Prior to the effectiveness of the Volcker Rule in April, 2014, we more regularly saw banks participating as limited partners in venture capital funds. The rule placed significant limitations on banks’ ability to make investments in private funds, and over the last 6 years the frequency of investment and capital committed by banks has dropped, if not to zero, very significantly.
On June 25, 2020, various U.S. agencies and the Federal Reserve Board issued a new final rule to revise the 2014 rules, adopting several new exclusions, most notably an exclusion for “qualifying venture capital funds.”[1]
The venture capital exclusion being enacted now in 2020 is intended to support capital formation, job creation and economic growth to small businesses and start-ups, and to help ensure that banking entities can indirectly facilitate this activity (through investments in venture funds) to the same degree that banking entities can do so directly.[2] Promoting these investment and development activities for the U.S. economy is a worthy goal, and the Volcker Rule had the unfortunate consequence of curtailing such activities. Given that the Volcker Rule was designed in general to reduce systemic risk to the financial system, of which from our vantage point we see relatively little such risk arising from investing in venture capital funds, we view this is as a somewhat overdue acknowledgement and course correction of the overbroad nature of the 2014 rule as pertaining to these sorts of investments.
Under the Final Rule, a banking entity is permitted to invest in “qualifying venture capital funds,” in general defined as any fund that meets the “exempt reporting adviser” definition of a “venture capital fund”. This likely creates an additional incentive for venture capital sponsors to stay inside that exemptive definition (for example a venture fund that does secondaries and is considering increasing the proportion of secondaries investments over 20% of fund capital would stand to fall outside this definition, and would have to query if changing strategy is worth it as against being able to attract banks as investors in their fund).
If a bank invests in a venture capital fund, the bank’s investment in, and relationship with, the fund must comply with certain rules regarding material conflicts of interest, high-risk investments, safety/soundness and financial stability. Finally, while less common, if a bank wants to establish and act as sponsor of a venture capital fund, or be an investment adviser to such a fund, additional rules and disclosure requirements apply.
[1] A copy of the Final Rule is available at https://www.fdic.gov/news/board/2020/2020-06-25-notice-dis-a-fr.pdf, and becomes effective on October 1, 2020.
[2] Final Rule, pg. 11.
The authors
