In the public policy arena, the law of unintended consequences is one that the venture capital asset class has become all too familiar with over the last several years. Regulatory and legislative initiatives that were built upon the noble intention of protecting investors also carried with them the uncanny capacity to negatively impact our ability to build companies.
Following on the heels of the Sarbanes Oxley Act and the FASB proposal to mandate the expensing of employee stock options for public and private companies, a new threat has emerged. The Securities & Exchange Commission’s recent proposal to require the registration of hedge fund advisers places us on the edge of a slippery slope where we could fall into unnecessary and inadvertent regulation.
The SEC’s proposal for hedge fund registration is the result of a multi-year investigation and rulemaking process. The proposal was released for comment in mid-July on a 3-2 vote, with Commissioners Atkins and Glassman vigorously dissenting. The NVCA does not have a position on the proposed hedge fund rule as it relates to the hedge fund industry. However, because venture capital and hedge funds are covered by the same rules that provide exclusions and exemptions for SEC regulation, we are concerned with how this latest proposed ruling may affect our businesses.
The SEC process never involved venture capital and rightly so. Venture capital and hedge funds are mutually exclusive, unrelated vehicles-with dissimilar investment strategies, focused on a different universe of investors. Venture capital funds are comprised almost exclusively of sophisticated institutional investors with a seven-to-12-year time horizon who want to invest in privately held companies. Investors have no control over short- term liquidity in venture capital.
Conversely, hedge funds invest on behalf of institutions and individuals who are seeking greater liquidity and are generally looking for trading opportunities. Hedge funds use a variety of investment vehicles and take long and short positions in many markets. Interests in hedge funds are often sold by brokers who have no influence on the direction of investments.
Despite the SEC’s acknowledgement of these differences, there are nuances in the proposed hedge fund regulation that give us pause, particularly as it relates to exemptions for venture funds. One example is the SEC’s suggestion that pension fund investment in hedge funds amounts to significant “retailization,” which justifies SEC registration. On a standalone basis, this generalization could apply to venture capital. Another example involves the SEC’s definition of a “private fund,” which triggers the new regulation.
As it stands today, the proposal includes venture capital in two of the three parts of the definition. The third part involves a two-year investment lockup requirement for exemption. While most private equity funds can meet this criterion, there could be circumstances not covered by the exemption language in which limited partners may need to liquidate their investment before two years. It is critical that the language in this definition is crystal clear and covers such circumstances.
Another example of language that is problematic is the “fund as client” definition. The Investment Advisors Act currently exempts from registration a VC fund that has fewer than 15 clients. SEC regulations define a client to be the venture capital fund itself, rather than the individual LPs because the general partners focus on the investment goals of the fund rather than the individual investors. VC firms typically do not manage more than 14 funds at the same time, so they are exempt from registration. Under the new registration requirement, this interpretation would no longer apply to advisors of “private funds” and they would be required to count each LP as a client, making the 15 client exception unavailable for most firms.
The concerns that led to the SEC hedge fund investigation are unrelated to venture capital. Yet, the dissenting views of Atkins and Glassman suggest that the proposal has future implications for private equity and VC. It appears that Chairman Donaldson is eager to act on a final rule-probably by year-end or perhaps even before the election. The venture capital industry should be equally as eager to raise the appropriate questions around this proposal and its implications for our future.
Mark Heesen may be reached at