Volcker Rule Part II: A Lopsided Debate
As I mention in my last article titled Volcker Rule Part I: What is the Law and Why are PE and VC Funds Upset?, the Volcker Rule prohibits financial institutions from conducting proprietary trades and acquiring an interest in private equity funds. The former addresses activity surrounding credit default swaps and collateralized debt obligations that banks bought and sold ultimately leading to the recession in 2008. The latter, which I focus on in this article, seems less applicable to mitigating a future recession.
Put squarely, arguments against the Volcker Rule arise because banks and large financial institutions are prohibited from investing in venture capital funds.¹ Is this an appropriate safeguard to prevent future economic downturn? Spoiler alert, the answer goes back to Congress.
The Text of the Statute and Regulation
My professor and current 6th Circuit Judge emphasized the importance of starting with the text. I don’t want to let Judge Sutton down, so let’s start here. The relevant language of §619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) states:
(a)(1) Unless otherwise provided in this section, a banking entity shall not —
(B) acquire or retain any equity, partnership, or other ownership interest in or sponsor a hedge fund or a private equity fund.
This comes down to whether a venture capital fund should be considered a “covered fund” where the statute states “private equity fund” in §(B). There are arguments that the Dodd-Frank Act differentiates venture capital from other private equity funds throughout the statute. However, the language of the Volcker Rule does not specifically address whether venture capital funds are included, giving some room for push back.
The Securities Exchange Commission (SEC), Commodity Futures Trading Commission (CFTC), Federal Deposit Incorporation Corporation (FDIC), Federal Reserve System, and the Department of the Treasury Office of the Comptroller of the Currency also created regulations based on the Volcker Rule to enforce the law. One example is the SEC’s regulation:
(a)(1) Except as otherwise provided in this subpart, a banking entity may not, as principal, directly or indirectly, acquire or retain any ownership interest in or sponsor a covered fund.
Again, the term “covered fund” is the core issue. The agency did not differentiate venture capital from other private equity funds leading to their inclusion of its enforcement.
While the clarity of the language may be further debated, the next argument may be determinative: legislative history and intent.
Legislative History and Intent
After interpreting the text, legislative history and intent is a typical next step in determining how new statutes should be implemented. For the purposes of this issue, legislative history and intent may be the most important argument and seems to make this a simple answer.
The legislative history specifically shows Congress did not want to include venture capital within the confines of the Volcker Rule’s reach. Senator Boxer clarified the intent to leave venture capital unharmed by the Volcker Rule, and Senator Dodd confirmed stating²:
But properly conducted venture capital investment will not cause the harms at which the Volcker rule is directed. 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 [venture capital] using their authority under section 619(J).
The National Venture Capital Association resources offer additional insight into the matter in an article and an official Volcker Rule Comment Letter. The American Bankers Association submitted a similar comment, specifically addressing venture capital on page 13.
Is legislative history and intent persuasive? I think so, particularly in this instance where the issue is directly addressed in the Congressional Record. That said, relevant agencies like the Securities and Exchange Commission have the right to interpret the statute in their enforcement. Considering the text itself is somewhat ambiguous, the argument exists to allow for the inclusion of venture capital as a “covered fund” unless and until Congress amends the statute.
Risk vs. Return — Overall Impact on the US Economy
Despite the clarity offered in the legislative history, there is always a policy or the common slippery slope argument.
Venture capital is notoriously high risk. Allowing banks to risk their cash may put the entire economy at risk. If the banks collapse, the government will offer a bailout as we have seen time and time again, and the economy and everyday people will ultimately feel the negative impact. Additionally, the slippery slope argument of “but if we let them invest in venture, they’ll keep pushing for more exceptions.” However, banks generally don’t allocate a large enough portion of their investments to induce significant financial stress, and this slippery slope fallacy is a bit extreme under this circumstance.
For example, JP Morgan has ~$278B in cash and equivalents per Yahoo Finance. Let’s say JP Morgan invests $1B across 20 funds, averaging $50M per fund. This represents 0.36% of total cash and equivalents on the balance sheet. $1B is no small number and should not be taken lightly, but the “you’re risking the bank and the economy” argument doesn’t hold up very well. Additionally, the likelihood of the investment being entirely written off is extremely unlikely, and I would encourage someone to send me any examples they can find.
The average internal rate of return (IRR) of a venture capital fund at the 10 year mark is 9.04%.³ It is typical to expect a 3x return on investment from a venture fund. Overall, venture is a well-performing asset class as demonstrated by Cambridge Associates analysis of the industry. The number of jobs only made available from venture capital investment continues to grow, and some of the largest companies such as Google, Facebook, and Uber would not be where they are today without it. This Stanford Graduate School of Business article further outlines the economic benefits of venture capital.
Finally, regarding the slippery slope fallacy, there really isn’t much to say given the clear intent behind Congress. The SEC erred incorporating venture into Volcker based on statements in the Senate. Failing to make appropriate adjustments due to the fear of additional changes would threaten the purpose and ability of passing statutory amendments.
Has there actually been a negative impact?
Everything seems to point towards excluding venture funds from Volcker, but has its inclusion harmed the industry? Assets under management in venture are at all-time highs landing $53.5B in 2018.⁴ There is a plethora of capital in the Bay Area, NYC, and Boston. Some argue the inclusion of venture funds has not had a significant impact on the industry, but the additional protections against banks from irresponsible investments is a positive for the community.
I don’t find this argument persuasive. Particularly due to the lack of capital in the rest of the country outside of the Bar Area, NYC, and Boston. Capital continues to grow on the coasts, but venture funds in the heartland experience difficulty raising new funds. While other potential LPs exist, prohibiting banks with vasts amount of capital investing and growing funds in the Midwest is harmful to industry.
What do you think?
I am admittedly biased. Working in venture capital obviously pushes me towards the viewpoint of easing the fundraising process, given how difficult it already is. However, I can appreciate the impact of the 2008 recession and goal of limiting future economic downturns. Ultimately, I don’t think including venture in the Volcker Rule makes much of an impact in preventing future financial crises, but it does damage the average VC’s ability to fundraise and deploy capital.
This article offers the views of the author and should not be taken as legal advice. The author is not a law student, not a licensed attorney and is not intending to provide legal advice.
[1]There are a few exceptions found in § 12 U.S.C. 1851_(d)(1), but the best case scenario is banks and venture funds spend considerable time and money on compliance in the few instances an exception is applicable.
[2]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
[3] US Venture Capital Index and Selected Benchmark Statistics, Cambridge Associates, December 31, 2017 (found here)
[4]2Q 2019 PitchBook-NVCA Venture Monitor, pg. 30 (found here)
