Are VCs Next On Fed Hit List?

Britt Tunick

If Harry Potter were giving away his invisibility cloak, the venture capital industry would likely be among the first beating on his door. With the Justice Department now focused on securities fraud and insider trading in Silicon Valley, VC industry participants expect it is only a matter of time before the Fed’s scope is broadened to include the virtually unregulated VCs.

“Some of the things that I’ve seen when doing due diligence on certain funds have bordered on the abominable and truly indecent,” said Lucy Marcus, managing director of U.K.-based Marcus Venture Consulting, a consultancy for both U.S. and European venture capitalists and start-ups. She said there is no question that things such as questionable accounting practices have occurred in the VC industry, particularly at the height of the dot-com bubble.

“I think they thought that because they were out in California that no one would think to look at them and they’d just get ignored,” said Marcus. “The managers at some of the firms really play fast and loose on this stuff and I think, for some of them, they just simply forgot the rules, or thought the rules didn’t apply to them.”

Industry observers expect that accounting will raise the biggest red flag for regulators-that of both the VCs themselves, as well as the companies within their portfolios. Industry observers cited rampant inconsistencies in everything from the way portfolio companies are valued to the internal rate of return (IRR) calculations they provide their investors. In particular, they said it would not be surprising to find questionable accounting practices related to third-party partnership agreements between portfolio companies-agreements similar to the current investigation into the revenues America Online Inc. reported from some of its own partners such as

“The market has been such that everybody has been so excited to get into VC funds that no one has questioned them about their accounting. But there are no standard rules-none at all. So, you can really make it up as you go along,” said the former head of one large technology VC fund. In fact, he said accounting manipulation is quite common among some of the most powerful VCs.

“There are no rules that I’ve ever heard of in terms of VC funds, LBO funds or any of the ones that have limited partnerships, in terms of their accounting. You can manipulate those numbers incredibly and every single one of them does-whether it’s their IRR or other things,” he said. This individual said that at some VCs, portfolio company valuations have been altered quarterly in order to meet investors’ expectations.

VCs and their portfolio companies don’t have to adhere to generally accepted accounting principles (GAAP). Their general industry practice suggestions come from the National Venture Capital Association (NVCA), which is itself more of a lobbying organization for the industry than anything else.

But while industry observers said accounting issues are still a concern in segments of the VC industry, they also said things have gotten significantly better since the explosion of the dot-com bubble spurred heightened investor demand for transparency and accountability.

“Some of them only recently got CFOs or senior financial managers, but previously had nobody controlling the funds or tracking things. It was a really big problem,” said Marcus. She said that up until the last year or so, many VCs couldn’t even show her their books when she went in to talk with them.

“When we do due diligence we’re looking for good business practices, and up until the past year and a half or so some funds didn’t think of themselves in that context. But good solid, corporate governance practices belong in every business of every kind-most of all fund businesses,” she said.

But even VCs that have been entirely above board with their businesses and accounting practices are facing heightened scrutiny. That has them fuming. “It’s private equity and people should remember that-it’s private, not public. Our investors are all sophisticated, knowledgeable people who understand our industry,” said Brenda Gavin, a managing director with Quaker BioVentures, a biotechnology-focused VC, and an NVCA board member. “If any regulatory agency tries to put some sort of reporting standards on us a lot of them won’t make sense.”

When it comes to issues such as valuing the companies within their portfolios, Gavin said she believes most VCs legitimately try their best to assess those values and look to measurements such as comparable companies. But with early stage companies prone to major valuation swings, it would be all but impossible to levy general rules for accounting on VCs, she said.

Considering the prospect of increased transparency in the industry and providing more of this type of information to the general public, Gavin said such changes would simply create problems for VCs and fund products that have long relied on keeping their investment strategies from their competitors.

If regulations and transparency requirements are levied on the industry, she added, it is also likely more investors would back away from investing in VCs.

“The thing that distinguishes this country from every other developed country in the world is the availability of venture capital here-there’s somebody that’s willing to risk their capital on these deals,” said Gavin, adding that most VC-backed companies could never secure bank loans otherwise. “Our capital is definitely high-risk, but we give a good return to our investors in our portfolio. We’re definitely taking a roll of the dice with some of these, but we will always have enough that make it to give an overall good return.”

But those arguments failed in court recently, adding more impetus for greater disclosure. Indeed, the looming Justice is greater because it comes atop recent lawsuits against the industry that have already begun chipping away at the secrecy VCs are dependent upon. In October 2002, the San Jose Mercury News successfully used freedom of information requirements to sue the California Public Employees’ Retirement System and force it to reveal details about the performance of its $20 billion investment in venture capital and private equity firms. (See CalPERS Opens Up-More or Less,” p.15)

Facing similar threats of lawsuits and an order from Texas Attorney General John Cornyn, the University of Texas Investment Management Company voluntarily published its own venture capital-related investment records in late September.

“The University of Texas is a huge issue because it opens up a lot of issues about VC performance and how they account for a lot of the investments and stuff they do,” said the former VC fund manager. “Just looking at the way they do business, people would be appalled if they just went and said Okay, run of the mill, not even in-depth, how do you value the company and is there one valuation accepted process, method or general industry-accepted number that they compute to show their fund made X%?’… But because it’s all so cloaked in secrecy, it is truly a secretive process and the University of Texas threatens that.”


6 January 2003

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