Several private equity and venture capital professionals in the US voiced their concerns to Congress on 26 March, testifying before the House of Representatives' Small Business Committee about a number of issues affecting their industry, including burdensome Sarbanes-Oxley compliance, FAS 157 accounting rules and a capital gains tax hike.
The six representatives were: The Riverside Company chief operating officer Pam Hendrickson, Quaker BioVentures founding partner Sherrill Neff, i2e president and CEO Tom Walker, Blue Tree Capital Group CEO Catherine Mott, Angel Capital Association chairman John May and Patrick Dalton, president and COO of Apollo Investment Corporation.
They were summoned to discuss current issues relating to equity investment in small business, with an emphasis on how the recession has affected investment in small firms. All six emphasised the important role of private investment in driving job creation, innovation and growth at small businesses.
Several of the presenters cited mark-to-market accounting rules as a significant burden. Hendrickson said FAS 157 costs Riverside an additional $500,000 a year due to the additional time spent by the firm's internal team, outside consultants and auditors. Patrick Dalton of publicly traded business development company (BDC) Apollo Investment, described the unique impact mark-to-market accounting rules have on BDCs.
“We are a much less leveraged investment vehicle than banks, with a ratio of debt-to-equity of a mere 1 to 1,” he explained. “Further, we are required by statute to invest at least 70 percent of our capital in small and middle-market US businesses. And while we all make similar discrete hold-to-maturity loans, BDCs are obligated to mark-to-market 100 percent of our loans, while the banks and other commercial lenders only mark-to-market a minority of their assets.”
Sherrill Neff of Quaker BioVentures, speaking on behalf of the National Venture Capital Association, called on the government to provide funding for basic research in life sciences, energy and information technology. In particular, he called for small businesses backed by venture firms to be eligible for Small Business Innovative Research grants.
Neff also asked for comprehensive patent reform to help small companies without sufficient resources to “endless challenges” to their patents by large corporations.
Neff, Hendrickson and Catherine Mott spoke out against the disproportionate burden that Sarbanes-Oxley compliance places on small entities. Mott said that the cost for taking a company to the public markets has become “prohibitive”. “Venture capital funding that should be focused on research, or on sales and marketing, is today being directed towards accounting compliance,” Neff said.
John May warned that the number of potential angel investors is down dramatically, and those who remain have less wealth to invest. Given their important role in funding businesses too small to seek bank loans or even venture capital, the government should be doing everything it can to make angel investing easy and rewarding for those who can still afford it. In addition to criticising Obama's proposed capital gains rate hike, he suggested instituting federal tax credits for angel investors.
He recommended against raising the net-worth threshold for accredited investors, and suggested that the government might establish sidecar funds to invest alongside angel investors. He also said the government should increase funding for programmes that educate angel investors. Finally, he said that the government should not seek to increase regulation of angel investors.
Just what Congress chooses to do with this advice remains to be seen, but in the meantime, the investment community has made itself heard.
PE makes the case for private investment in small business
Text from the prepared remarks of each of the presenters at the hearing
“A few federal initiatives or draft legislation have recommended the establishment of government offices to oversee angel investment or to operate angel investment initiatives. The Angel Capital Association believes that such intervention would not have the intended result of improving entrepreneurs' access to angel capital and/or it would lead to frustration by both small businesses and investors. Past federal government experiments to create databases or websites to match small businesses in need of capital with investors have not worked.”
– John May, Angel Capital Association
“Every BDC, under the current interpretations of FAS 157, finds itself hoarding cash rather than making loans so they will not trip their statutory one-to-one asset coverage test … Apollo Investment Corporation, I am pleased to state, has recently reported that we are in compliance with all of our covenants. Yet, we still must be cautious about using any of our $700 million of available capital toward originating new loans. We have, therefore, voluntarily chosen to curtail new lending activities until such time as there is a resolution to this issue. This means that while we have the ability and desire to lend, we are unable to do so because of the policy and interpretive guidance that has emerged post-FAS 157.”
– Patrick Dalton, Apollo Investment Corporation
“Our system has worked for decades in large part because the capital gains tax structure has motivated venture capitalists to make these longer-term, high-risk commitments. The result has been the creation of assets – new companies and jobs – that did not exist before. Encouraging this investing behavior is exactly what Congress intended when it enacted capital gains tax legislation years ago. It is critical that venture capitalists continue to be rewarded in a manner commensurate with the huge risks we take. Otherwise our risk/ reward equilibrium will be thrown off, and even highly promising companies will not get funded because we cannot justify the risk.” – Sherrill Neff, Quaker BioVentures
“FASB 157, the so-called “mark-to-market” regulation, for example, does not allow us (as an industry) to apply the same methodology we use to evaluate potential acquisitions and exits as we do to value our unrealised investments. Instead, it applies a more public-company, academic approach to unrealised investments. As professionals with decades of experience evaluating small, private businesses, we worry that applying a more academic approach to valuations is actually less meaningful. It also could be doing investors a disservice because it implies some level of risk reduction that just doesn't exist in our world. This disparity is exacerbated by today's extremely volatile public equity market, because these methodologies assume that our assets are much more liquid than they actually are. Furthermore, it costs our investors approximately $500,000 more per year due to the additional time spent by our internal team, outside consultants and auditors.”
– Pamela Hendrickson, The Riverside Company
“This is an important distinction for the committee – the current economic crisis has crippled the average angel investor's ability to invest because their net worth has dropped to a point where they no longer can place discretionary/marginal capital “at risk” on start-up companies. According to the Spectrum Group, a research consultancy group, affluent households with $500,000 or more in net worth declined by 28 percent last year. At BlueTree Allied Angels, since September 2008, two-thirds of our 53 investors have ceased investing in early-stage companies.”
– Catherine Mott, BlueTrue Allied Ang
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