Charlotte Savercool

by & filed under Capital Formation & Regulation, NVCA Blog.

NVCA is working to allow banks to invest in venture capital funds again. As part of this effort, we recently filed a comment letter proposing two solutions for how the various federal agencies can accomplish this priority while still adhering to the broader goals of the Volcker Rule. Through this post, our aim is to share some background on the current regulation and provide an overview of what our proposal seeks to accomplish and why. 

Before the Volcker Rule became the law of the land, banks served as an important source of capital for venture capital funds, particularly for smaller funds in emerging startup ecosystems. According to estimates from Silicon Valley Bank, prior to the rule’s implementation, banks provided 7% of the dollars invested in venture capital funds, representing approximately $133 million to venture funds in the industrial Midwest and perhaps even as high as $247 million in the upper Midwest. But more than just providing capital, by serving as ‘anchor investors’ they played a critical signaling role in helping these funds attract further investment. Banks also benefitted by diversifying their investment strategies and gaining greater visibility into the development of the region’s next generation of companies. This connection was severed by the implementation of the Volcker Rule.

Passed into law in response to the financial crisis, the Volcker Rule was included in the 2010 Dodd-Frank Act with the goal of preventing banks from engaging in risky proprietary trading. Because the bill’s sponsors were concerned about banks shifting risky activity from their balance sheet to a sponsored investment fund, they included a prohibition on bank investment into so-called ‘covered funds’ and left the regulatory agencies with the task of defining that term. Unfortunately, during that process regulators unnecessarily included venture capital funds in the ‘covered fund’ definition and as a result, prohibited banks from investing in venture capital funds despite a clear congressional mandate not to do so. In fact, one of the authors of the bill that codified the Volcker Rule, Senator Chris Dodd (D-CT), stated during consideration of the legislation: “In the event that properly conducted venture capital investment is excessively restricted by the provisions of section 619, I would expect the appropriate Federal regulators to exempt is using their authority…” [1]

The decision to discourage capital formation is an unfortunate instance of regulatory overreach, and for the reasons outlined above, this decision has created a significant disadvantage for VC funds and entrepreneurs located outside of major traditional tech hubs. For perspective, if you remove the three most significant states for venture capital activity (CA, NY, MA), the median size venture capital fund in the U.S. is approximately $28 million, which can often be too small for large institutional investors to participate in a fund.

Fortunately, the Federal Reserve Board and other regulatory agencies with joint jurisdiction over the Volcker Rule recognized the need for change when they launched a reform process and opened a comment period earlier this year. The base proposal sets forth a number of questions for consideration that drew our attention, specifically those that addressed fund characteristics to be acknowledged in changes to the definition of ‘covered fund’ and whether venture capital should be excluded from the definition.

In response to these critical questions and the challenges VC funds have encountered by losing access to an important source of capital, NVCA submitted comments earlier this month on behalf of the venture industry. The comments outline our proposal to exempt venture capital from the Volcker Rule to allow bank investment into VC funds by offering two approaches:

  • A very narrow solution specific to venture capital: the regulators could simply use the SEC’s definition of venture capital, which currently protects VCs from registration requirements, to exempt VCs from the covered funds prohibition; and
  • A broader solution that would create parity between permissible direct investment by banking entities and indirect investing by banking entities through funds. In other words, if banks can finance direct equity investments in startups, which qualifying banking entities are currently authorized to do, they should also be permitted to invest in funds that conduct similar activity.

It is our hope that this reform process will allow the regulators to recognize the legal authority granted by Congress to revise the statute to more appropriately reflect congressional intent and concerns raised during the legislative process.

As NVCA expands upon in our comments, the decision to include venture capital funds in the Volcker Rule does nothing to achieve the objectives of the legislation. Precisely as policymakers like Congressman Randy Hultgren (R-IL) and Senator Mike Crapo (R-ID) have recognized in recent months in support of NVCA’s proposal, regulators should seize this opportunity to support reforms that encourage access to capital and economic growth in areas of the country where it is needed most.

Read NVCA’s full comments here.

For more information on NVCA’s efforts around the Volcker Rule, contact Charlotte Savercool at csavercool@nvca.org

[1] 156 Cong. Rec. S5904-S5905 (July 15, 2010) (colloquy between Senator Dodd and Senator Boxer stating that the statute’s prohibitions should not extend to venture capital funds).