An Open Letter To Congress About The Private Fund Transparency Act
Marc Averitt, a venture capitalist at Okapi Venture Capital, an Orange County-based venture firm, posted this Open Letter To Congress on his blog, and we're republishing it here with his permission.
I am writing to you today as a concerned citizen with a truly global perspective who also happens to be a co-founder and managing director of a small (~$30M) venture capital fund that invests in promising seed and early-stage technology and life science companies in Southern California. I want to relay to you my deep concern regarding S.1276 (a.k.a. the “Private Fund Transparency Act”) and any other such legislative proposals that will, unnecessarily, impose new regulatory burdens on the venture capital industry whole-scale. I truly believe these proposals will negatively impact the venture capital industry’s ability to fund and nurture the innovative start-up companies that have been and continue to be critical to U.S. economic growth as well as our country’s ability to effectively compete in the global market. To put the importance of venture capital in perspective, the venture capital industry has created over tens of millions of jobs for the U.S. economy just during my lifetime and venture capital backed companies now make up a significant percentage of our GDP.
I have spent a good portion of the past decade in the emerging markets of China, India, Russia, and Brazil/Argentina and have been amazed at the lengths to which these countries have been actively changing their regulatory, financial, and entrepreneurial ecosystems to encourage venture capital all while we, as a nation, seem bent on hindering it. While I am an educated man and understand that your analysis thus far has led you to believe that certain gaps in the regulation of U.S. banks and capital markets have been to blame for the subprime mortgage crisis and global financial calamity triggered after Lehman Brothers filed for bankruptcy a year ago today… I can only assume that the pending legislation in question is simply a result of our government asking and answering the third of three fundamental questions (1 how did the systemic financial crisis we are in occur?; 2 how do we fix it?; and, finally, 3 how do we prevent it from happening again?). As the road to Hell is also surely paved with good intentions, I ask you to consider this letter (and others like it) as you continue to analyze and discuss attempts to prevent future systemic financial meltdowns.
As for my particular issue, I am opposed to the current language submitted that would regulate “private pools of capital” as part of the financial industry regulatory overhaul effort. S.1276, if enacted as it currently stands, would require investment advisors to private funds, including hedge funds, private equity funds, venture capital funds, and others, to register withe the Securities and Exchange Commission (SEC). I believe that, in the House of Representatives, Chairman Barney Frank is expected to introduce this legislation imminently. While these proposals are typically referred to as “hedge fund registration rules”, they are much more than that and are truly unnecessary with respect to venture capital funds and I would like to take this opportunity to explain why.
While I use my own venture capital fund as an example throughout this blog post, it is merely included to illustrate the impact to small venture capital funds and the companies they invest in. The potential impact is far greater and I think you will find that the vast majority of venture capital firms like mine (which is clearly not a hedge fund or a buy-out fund) would be forced to register as investment advisors with the SEC. While this process is often portrayed as simply “filling out a form”, it implies a number of obligations with complications as well as a significant investment of financial and human capital resources.
If adopted, the current proposal would be an undue burden on the small yet significant venture capital industry as a whole, on that our industry and country can ill afford under the current economic circumstances and - more importantly - one that would not in any way help to prevent future systemic financial risk. For comparison, last year venture capital funds only averaged 8.5 principals per firm and held approximately $197.3 billion in aggregate assets… whereas hedge funds held approximately $1.3 TRILLION in assets (See Hedge Fund Intelligence Ltd., United States: The End of an Era? Global Review 2009). By categorizing venture capital funds under this “private fund” umbrella, we are being asked to shoulder a burden that, in addition to the issues already addressed, does not benefit the government in terms of identifying or preventing systemic risk.
While I will not speak to the nature of the other fund entities here and now, venture capital funds should not be regulated under this legislature for several fundamental reasons:
1) Venture capital funds do not use leverage/debt like banks, hedge funds, and buy-out funds typically do and they do not engage in any lending of credit like banks do. For example, my fund “calls” committed capital from its investors (a.k.a. “limited partners”) over the 10-year term of our fund to purchase preferred shares of private companies and we do not rely on debt the way banks, private equity, and some hedge funds typically do. In fact, we are contractually prohibited from using debt in such a way pursuant to the terms and conditions of our limited partnership agreement. Our financial risk is therefore contained and limited to ourselves, our limited partners, and our portfolio companies, and any resulting loss is limited to the amount of the investment only.
2) Venture capital funds neither trade in the public markets nor use complex financial tools such as derivatives or swaps like hedge funds do. Like the vast majority of venture capital funds, my fund operates as a private, closed-end, limited partnership governed by an agreement wherein our limited partners meet the SEC’s requirements of being both “qualified” and “sophisticated” (i.e., such limited partners must have substantial net worth and be educated enough to appreciate the risk associated with investing in venture capital funds). Additionally, my fund (and most other venture capital funds) is prohibited from purchasing public equities pursuant to our limited partnership agreements; therefore, we only purchase shares in private start-up companies through private, SEC regulated transactions. While a few of the larger venture capital funds have admittedly evolved and now purchase public equities privately through PIPEs (Private Investment in Public Equities), I think you will find the vast majority of venture capital funds do not.
3) There are no third party positions to be taken in venture capital in that no other entity aside from the limited partners and general partners of our funds and company founders are investing. We are closed funds with a set term and are not open to the public. Venture capital loss is strictly limited as any losses do not extend beyond our limited partners pro-rata. Simply put, venture capital funds are private investments (i.e., do not act as a source of liquidity for the financial system) and only provide equity capital to a select few portfolio companies through private investments. Venture capital funds do not pose any systemic risk to capital markets.
In summary, the venture capital industry does not meet a single criteria listed by Treasury Secretary Geithner as indicators of systemic risk, yet we are being swept into the proposed language. To reiterate, if a venture capital fund or one of its portfolio companies goes under, the loss is limited to the amount of investment and would not affect the broader markets the way a failed hedge fund, buy-out fund, or bank might.
While I applaud the efforts to address systemic risk and the activities that were at the root of our nation’s devastating financial distress, and appreciate the difficulties associated with bringing legislation to bear as an ex-attorney, the venture capital industry played no role and should not be targeted. Now is not the time to increase the burden on an industry that has been and continues to be central to our great nation’s ability to fund entrepreneurs, build start-ups, create high-paying jobs, and produce revolutionary technology and products that better our lives in so many ways.
Bottom-line: Venture capital should not be included in the Privacy Fund Transparency Act (or any other such legislation) and I urge you to take these concerns forward on behalf of both your constituents as well as our nation as a whole. For any Representatives or Staffers actually reading this, I would be more than happy to discuss this matter further.
Marc Averitt is a Co-Founder and Managing Director of Okapi Venture Capital (www.okapivc.com">http://www.okapivc.com">www.okapivc.com) and is responsible for Okapi Ventures' information technology investments. Marc also maintains a personal blog about venture capitalp in and around Orange County at http://ocvcblog.com.