What is the basic goal of venture capital? The answer is generally pretty straightforward: Trade cash for equity in companies with the hope of realizing outsized returns on those investments.
Isn’t that pretty much what hedge funds do? If both groups try to do the same thing, then shouldn’t they be regulated the same way?
I think this must have been U.S. Treasury Secretary Timothy Geithner’s line of reasoning during his recent testimony before Congress.
VC’s opposition to this re-characterization was immediate and vigorous, both in the op-ed pages and the blogosphere.
According to the financial team at knowledgefirstfinancialcompanyhistory.ca/ there are a few fundamental differences between VC and hedge funds that merit different regulatory approaches:
1. VC investors tend to be different than hedge fund investors. Hedge funds typically get a higher percentage of their LPs from the ranks of individual investors (high-net worth investors called “accredited investors”) than VCs, who more often are tapping institutional investors such as college endowments and municipal retirement funds. Not to pile on all of those folks who invested in Bernie Madoff, but potential LPs of VC firms typically do a whole lot more due diligence before wiring over the money.
2. The magnitudes of the two industries are different. Of the 168 VC funds that I track (which corresponds to a little over 10% of the total number of VC funds going back to 1976), the mean size is $270 million and the largest are $2.5 billion (New Enterprise Associates XII and Oak Investment Partners XII. I should also mention that NEA is aiming for $3B in their fund XIII). While I easily may have missed the fund with the most assets, my point is that these large VC funds are all small compared with the largest hedge funds. In fact, the $30 billion or so raised by all VCs last year would rank third on a list of the world’s largest hedge funds.
3. Their use of debt is different. In general, VCs invest in early-stage companies that can’t get debt financing precisely because they are so far from seeing revenue. According to Silicon Valley Bank president Greg Becker, quoted in a Wall Street Journal, “Loans to venture-backed firms never account for more than 10%-11% of the bank’s business.” Hedge funds are much more likely to use debt to fund a leveraged buyout.
4. The relationship with their portfolio companies is different. Most VC funds expect to have a 10-year investment window, although individual companies are (hopefully!) held for less time. After that, VCs typically cash out for whatever they can get, unless they can raise additional money to keep their ratable stake in these investments. Hedge funds do not take such a long-term approach to investing.
Simply put, there are no VC funds “too big to fail” and applying sweeping regulatory changes to venture capital that might be desirable for hedge funds or other segments of the finance industry does not make sense. VC is not a “threat to financial stability.”
Mr. Geithner, are you listening?