The Securities & Exchange Commission’s proposed regulation for hedge funds sounds innocuous enough. Entitled “The Registration Under the Advisers Act of Certain Hedge Fund Advisers,” the proposed rule is scheduled to undergo public review and comment until Sept. 15.
But a reading of SEC Commissioner Paul Atkins’s statements at a hearing on the regulation in July may change the perception of many in private equity and venture capital as to whether the proposed regulation is harmless.
Atkins admonished advisers to venture capital and private equity funds to “ask themselves: Why are you so special? Why are you not inevitably next” to be regulated? And he warned that advisers to venture capital and buyout funds should realize that, if worries about proper valuation of portfolio investments by hedge funds are driving this rulemaking at least in part, then those issues are “equally as valid for your funds.”
SEC Chairman William Donaldson, who voted in favor of sending the hedge fund rule on its way to adoption, says that the regulation is needed for several reasons, the most important being the “retailization” of the hedge industry. Donaldson noted that an increasing number of investors have exposure to hedge funds through public and private pension funds, institutional funds and endowments. In citing data from the Hennessee Group for the proposed rule, he said that direct investments by pension funds into hedge funds totaled $19 billion last year. In comparison, pensions invested $4.5 billion into venture capital during 2003, according to Anthony Romanello, director of investor services at Thomson Venture Economics (publisher of VCJ).
Donaldson also cited testimony by the chief investment officer of the California Public Employees’ Retirement System (CalPERS), who told the SEC that he could not get all the information he desired from fund managers.
Another concern is the increase in fraud by the managers of funds. Specifically, Donaldson says that hedge fund managers have increased the overstatement of performance of funds, payment of undisclosed commissions and the improper valuation of hedge fund assets. Donaldson testified to the Senate Banking Committee that hedge funds employ a compensation structure “based on performance that provides an incentive” to engage in fraudulent activity. This same issue has been felt in the venture industry, since firms may potentially overstate portfolio valuations. Similar to hedge funds, the VC industry also has no formal standards for the statement or calculation of performance figures.
For these and other reasons, Donaldson told the Senate committee that the SEC believes that it is right in “recommending a very moderate and reasonable action.” The proposed rule would require registration with the SEC of hedge fund advisers. In this era of increased corporate transparency, it’s not surprising that Donaldson said it was high time that hedge funds are “brought out of the shadows.” And he said that the SEC has the need to gather information to better determine where fraud is occurring to protect investors, and to legitimize the hedge industry.
Again, it seems likely that this same logic may one day be applied to venture firms.
Brian Borders, outside counsel for the National Venture Capital Association on regulatory matters, says that ordinarily regulations as portentous as this proposed rule take a long time to move to implementation. But, due to problems the SEC has faced over the last few years on issues such accounting fraud, Borders expects the regulation to be implemented by the end of the year.
In the past, the venture industry has dodged regulatory bullets and regulation by developing its own best practices policies for matters such as the valuation of portfolio companies. But unlike the Private Equity Industry Guidelines Group-which has promulgated voluntary procedures for venture firms to calculate valuations-this proposed rule on hedge funds is being developed from outside of the private equity industry by a governmental body that is trying to become a more proactive agency.
“We must know whether hedge fund advisers are adhering to federal securities laws,” Donaldson says.
Some are cautiously optimistic that the SEC won’t push to regulate PE firms. Barry Barbash, a partner with the law firm Shearman & Sterling and a former director of the SEC’s Investment Management Division, says, “the SEC does not appear disposed” to regulate private equity more broadly. “But that’s not to say that down the road the SEC won’t take back its current exemption of venture capital firms [from the current rule].”
The SEC makes it clear in the proposed rule that it is concerned about whether advisers apart from hedges require regulation, asking in the proposal whether the rule “should include private equity, venture capital and other investment pools that are not hedge funds.”
Those familiar with the regulatory process recognize such questions as handwriting on the wall. Bill Davidow, co-founder of Mohr, Davidow Ventures, says that this may be another case of making a rule before the regulator understands the problem. “The introduction of more rigid valuation methodologies could result in worse results [for investors and venture firms], not better,” he says.
Adding to the uncertainty, the NVCA’s Borders says that as written, it is not even clear that venture funds merit exemption from the proposed rule.
If venture and buyout funds do escape inclusion in this round of regulation, it’s going to be a lucky bounce of the regulatory ball. But as baseball fans know, such things do happen. Sometimes.