A couple of weeks ago, US Treasury Secretary Tim Geithner unveiled his rescue plan for the US market. The plan includes provisions for the private equity and venture capital industries.
The plan's aim is clear: transparency and new regulation that will prevent the kind of deterioration that the US economy has suffered since August 2007 when the sub-prime mortgage bubble burst. Transparency for venture capital? You could say that since the plan was released, the US venture capital industry has been in a state of high anxiety.
The details of the plan have yet to be finalized, but it is clear that the consequences for the venture capital industry will be considerable. In the US, this industry manages assets to the tune of $200 billion, and, compared with other branches of the investment industry, it enjoys privacy and freedom. The freedom is partly thanks to the fact that it manages private money.
Alongside the objections to tighter regulation, people in the industry also fear higher taxation on venture capital fund profits. As far as regulation is concerned, it appears that Geithner will require venture capital and private equity funds to report to the SEC. The fear among venture capitalists is that he will adopt the proposal of Senators Charles Grassley and Carl Levin for tighter regulation of all investment companies and their advisors.
There are also those who recall that venture capital was responsible for the previous crisis. In 2000, venture capital funds raised some $100 billion, and the bursting of that bubble dragged down the entire capital market. What are venture capitalists afraid of? They fear that over-tight regulation will mean fewer start-up companies and fewer jobs.
Opposition to the rules being drafted is to be found in Israel as well. Michael Eisenberg, partner at VC firm Benchmark Capital, takes issue with the intention to impose the regulations on the world of venture capital.
"Geithner spoke of the need for regulation of anything that could become a substantial threat to the economy," he says, "and I don't see how a venture capital fund could represent a threat to the entire financial system. But we can relax. Regulation will apply to venture capital finds that will be put together in the future, so no problems are expected for funds that have already raised capital."
How far will the new rules affect Israel's high-tech industry?
"It's hard to know what the regulation will consist of. If there's a requirement to report on every investment, that will be impossible. However, for Israel this is in fact a once in a lifetime opportunity, one that could make it a world financial center. If they impose restrictions on the funds in the US, in Israel we should give incentives, loans and insurance that will encourage funds to register in Israel. That way we won't be the carriage but the locomotive.
"Money is mobile. It looks for the place with the freest market and the least regulation. Netanyahu's challenge is not to start on Geithner's track with more regulation, but to be a trailblazer: to create incentives that will bring all the private equity and venture capital funds to Israel. That could generate thousands of jobs."
Eisenberg isn't done. "To attract a financial industry to Israel, there has to be an active capital market. The Israeli market is characterized by a lack of liquidity, because of the concentrations of control in the large companies that prevents shares from being marketable. Here is another golden opportunity instead of giving guarantees and insurance, it's possible to insist that companies should redeem their bonds and issue shares to the public in order to pay. That way, the concentration of control in the large companies will be reduced and the level of marketability and liquidity will rise."
Does that sound realistic to you?
"Why should the taxpayer pay the bonds with nothing in return? Why should taxpayers' money safeguard corporate bonds? No disaster will happen if the controlling shareholders are diluted."
Shibolet & Co. managing partner Adv. Lior Aviram, who manages the firm's high-tech activity, presents a slightly different approach to regulation.
"Traditionally, private equity makes investments carrying lower risk than those made by venture capital. However, the private equity fund managers receive profits only in cases of success. The consequence of this model is that if the fund loses, the managers may not receive profits, but they also don’t lose, and they still enjoy nice management fees. On the other hand, to make a lot of money they have to generate big gains, and that gives them an appetite for high-risk investments. So in the past few years private equity has adopted a mode of activity similar to that of venture capital.
"For its part, venture capital by its nature is intended for high-risk taking at the level of the individual investment, if not in respect of the portfolio as a whole. Good venture capital fund managers are those who know how to channel the high risks and to succeed in generating a suitable return."
And there, regulation is a bad idea?
"Regulation that reduces the motivation of venture capital to take risks is liable to neuter the potential latent in the funds in this area, which, as their name implies, are supposed to take risks. In the US, venture capital is a much smaller field than private equity. In Israel, the situation is different, because here the economy is high-tech orientated in an extreme way in comparison with other economies. Any regulation that prevents risk or reduces the appetite of investors and fund managers will harm this industry.
"It could be that the public in the US that invests in private equity via pension funds needs regulatory protection. By contrast, investors in venture capital, even if they are pension funds, invest only a small percentage of their assets in this area, and their intention in making such an investment is explicitly to take a risk. Any regulation that discourages that will cause damage."
Will venture capital manage to escape the claws of the regulator?
"Any arrangement must leave the funds with the appetite for risk and with reward for managers for good returns. The venture capital industry has a deeply rooted tradition in American culture, and it could be that it will be able to escape decrees that will remove its sting."
Why the panic over the word regulation?
"Because we have seen in the past that sometimes the regulator makes one rule to fit all. The Sarbanes-Oxley rules were imposed on large and small companies alike, and in the case of the small companies that created an unbearable economic burden, with the price far exceeding the benefit, even in the opinion of those who support the law. It could be that there will be an initial wave of regulation, and that after that they will learn from experience and the pendulum will swing the other way. I hope that the strength of the industry and the understanding that it is a small, specific niche will help."
Published by Globes [online], Israel business news - www.globes.co.il - on April 13, 2009
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