{"id":8198,"date":"2020-12-08T02:35:37","date_gmt":"2020-12-08T02:35:37","guid":{"rendered":"http:\/\/www-staging.carta.com\/sg\/?p=8198"},"modified":"2021-03-05T06:54:03","modified_gmt":"2021-03-05T06:54:03","slug":"volcker-rule-reform-unlocking-capital-for-venture-funds","status":"publish","type":"post","link":"https:\/\/www-staging.carta.com\/sg\/blog\/volcker-rule-reform-unlocking-capital-for-venture-funds\/","title":{"rendered":"Volcker Rule reform: unlocking capital for venture funds"},"content":{"rendered":"

Rarely do new pools of capital become available overnight. But that is exactly what happened October 1, 2020, when regulators revised the Volcker Rule\u2019s <\/span>covered funds<\/span><\/i> section to enable banks to invest in venture capital funds once again.\u00a0\u00a0<\/span><\/p>\n

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.<\/span><\/p>\n

The Volcker Rule and venture capital<\/span><\/h2>\n

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\u2019s depositors to losses or result in the bank\u2019s failure. Such a failure, policymakers feared, would in turn disrupt the broader financial system. Their answer: ban the behavior.\u00a0<\/span><\/p>\n

To do so, Congress enacted the Volcker Rule to prohibit banks from proprietary trading or investing in entities defined as <\/span>covered funds<\/span><\/i>, including venture capital funds. Although well-intentioned, the originally enacted <\/span>covered funds<\/span><\/i> section of the Volcker Rule, which went into effect April 1, 2014, missed the mark. There is no data to indicate that banks\u2019 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.<\/span><\/p>\n

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.<\/span><\/p>\n

Revising the <\/span>covered funds<\/span><\/i> section can change the trajectory of innovation ecosystems across the U.S. We agree with the agencies:\u00a0\u00a0<\/span><\/p>\n

\u201cThe 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.\u201d<\/span>\u00a0\u00a0<\/span><\/p>\n

The revised rule & implications for venture capital funds<\/span><\/h2>\n

In June 2020, regulators recognized the negative effects of the overly broad application of the Volcker Rule\u2019s <\/span>covered funds<\/span><\/i> section and decided to exclude venture capital funds from the definition, enabling banks to invest in qualifying VC funds.<\/span><\/p>\n

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.<\/span><\/p>\n

For the venture fund to qualify under the exclusion, it must meet the definition under Rule 203(<\/span>l<\/span><\/i>)-1 of the Investment Advisers Act of 1940 and not engage in proprietary trading as if it were a banking entity. Rule 203(<\/span>l<\/span><\/i>)-1 requires the following:<\/span><\/p>\n