Volcker Rule Part I: What is the Law and Why are PE and VC Funds Upset?
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No great legislator (or, let’s be honest, any legislator) will let a historical economic crisis slip by without making their mark on financial regulation. The “Great Recession” resulted from illicit banking practices relating to credit default swaps, creatively packaged collateralized debt obligations (CDOs), and generally appalling standards for offering and unloading sub-prime loans. Naturally, this led politicians supporting heightened government control to take action and push out stringent regulation.
I am not sure if anyone opposed adjustments to financial regulation after one of the worst economic downturns in US history; however, there is lively debate about the reach of the Dodd-Frank Act and, more specifically, the Volcker Rule.
So what is the Volcker Rule, and what does it do?
In summary, the statute prohibits financial institutions from making risky investments in high risk asset classes like hedge funds, PE funds, and VC funds. The goal is to control the level of risk big banks on wall street take on to ensure they are being responsible and not selling high risk re-packaged loans to pension funds.
Technically speaking, §619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) codifies the Volcker Rule which may be found at 12 U.S.C. 1851. To identify the purpose of the statute, one need not look further than the title: Prohibitions on proprietary trading and certain relationships with hedge funds and private equity funds. The Federal Reserve has a great summary along with additional materials to consider.
The precise language from the statute is as follows:
(a)(1) Prohibition Unless otherwise provided in this section, a banking entity shall not —
(A) engage in proprietary trading; or
(B) acquire or retain any equity, partnership, or other ownership interest in or sponsor a hedge fund or a private equity fund.
Proprietary trading in §(a) is more intended to cover trading credit default swaps and CDOs which was a main catalyst to the recession in 2008. §(b) is intended to limit high risk investments in several types of funds, although there are a few exceptions.
§(h)(4) of the statute gives a long, drawn out definition of proprietary trading. To summarize, proprietary trading is when a bank or financial institution trades or invests on its behalf to make a profit rather than trading for a client and profiting off of fees or a thin margin. I probably rely on Investopedia more than I should, but they have a lot of helpful information and give a great definition here.
Further precluding banks from investing or acquiring an interest in venture funds, §(b) directly prohibits taking an equity positions in a private equity fund (including venture funds) which is precisely what an LP does. Perhaps this does protect a lot of capital considering the risk of PE and VC. However, it more so increases the compliance costs of a financial institution making these investments rather than completely deterring them.
Exceptions to the Volcker Rule
Numerous “permitted activities” are included in the statute which allow for financial institutions to make some proprietary investments or acquire an interest in a private fund. §(d) of the statute codifies these activities. This list consists of §(1)(A) through (J) with sub-sections, so I won’t list all of them. One permitted activity to highlight is §(d)(1)(E) which allows for financial institutions to invest in private funds registered as a Small Business Investment Company (SBIC) defined in 102 of the Small Business Investment Act of 1958 (15 U.S.C. 662). If the fund registers for SBIC status with the Small Business Administration (SBA) a financial institution may invest in the fund.
Additionally, §(b)(4)(A) allows for a financial institution to make a de minimus investment into a private fund. This is allowable if the financial institution is “(i) establishing the fund and providing the fund with sufficient initial equity for investment to permit the fund to attract unaffiliated investors or (ii) making a de minimis investment. Again relying on my favorite — Investopedia — the definition of de minimis is where an investment adviser is exempt from registration if they have 15 or fewer clients over a 12-month period with a physical address.
There are litany of other exceptions to the rule for both proprietary trading and acquiring ownership in private funds, but the above two are often relied upon in venture capital.
What is the impact on venture and startup companies?
Limited access to capital. Large banks are a common Limited Partner in PE and VC funds (if you aren’t sure what a Limited Partner is, check out my last article A Look Under the Hood of Venture Capital Firms). Thus, funds have fewer options to raise capital from, especially where a bank was a fund’s core investor prior to the Volker Rule. Sure, funds can raise directly from pensions, high net worth individuals, and corporations, but financial institutions were a large chunk of LP capital in venture.
Subsequently, there is less capital available to entrepreneurs. Funds began losing key investments from banks leading to smaller funds or potentially no fund at all. This means less capital to be invested into high growth technology companies.
However, the actual impact of the Volcker Rule is a current topic of debate. VC firms and their supporters are naturally upset with the regulation. Those whom prefer heightened regulatory schemes governing Wall Street and big banks may be happy. The data may support the pro-Volker Rule viewpoint as the total amount of capital raised and deployed continues to increase per Pitchbook.
Page 30 of the 2Q 2019 PitchBook-NVCA Venture Monitor (downloadable free here) shows total capital raised in VC was at an all-time high of $53.5B in 2018. However, there was a ~$5M decrease in the average fund size in 2019 through Q2 compared to 2018. So who is right? Is the Volcker Rule to cumbersome on VC firms? Should the regulation strictly be place on trading CDOs and credit-default swaps?
Check out Part II of my take on the Volcker Rule next week where I will dive into the debate and the data supporting both sides.
*This should not be considered legal advice. Please consult a licensed attorney if legal advice is needed*