Where They Stand on VC Regulation: Toss-Up –

VCs can cast a vote for President Bush or Sen. Kerry under the fairly safe assumption that their vote will matter. But there is one issue that would have a dramatic impact on the venture industry yet is unlikely to be affected by whom they vote for: regulation of private equity.

That is because William Donaldson, chairman of the Securities & Exchange Commission, a man appointed by a Republican administration, has taken a decidedly Democratic view of the private equity world.

If Bush is re-elected, Donaldson has shown no indication that he is likely to step down as SEC chairman before his term ends, so his efforts to regulate PE would likely hurtle forward.

If, on the other hand, Kerry is elected president and chooses a Democratic SEC chairman, regulation could hardly proceed with more vigor than that brought to bear by Donaldson.

How did the industry end up in this awkward position? Isn’t it perfectly clear why venture capital firms and other private equity firms should be exempt from SEC oversight? Industry cognoscenti, such as Stephen Holmes, a general partner at Interwest Partners, can easily tick off a lengthy list of reasons why VC firms and GPs have been excluded from SEC regulation:

* They only invest the money of “qualified investors.”

* Their investments are illiquid compared to publicly traded stocks.

* Their investors have largely been institutions and not individuals.

* They provide their investors with access to detailed information about their investment decisions.

* And their investors have participated in venture funds as LPs with limited liability precisely because they want to avoid the legal liability involved in making risk investments.

Right up to the last few years, those reasons have been sufficient to insulate venture capital firm from the increasing regulatory burden imposed on companies, corporate executives, research analysts, investment banks, brokers and dealers in the wake of Enron, Arthur Anderson and other financial scandals.

Threatening Language

But today that is changing. Suddenly the SEC, and its tough talking chairman-a prominent Republican appointee and a founder of Donaldson Lufkin Jenrette-is talking about regulating private equity with all the vigor of a young Teddy Roosevelt. Donaldson has told the world over the past year that private equity firms should be regulated. And before you wave off the chairman’s statement as hyperbole, you should know that the SEC is actively asking whether venture capital should be regulated as it considers regulation of hedge funds.

The SEC is governed by five commissioners, all appointed by the President, who also designates one of the appointees as the chairman. The commissioners, including the chairman, serve for five years. No more than three of the commissioners may belong to any one political party. Each year the term of one commissioner ends and the President appoints a new commissioner. At present, there are two Democratic and three Republican commissioners, as one might expect at the end of a Republican administration.

There is the very real possibility that Donaldson could remain SEC chairman under a Democratic administration, but if Kerry wins the election, the commission would quickly take on a Democratic majority as Republican commissioners end their terms. Consideration of a Democratic-oriented SEC may be moot, however, because Donaldson, in the words Allan Ferguson, the newly appointed CEO of 3i USA, is a “man with a mission.” Donaldson, it seems, has gone over to the other side.

Bush appointed Donaldson with the support of the financial industry and in the face of fierce criticism from industry watchdogs. But like so many bright and independently wealthy people appointed to political office late in life, Donaldson appears to have developed a zest for his role as the advocate of the investors that his agency is supposed to protect. To the great surprise of the few who have bothered to take note, it is Donaldson himself who is taking the lead in demolishing the old myths about why private equity firms should be excluded from regulation and oversight.

In his testimony to Congress, in his speeches, and in the proposed rule for the regulation of hedge funds, Donaldson says there are several reasons why the regulation of private equity funds is necessary. His primary concern is that the private equity industry is being “retailized,” as pension funds have displaced wealthy individuals as the single largest source of funds for the private equity industry. More than 26% of the money invested in VC firms for the first six months of 2004 came from pension funds, according market researcher Thomson Venture Economics (publisher of VCJ). VCs proffer a host of counter arguments on this point, but Donaldson has made it clear that he is not going to be dissuaded from his position by such reasoning.

More than a few wealthy investors are deeply involved in private equity, as has become clear with troubles at United Airlines’ bankrupt pension fund. With 150,000 members, the pension fund has attributed problems with the returns on its private equity investments as a key factor in its insolvency.


Another important theme for Donaldson is that the lack of supervision of the private equity industry and its “operation in the dark” encourages fraud. Examples that Donaldson has specifically mentioned include portfolio pumping, improper valuation of assets, falsification of experience of fund managers and misrepresentations of portfolio performance.

Mention those assertions to one of the upright senior members of the venture industry and they react as if they have been touched with something red-hot. If they recover from the shock of such accusations, they proffer a host of proofs that this does not happen at their or any other firms that they know off.

And while those VCs are credible, Donaldson has taken the almost biblical position that the sins of one or a few are sufficient reason to cast venture firms out of the Eden of regulatory freedom.

Info Shortage

Donaldson’s third major theme in developing his position on regulation is that as the SEC becomes more proactive in protecting the rights of investors it must have more information with which to make informed decisions. Therefore, it must gather information about investment advisors, including those in private equity.

The chairman says that the economic cost of registering and reporting to the SEC is minimal. Moreover, he touts the benefits of having more open, standardized information available. Donaldson has noted that no less than the chief investment manager of the nation’s largest public pension fund-the California Public Employees’ Retirement System-has complained that even he can’t get all the information that he needs from managers at private equity funds. PE information provided to the SEC, according to Donaldson’s line of thinking, will end such concerns and encourage further growth of the private equity industry.

VCs who are willing to debate these points do so with great vigor, but the days of defensibility are nearly over given the Donaldson conundrum.

At best, the presidential election may slow the adoption of new rules regarding regulation of private equity, but regulation appears to have become an issue of “when” not “if.”

“I don’t think it’s important in this debate who is elected [president],” says 3i’s Ferguson, an NVCA board member who has met with Donaldson. “I think that Donaldson will remain and that he is on a mission to clean up the industry.”

Good for the Gander?

Ferguson’s predecessor as CEO of 3i, Martin Gagen, makes much the same point, but from a different perspective. He points out that the 3i, as an international private equity firm, is “regulated in 14 different countries already, and operates under different legislative environments, with different registration requirements depending upon whether you’re working in Germany or Singapore. Firms like Carlyle, JPMorgan, Apax and others up and down Sand Hill Road already deal with [regulation].”

From Gagen’s vantage point, the “professionalization” of the private equity industry merely reflects the maturation of the industry. Regulation is, therefore, a natural consequence and isn’t based upon who is elected in the United States.