Since our last post on the state of the venture capital market, the industry has seen even more bad news emerge. A July 1 report issued by VentureSource, a research company focused on the venture capital industry, showed that liquidity in venture capital investments for the second quarter of 2009 fell 57% when compared to the same period last year. The report called the quarter “one of the worst for venture capital-backed liquidity since the doldrums of early 2003.” The entrepreneurial spirit, however, abhors a perceived piling-on of pessimism, and is, by nature, guardedly optimistic; this optimism is reflected in a survey of sentiment among venture capital professionals released on July 9 which showed, despite the gloomy figures for the quarter, a marked increase in confidence among industry figures. The survey noted that while the effects of the financial market disruption on the venture industry will linger for some time, most [venture capitalists] observed an increasingly determined and talented pool of entrepreneurs and a continuing march of innovation.” Similarly, Scott Austin, the author of the Wall Street Journal’s Venture Capital Dispatch, declared the second quarter figures released by Venture Source a “healthy surprise.” While he noted the dramatic (and not entirely unexpected) decline in liquidity for venture capital investments, he believed the numbers evidenced that “investors are putting money to work in health care, with big gains [in terms of investment] occurring across the board in biopharmaceuticals, medical devices, health care services and medical software and information services.” (http://blogs.wsj.com/venturecapital/2009/07/15/expect-a-healthy-surprise-in-2q-venture-funding-report/)

Venture capital managers are not only contending with difficult market conditions; they are also facing the possibility of increased regulation.  Legislation that would require venture capital management firms to register as investment advisers with the Securities and Exchange Commission is gaining momentum in Congress. Among other things, this would subject managers to extensive recordkeeping requirements, requirements governing the manner in which investor assets are custodied, restrictions on managers’ ability to receive performance-based compensation from a fund (such as the “carried interest” allocation customary in the venture capital context) and periodic examination by the SEC staff. Although primarily targeted at hedge fund managers, the investment adviser registration requirements currently supported by the SEC and the Treasury Department would include managers to venture capital and private equity funds within its scope.

Industry professionals as well as representatives from the National Venture Capital Association (or NVCA), the venture capital industry’s main trade association, have appeared before Congressional committees and government agencies argue that venture capital managers should be excluded from the scope of the legislation. These professionals and representatives argue that the potential failure of a large venture fund does not pose the same systemic risk to the U.S. economy as that of a major hedge fund, given that venture funds are not leveraged like hedge funds. In addition, they argue that the activities of venture funds make them less likely or able to engage in the misdeeds Congress seeks to prevent, since venture funds do not “short” stock, do not engage in short-term trading and do not purchase or sell publicly-traded securities that would be most subject to manipulation. As a result, the venture capital industry believes that SEC oversight of venture fund managers is unnecessary, and the resulting burden upon an industry essential to the American economy would outweigh the potential benefits gained or harms prevented. Stay tuned for more to come!