Regulating Venture Capitalists? The Right Case and the Wrong One

Financial market regulation should be driven by risk and assets, not by title. That's why I find the whole discussion of regulating venture capitalists more than a little bizarre: Regulate them if you take the principled position that they are a source of systemic risks; don't regulate them if they are not.

Broadly, venture capitalists do not engage in systemically risky activities. They do not usually have leverage, nor do they use complex financial derivatives, nor are they tightly intertwined into the banking system. By those measures they are not source of systemic risk, as commonly understood, in financial markets in the U.S. or elsewhere.

The preceding is the point made in a weekend NY Times OpEd by Alan Patricof and Eric Dinallo. They argue, fairly convincingly, that venture capitalists are not sources of systemic risk, at least not the kind that we tell ourselves we should be worried about post this global financial crisis.

Having said that, however, Dinallo and Patricof make an overbroad claim. Mid-way through they say the following:

Venture-capital funds deal solely with privately purchased equity securities in start-up companies, which are not traded in public markets.

That is untrue.  Venture capitalists regularly participate in PIPEs (private investments in public equities), and they often hold large amounts of stock in portfolio companies that have newly gone public. If the goal is to regulate any institutional investor with a material amount of assets who regularly invests in public markets, it will be hard for venture capitalists to avoid regulation.

All of this drives home why we need to regulate financial market risk, not regulate professional titles. The question isn't whether you are a venture capitalist, a mutual fund, a hedge fund, or a private equity manager. The question should be whether you are, or reasonably could become, a source of systemic financial market risk. Venture capitalists generally don't qualify, but saying that is because they don't participate in public markets isn't the way to make the case.

Comments

[Entrepreneur]

As an entrepreneur, I absolutely support having oversight on VC funds. The days when VCs nurtured innovation are long gone. Now they are just keeping the money under the pillow and have gone on vacation. They have also started investing heavily in public markets. I know of at least a few west coast fund which have invested heavily in public securities, instead of deploying their capital on startups.

[David Croson]

When you say

"Venture capitalists regularly participate in PIPEs (private investments in public equities)..."

do you mean to say that the VCs are actually buyers, or merely sellers, of the securities in PIPEs?

Your statement is certainly true on the sell side (it's a way to liquefy large blocks), but that doesn't make Dinallo and Patricof wrong.

Is the line between VC and private equity so blurred now that VCs really buy into PIPEs on a regular basis?