Dealmaking

Banks can provide capital for VC funds again

The rule was loosened effective on October 1

Investment banks are allowed to invest in direct lending funds and venture capital funds again as either a limited partner and a general partner with the loosening of the 2014 Volcker Rule, which had prevented them from participating in these riskier investments.

The 2010 Dodd-Frank Act included the Volcker Rule to avoid and prevent banks from conducting more risky trading of assets after the Great Recession. 

The rule was loosened effective on October 1 and fears that the rollback could result in “unchecked bank behavior reminiscent of certain pre-financial crisis behavior are not unfounded,” wrote Kevin Tran and Marc Adesso, attorneys for Waller, a Nashville-based law firm.  As such, “significant safeguards remain in place.”

The industry had fought back against these rules. In late 2018, the National Venture Capital Association said that the median size of a venture capital fund outside of California, New York and Massachusetts was $28 million, which was too small in size to attract institutional investors. Silicon Valley Bank said that before the rule was implemented, banks funded 7% of the capital in VC funds and often served as “anchor investors” in an effort to attract additional investments into the funds. 

The changes to the Volcker Rule are meant “to ensure that banks can better serve their customers and direct credit and deploy capital to places in the economy that can most benefit from such attention while staying true to the Volcker Rule’s original intention of prohibiting banks from speculating in markets in a manner that could contribute to another financial crisis,” Tran and Adesso wrote in a blog post. “Banks will need to be thoughtful and comprehensive in their risk analyses before engaging in any newly permissible covered fund activities.”  

Banks providing capital for VC funds will not make a “huge” difference because many of them already have similar existing ventures, said Don Butler, managing director at Thomvest Ventures, evergreen cross-stage venture capital fund based in San Francisco with $500 million in assets. Thomvest Ventures was founded in 1996 by Peter J. Thomson, a director of Thomson Reuters Corp.

Wells Fargo, the San Francisco-based bank, is the main institutional limited partner of Norwest, a San Jose, California-based venture capital and growth equity investment firm managing more than $9.5 billion in capital, has funded over 600 companies including well-known ones such as Uber, Dairy Queen, Kayak and Spotify.

Goldman Sachs said it will raise funds for a $2 billion venture and growth fund, but has not released any details. The investment could have been preparing for the loosening of the Volcker Rule – their pace of investing in startups has increased dramatically over the last couple of years and the bank invested in a record-high 23 startups in the fourth quarter of 2019, according to Crunchbase. Overall, in 2019, Goldman Sachs backed 61 companies, according to Crunchbase data. Goldman Sachs has a history of backing fintech startups, including two that went on to large exits: Plaid (which Visa announced earlier this year it would acquire for $5.3 billion) and Square (which went public at a $2.9 billion valuation in 2015).  

In January, Citigroup said it would launch a $150 million impact fund to address workforce development or  solutions that train and connect people to careers, financial capability or solutions that increase access to the financial system, physical and social infrastructure or solutions that improve an individual’s way of life through housing, healthcare and transportation and sustainability or solutions that address issues related to energy, water and sustainable production.

The banks that will invest in these funds will likely be ones that already have a strategic investing partnership in place or have acquired technology to boost their offerings. 

“This will not necessarily lead to a large difference,” Butler said.

Banks could follow two strategies – create credit funds and establish funds to give more access to family office funds that decrease their risk and would receive investment results sooner.

Since banks are already experienced in lending, the creation of credit funds would be an extension of their current strategy and would be less risky than investments in venture capital-backed companies that can take seven to 10 years to get a return on capital, leaving the capital illiquid for that duration. Some banks already are providing credit to startups, such as Silicon Valley Bank, which has funded over 30,000 startups and Comerica, the Dallas-based bank which provides small business lending, equipment leasing and middle market banking, Butler said.

The family offices of high net worth individuals could also be a larger part of the venture capital ecosystem and invest in more startups, particularly if the startups are focused on industries that the families are familiar with.

Since investments from China to venture-backed limited partnerships took a dive in 2019, the relaxation of the Volcker Rule could prompt a larger inflow of capital since interest rates are low and investors are seeking investments that are not correlated to the stock market.

“This could help fill the gap,” Butler told FinLedger. “We were expecting to see a drop-off in the investment into venture funds, but the combination of low rates and relaxation of the Volker Rule could drive continued investment into venture funds and the entrepreneurs they serve.”

The real winners of the Volcker modifications are the banks, not the VC industry nor the entrepreneurs, said William Andrews, an associate professor of management at Stetson University in DeLand, Florida. The investment banks will reap sizable fees as sponsors or general partners, plus commissions and markups as “they securitize the limited partner interests of the fund and sell them to the hapless retail investor,” he said.

Retail investors could be lured into the promise of greater returns since they will have the “opportunity to buy into the next pre-IPO Google, Apple, Amazon or Facebook through a securitized interest in the fund,” Andrews said. 

These banks will also be able to extend credit lines to the VC sponsors, “knowing that they will be repaid not when the fund matures in 10 years, but when the securitized interests are sold to the public,” he said.

The banks will earn profits via three new sources of fee income, aside from any potential investments they may make as limited partners – as sponsors or general partners they receive fees, as lenders they can provide loans to the fund and they can sell securitized interest in the fund to the retail investors.

The securitization deals associated with all home mortgages failed in 2008-09 since underwriting standards plummeted and many billions of dollars were lost.

“I fear the same will happen with securitized VC deals,” Andrews told FinLedger. “Venture investing is intrinsically high risk.”

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