Rarely do new pools of capital become available overnight. But that is exactly what happened October 1, 2020, when regulators revised the Volcker Rule’s covered funds section to enable banks to invest in venture capital funds once again.
In this post we will explore how we got here, what this means for venture capital, and what fund managers should consider as part of this policy change.
The Volcker Rule and venture capital
In the aftermath of the 2008 global financial crisis, policymakers were concerned that banks were investing their own capital in financial instruments that could, if they lost sufficient value, expose the bank’s depositors to losses or result in the bank’s failure. Such a failure, policymakers feared, would in turn disrupt the broader financial system. Their answer: ban the behavior.
To do so, Congress enacted the Volcker Rule to prohibit banks from proprietary trading or investing in entities defined as covered funds, including venture capital funds. Although well-intentioned, the originally enacted covered funds section of the Volcker Rule, which went into effect April 1, 2014, missed the mark. There is no data to indicate that banks’ previous investments in and relationships with venture capital funds caused the financial crisis. Further, many have argued that enabling banks to invest in qualifying venture capital funds would allow them to diversify their assets and income streams, reducing their risk profile. This promotes the safety and soundness of the bank, as well as the broader financial system.
Revising this rule not only helps fund innovative companies and create jobs, but it also could help spread the geographical distribution of capital. Unsurprisingly, major hubs like San Francisco and New York attract the bulk of venture capital, while funding is less available outside of those areas. Unleashing funding streams from a national network of banks with regional expertise has the potential to drive capital allocation beyond the major epicenters and into other states and communities across the country.
Revising the covered funds section can change the trajectory of innovation ecosystems across the U.S. We agree with the agencies:
“The agencies believe the exclusion for qualifying venture capital funds will support capital formation, job creation, and economic growth, particularly with respect to small businesses and start-up companies. These banking entity investments in qualifying venture capital funds can benefit the broader financial system by improving the flow of financing to small businesses and start-ups.”
The revised rule & implications for venture capital funds
In June 2020, regulators recognized the negative effects of the overly broad application of the Volcker Rule’s covered funds section and decided to exclude venture capital funds from the definition, enabling banks to invest in qualifying VC funds.
If a bank elects to invest in venture capital funds, it still must comply with limitations on conflicts of interest, investment risk, and safety and soundness. And the rules are even stricter if the bank sponsors a venture fund, meaning the bank has more involvement and control in the fund, such as serving as a general partner or controlling a majority of directors or managers.
For the venture fund to qualify under the exclusion, it must meet the definition under Rule 203(l)-1 of the Investment Advisers Act of 1940 and not engage in proprietary trading as if it were a banking entity. Rule 203(l)-1 requires the following:
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Venture capital strategy: the fund should clearly represent to investors that it pursues a venture strategy;
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Investment holding limitation: the fund may hold no more than 20 percent of total assets in non-qualifying or short-term investments;
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Borrowing limitation: the fund does not borrow or incur leverage in excess of 15 percent of fund’s aggregated capital contributions, and any borrowing must be for a non-renewable term of less than 120 calendar days;
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Redemption rights: the fund may only issue securities that do not provide the holder the right, except in extraordinary circumstances, to withdraw or redeem; and
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Investment company registration: the fund cannot be registered either under the Investment Company Act of 1940 or elect to be treated as a business development company.
A nuance is what constitutes a qualifying investmentthat must amount to at least 80 percent of the fund’s total assets. Under the final rule, a qualifying investment is an equity security issued by a qualifying portfolio company that has been directly acquired. To put it in plain terms: the investment must be equity, not debt, and it should be purchased directly from the issuer, not a third party.
Pulling back the curtain further, a qualifying portfolio company is an issuer that is not publicly traded at the time of investment and does not borrow or issue debt obligations in connection with the investment.
Leveraging this policy change
Legal and governance foundation
Banks have spent the last decade changing their behavior to curtail the investment in and sponsorship of venture capital funds. VCs must be willing to help banks rebuild this practice. Core to that is easing friction around legal and governance. Fund managers should ensure they meet all legal parameters of a qualifying fund and be able to represent that to the banks. This includes investor representations and qualifying investment parameters. Banks should be assessing decisions on the economic merits, not whether they pass regulatory thresholds.
Further, venture capital fund managers should be prepared to walk institutions through the structures of the venture fund and the implications for liquidity.
Regional footprint
Policymakers believed that amending the covered funds component of the Volcker Rule would facilitate capital allocation beyond major tech hubs in the U.S. To the extent this applies to a venture fund, it should prove the regulators right. Changes to the Volcker Rule represent an opportunity for venture capital funds to engage community, mid-size, and regional banks, all of which have expertise in geographical areas and potentially sectors aligned with your fund’s investment philosophy.
Portfolio company footprint
Ultimately, the new changes to the Volcker Rule aim to drive the flywheel of innovation. When regional banks can invest in local venture capital funds, regional entrepreneurs have more access to capital. Those entrepreneurs invest that capital to grow their companies, creating jobs and economic growth for regional startup ecosystems.
Venture fund managers have a chance to access this new pool of capital. Our goal is to help managers understand this opportunity so they can raise capital that supports the innovative companies of tomorrow.
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