Should VC Funds Be Regulated? Let’s Start By Redefining “VC Funds”

The big news this morning is that eBay has agreed to sell a 65% stake in Internet calling company Skype to a group of private investors, at an enterprise value of $2.75 billion. The buyers include Silver Lake Partners, Canada Pension Plan, Index Ventures and Andreessen Horowitz.

Here’s my question: Does this mean that Index and Andreessen Horowitz are no longer venture capital firms?

This might sound like an academic question, but I mean it as a follow-up to Alan Patricof’s op-ed from Sunday’s NY Times. For the uninitiated, Patricof and former regulator Eric Dinallo argued that venture capital firms should be excluded from proposed requirements to register as investment advisors. They argued that VC firms do not pose the types of systemic risks that the rules are designed to guard against, and that imposition of such requirements could damage venture capital firms from a cost perspective. It’s also a case that the NVCA has been making on Capitol Hill.

I agree with Patricof and the NVCA, that venture capital does not pose systemic risk. It is true that the economy would be severely harmed if most VC firms went belly-up tomorrow, but there is no conceivable scenario under which that would happen (save for nuclear holocaust, etc.). Venture capital commitments are relatively stable, and VC firms typically do not use leverage and other outside instruments.

What I have more trouble with, however, is crafting language under which venture capital would be excluded from the registration rules, which really were written with hedge and LBO firms in mind. If you just ask firms to check off a box, then Bill Ackman and Leon Black will officially (and ludicrously) convert to venture capitalism.

A solution, therefore, is to require “venture capital” firms to assert that their investments include something like the following characteristics: (1) Invest more than 90% of their capital in equity-only deals; (2) Invest more than 90% of their capital in private companies; (3) Hold 90% of their investments for at least three years.

An interesting byproduct here is that many of the best-known “venture capital” firms might not qualify. Sequoia Capital, for example, has a burgeoning PIPE practice, while many firms have begun using leverage both for buyouts and to help finance cleantech projects. And, yes, the Skype deal is being leveraged.

But such exclusions are relatively unimportant. Wealthy firms like Sequoia or NEA are not the ones that would really suffer from the added registration expenses. Instead, it would be the smaller shops with much lower overhead. Luckily, this latter group also happen to be the firms less likely to use leverage, do PIPEs, etc.

In short: Venture capital can should support reasonable compromise language that would protect its most vulnerable members, even though it would leave some of its bigger names exposed.