much value?

[reason]

I can only imagine the extent to which the failure of joesonlinepoker.com crippled the economy. Smart...