Regulators’ broad brush could paint VCs into a corner

It’s no secret that the private equity universe is coming under serious scrutiny by federal regulators. But what’s still unknown is how some proposed regulations would impact venture capital firms.

Of course, most of the unwanted attention—including tough talk from politicians, trade groups and the press—is directed at venture capital’s richer relatives: buyout firms and hedge funds.

Hedge funds have been in the sights of regulators for the past several years, mostly because the government now feels the need to closely monitor this massive yet secretive industry that boasts approximately $1.3 trillion in assets. The Securities and Exchange Commission, for instance, is investigating possible insider trading by hedge funds after uncovering suspicious buying and selling activities before the announcements of some corporate mergers.

More recently, the regulatory heat has also been turned up on buyout firms. These groups have raised enormous amounts of money and are dramatically alerting the corporate landscape by wresting control of some of the world’s biggest brands. In doing so, they have also raised the eyebrows of regulators both here and abroad, who question whether this is a healthy turn of events.

“Buyouts and hedge funds are drawing attention to themselves because of various issues and excesses they face,” says David Spreng, a managing general partner at Crescendo Ventures. “Yet I fear the venture industry is getting dragged into the morass because these guys are trying to hide behind venture capital to avoid being regulated. But they are not like us in terms of the good we do for the economy.”

Specifically, there are at least three proposed regulations targeted at hedge funds and buyout firms, but which could also affect venture capital. That’s because each of these forms of private equity are covered by the same rules that provide exclusions and exemptions from SEC regulation.

The tax man cometh

I fear the venture industry is getting dragged into the morass because [buyout and hedge funds] are trying to hide behind venture capital to avoid being regulated.”

David Spreng, Managing General Partner, Crescendo Ventures

One potential regulatory change is the prospect of taxing private equity profits, or carry, as ordinary income instead of as a capital gain. The difference between the two, of course, is enormous. Capital gains are taxed at 15%, while the tax rate for regular income is 35 percent.

The SEC is also proposing to adopt a new antifraud rule under the Investment Advisers Act of 1940 that would clarify the ability of the SEC to bring enforcement actions against investment advisers—including hedge funds, buyout firms and VCs— who defraud investors or prospective investors.

“The problem with this rule is that it has no requirement for intent and, arguably, a statement made to potential investors that is simply incorrect could become a source of liability,” says Brian Borders, a private practice attorney in Washington who counsels the National Venture Capital Association. “This could have a chilling effect on the candid flow of information that now exists between VC funds and their investors.”

Finally, the SEC is considering whether to raise the accredited investor standards for private equity that have been in place for the past 15 years. In particular, the SEC has proposed limiting participation in hedge funds to investors who have a minimum of $2.5 million in investible assets, excluding the value of their primary home.

Currently, investors must have a minimum of $1 million in net worth (including real estate) or earn at least $200,000 a year. Raising the bar could prevent entrepreneurs and other important members of the VC network from participating in the success of a fund, ultimately harming the overall ecosystem.

While VC funds are currently excluded from this accredited investors proposal, some hedge fund operators have questioned why the SEC is limiting the minimum eligibility requirements to just them. SEC Commissioner Paul Atkins thinks they may have a legitimate point. “There’s little to differentiate hedge funds from private equity funds and venture capital funds from the way business is trending in the last few years,” he said recently.

When lines blur

It typically takes six to 10 years of investment work by the VC to earn that carried interest, so to say it should be taxed as regular income undermines the nature of the business.

Pascal Levensohn, Managing Director, Levensohn Venture Partners

Indeed, one of the biggest problems facing the venture capital industry is that the lines seem to be blurring between all facets of private equity. Hedge funds, for instance, are making more VC investments (consider Artis Capital Management and D.E. Shaw), while some VCs are investing greater sums in later stage deals that could be construed as buyouts.

Those cases are certainly more the exception that the rule, but the nuance may be lost on overzealous regulators. “We are in a completely different business than these other two types of private equity,” insists Spreng. “But as the momentum for regulation grows, hedge funds and buyout firms will attempt to deflect the criticism by comparing themselves to venture capital. We have to do everything we can to not let changes meant for one sector impact us, because that could have implications for the entire economy.”

Pascal Levensohn, managing director at Levensohn Venture Partners, is very worried about getting lumped in with other private equity firms. “This is something that should concern all VCs,” he says. For instance, he believes it’s ludicrous for VC carried interest to be taxed as anything other than a capital gain.

“The key thing here is that it typically takes six to 10 years of investment work by the VC to earn that carried interest, so to say it should be taxed as regular income undermines the nature of the business,” he says. “This proposal runs contrary to the notion of building companies to last. Instead, it could introduce short-term thinking into the venture business and force people to make decisions based on what is best for them personally.”

On guard

Bob Pavey, a partner at Morgenthaler Ventures, is thinking about regulatory issues more and more these days. “The situation does concern me,” he says. “We need to stay vigilant or our environment could deteriorate.”

Pavey believes a number of regulations have already had an unintended impact on the venture capital industry. For instance, he blames Sarbanes-Oxley for slowing down the IPO market in the United States and forcing promising startups to list overseas.

We need to stay vigilant or our environment could deteriorate.”

Bob Pavey, Partner, Morgenthaler Ventures

“I still believe that some forms of regulation are necessary, but we should be careful not to shut down the entire financial system just because we found a few bad guys,” he says. “The last thing we need is congressional overreaction.”

That’s exactly what Pavey sees in the latest proposal to change the way private equity is taxed. “The country currently has a budget deficit, so this is a blatant attempt to raise taxes from hedge funds and buyouts firms, where the fees have been enormous,” he says. “But as so often happens in Washington, everything else gets swept up in the process, which can make this an unattractive place to do business.”

Mark Heesen, president of the NVCA, says that regulations commonly follow the law of unintended consequences for the VC industry. “Initiatives built upon the noble intention of protecting investors also carry with them the uncanny capacity to negatively impact our ability to build companies,” he says.

To prevent this from happening, Heesen believes it’s crucial to remind regulators of the traits that set venture capital apart for other forms of private equity. For example, VC advocates argue that 16.6% of this country’s GDP and 9% of public sector employment can be traced back to companies that started with venture financing. Clearly, the same cannot be said for hedge funds and buyout shops.

“That’s why we need to keep meeting with Congress and the administration to explain all the good that VC does for this country and why the industry should not be burdened with additional regulatory requirements,” Heesen says.

Despite his concern, Heesen isn’t pulling the fire alarm just yet. “Until we see a serious threat, we will not go running to our members,” he says. “At this point, there is no reason for panic.” In the meantime, the NVCA will continue to hit regulators with its key message: Don’t confuse us with those other guys and don’t unfairly take a hammer to our industry when just a feather is needed.

(This story originally appeared in the May 2007 issue of Venture Capital Journal. —Ed.)