June 30 (Bloomberg) -- Venture capitalists have long distinguished themselves from private equity firms, claiming that they help build companies, avoid borrowing money and pose no risk to the broader economy. Regulators now agree with them.
The U.S. Securities and Exchange Commission exempted venture firms last week from a rule that requires private equity funds and hedge funds to register with the regulator, saving them millions in compliance fees and sparing their investments from a greater degree of scrutiny.
The ruling marked a victory for an industry that champions itself as having spent a half-century backing startups that later emerged as technology stalwarts such as Cisco Systems Inc., Microsoft Corp., Google Inc. and Facebook Inc. Too much regulation, the venture capital industry said, would harm its ability to fund innovation and support job creation, while doing nothing to protect the country from another financial crisis.
“The venture industry is never going to create systemic risk, so let’s not screw up the golden goose that’s producing so many jobs and doing so much to stimulate the economy,” said Bob Goodman, a partner at Bessemer Venture Partners in Larchmont, New York, and a director at the National Venture Capital Association. “Washington has done the right thing.”
Venture capitalists, private equity firms and hedge funds are often grouped together because they are structured similarly. Partners in each get paid a management fee, which is typically about 2 percent of a fund’s assets, and a performance fee of 20 percent or more of profit from the investments.
Venture firms are different in that capital is used to fund new companies and often enables startups to bolster their workforce. Hedge funds invest in assets, including stocks, bonds and commodities. Private equity firms usually purchase all or part of existing companies, often using borrowed capital, with the goal of eventually selling their stake for a profit.
Firms that borrow are considered a greater financial risk, because swings in the economy can hurt their ability to repay the lenders. The credit crisis of 2008 was caused by individuals and corporations defaulting on loans.
In 2010, venture funds in the U.S. raised $12.3 billion, compared with $85.1 billion for private equity funds and $22.6 billion for hedge funds, according to data cited by the SEC. Venture funds managed $176.7 billion in assets at the end of last year, compared with $1.7 trillion at global hedge funds, the agency said.
SEC commissioners voted 3-2 on June 22 to approve a Dodd-Frank Act measure calling for about 750 private fund advisers to publicly disclose data about their investors and employees, assets under management and potential conflicts of interest.
Venture firms are excluded from having to report, assuming they commit at least 80 percent of their capital to traditional venture investments and don’t borrow funds to finance deals. The rules only apply to new funds, while firms with less than $150 million in assets under management are automatically exempted.
In a letter to the SEC lobbying for an exemption, the NVCA cited a 2009 study from research firm IHS Global Insight, which said that venture-backed companies in 2008 accounted for 12.1 million jobs, or 11 percent of private-sector employment, and $2.9 trillion in revenue in the U.S.
While the NVCA succeeded in keeping members from having to register, exempt firms are required to file a minimal amount of information with the SEC, such as business activities and controlling individuals. The SEC has a one-year window to ask for more information.
‘A Different Environment’
“This puts the venture capital community on notice that we are playing in a different environment today than before the meltdown,” said Mark Heesen, chairman of the Arlington, Virginia-based NVCA, which represents more than 400 U.S. venture firms. “The government, like it or not, is going to be looking over your shoulder.”
Firms with more than 20 percent of assets in nontraditional venture investments will have to report with the SEC. For example, investments in startups purchased on secondary markets -- including exchanges like SharesPost Inc. -- would fall into that category. Morgenthaler Partners, with $3 billion under management, has separate funds dedicated to venture capital and private equity, and thus may have to disclose. Ching Wu, a spokeswoman at Morgenthaler, declined to comment.
Still, for the industry, the burden could have been heavier. Venture capitalists have estimated in interviews that costs to their firms for full SEC reporting would have been $500,000 to $1 million a year. About 280 U.S. firms have more than $150 million in assets, so an unfavorable ruling would have cost the industry at least $140 million a year.
Beyond the costs, regulation would hinder venture firms’ ability to operate because they would have to disclose data on early investments when their competitive advantage is keeping that information private, said Paul Maeder, chairman of the NVCA. When they pay off, like Google or Facebook, a multimillion-dollar investment can produce a multibillion-dollar return.
“We viewed this as almost an existential threat to venture capital,” said Maeder, who is also a general partner at Highland Capital Partners in Lexington, Massachusetts. “If all or the majority of venture capital firms were required to register, it would change the character of what we do. We’re investing in stuff that none of us can predict five years in advance.”
The ruling may provide further momentum for an industry rebounding from a decade-long slump, which saw the dot-com bust and global financial crisis put scores of startups out of business.
Fundraising rose 76 percent in the first quarter from a year earlier to $7.1 billion, the NVCA said. Last month, LinkedIn Corp. became the first U.S. social-media company to sell shares to the public, and is now valued at about $8.4 billion. Pandora Media Inc. held its initial public offering this month, and Groupon Inc. filed its IPO prospectus.
One reason it’s taken so long for companies to start going public again is the regulations that were created after the dot-com crash, said Dixon Doll, a former chairman of the NVCA and co-founder of venture firm DCM in Menlo Park, California. The Sarbanes-Oxley Act of 2002 raised the legal and auditing fees associated with being a public company in the U.S., making it prohibitive for smaller companies, he said.
“The last thing in the world the U.S. venture industry needs is more layers of government,” Doll said.
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