New Regulatory Considerations for Venture Firms

// Judith Erwin - Founder + EVP, Strategic Business

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September 5, 2013
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When it comes to regulations, it pays to stay diligent.  Last year’s implementation of Dodd Frank exempted venture capital firms from SEC registration for all the right reasons; however, other regulatory changes and trends are likely to affect venture capital firms. While not specifically targeted by the regulations, the impacts to venture capital firms may be fewer product options, increased regulatory compliance and changes to confidentiality norms.  Let’s consider three major issues facing the industry: Basel III, KYC & AML, and FATCA.

BASEL III Requirements and REPO Availability 

On January 1, 2014, Basel III regulations go into effect for banks with more than $250B in total consolidated assets or greater than $10B in foreign exposure.  These large banks are significant issuers of repurchase agreements, the primary investment vehicle for excess funds in venture capital firms.  Generally, collateral used in these transactions are securities issued or guaranteed by the US government or a Federal Agency, and the agreements reset each day.  The new Basel III capital requirements potentially make posting these securities as collateral – and therefore facilitating repo transactions – more difficult, as banks will tend to hold for their own account these government guaranteed securities due to the low risk weighting (and consequently lower capital requirements) they carry under Basel III.  Additionally, the supply of this high quality collateral has diminished because of the Federal Reserve’s asset purchase plan.  On balance, the availability of repo collateralized by high-quality, low risk securities may decline over the near term, resulting in a shift towards lower-quality, higher risk collateral for longer terms. 

We might see the development of alternative interest bearing investment products as a result of this potential shortfall in repo inventory.  The options currently are limited given UBTI is a concern for many venture capital firms.

Know Your Customers (KYC) and Anti-Money Laundering (AML)

KYC and AML regulations have existed in the United States since the 1970s, largely enacted to combat money laundering and the drug trade.  With the implementation of the US PATRIOT Act, the scope of these regulations expanded to include terrorist financing, and spread beyond US borders to many other countries.  Banks and other financial services companies are required to be enforcement agents under these rules, and banks that fail to comply receive significant fines.  AML violations are attracting the attention of regulators – a $1.5 billion fine was levied against UBS in 2012, and India has fined 22 of their banks so far this year – so it is reasonable to expect that banks will be tightening their KYC and AML procedures.

The impact to venture capital firms will be felt primarily at account opening (brokerage accounts, etc.).  Many banks (especially larger banks), acting ahead of potential regulation changes, now require entities opening accounts to be able to provide identifying information down to the “natural person” – or “two legs” – level.  For venture firms, this means drilling down to the Limited Partner level.  For institutional LPs, this may be very straightforward.  For Fund of Funds or Family Office LPs, this may become more onerous.  If the VC firm has established its own AML program in accordance with existing KYC and AML regulations, this may be sufficient to meet these banks’ requirements.  Rather than go into the details of how to build this program, here is a link to FINRA’s website which includes an AML Program Template: http://www.finra.org/Industry/Issues/AML/P011419. Even though this is not yet required by law, many banks now require this in anticipation of the changing regulations.  Venture capital firms and limited partners have traditionally operated at a very high level of investor confidentiality.  These KYC and AML changes could require a significant philosophical and operational shift.

Other related regulatory trends should also be monitored.  The JOBS Act’s lifting of the general solicitation ban for private equity firms also may augment the need for heightened KYC requirements, as many will pursue a new, unknown population of individual investors.  Questions remain about how much due diligence might be required when acquiring the securities of a portfolio company to confirm there are no AML issues at the individual investor level.  In addition, how will portfolio companies receiving investments be required to gather KYC information from their investors?  Will they need to know the LPs in the funds investing in them?  One wonders where the chain ends.   Regulatory changes will inevitably continue, and so must the diligence to manage, understand and comply with the changes.

Foreign Account Tax Compliance Act (FATCA)

FATCA will require Foreign Financial Entities to register with the IRS, starting in July 2014 (although this implementation date has been pushed back since the final ruling).  The focus is on the reporting of US taxpayers for foreign financial accounts and offshore assets as well as foreign entities in which US taxpayers own an interest.  Venture firms with foreign LPs and/or foreign limited partnerships must register with the IRS or be subject to withholding of 30% on any income, which may include any proceeds from the liquidation of any fund investments.  This has been discussed in the industry since 2010, and we will continue to monitor FATCA to see how it ultimately plays out.  Registration with the IRS is now available online: http://www.irs.gov/Businesses/Corporations/Foreign-Account-Tax-Compliance-Act-(FATCA) .  Information regarding what payments or movement of money will require withholding can be found at:  http://www.irs.gov/pub/irs-drop/n-13-43.pdf .

In a world of complex and interrelated regulations, the best defense is to stay diligent and prepare for what those changes mean.


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