Last week, CCH released a white paper outlining President Obama’s proposed regulation of hedge funds, private equity, and venture capital. To view the full text of the White House’s proposal, click here. This is largely a reaction to the perceived secrecy of these funds, what they do, how they invest, and how they either are or could pose a threat to the securities markets and economy. The proposal includes an exception for small funds, but rumor is that this threshold is anticipated to be pretty low — $30M to $50M or so.

Dan Primack of PEHub interviewed a representative of the NVCA who did a good job of articulating why venture funds should not be lumped into this group. According to this spokeswoman, “we strongly assert that VC, as important as we believe it is to economy, does not pose a threat to financial stability in U.S. markets. We have no leverage, don’t trade in public securities and people don’t rely on VC-managed funds for liquidity.” Well said. We would add that limited partners monitor venture capital funds in vastly different ways than banks monitor hedge funds.

Regulations like Sarbanes-Oxley and Section 409A of the Internal Revenue Code are costly and can have unintended consequences. In the case of SarBox, good companies that would have gone public in the US often now either resist doing so altogether or register in foreign jurisdictions. Even the companies that do go public have to spend large sums of money on compliance rather than using that money for purposes that arguably would have had a greater social benefit. If SRS were in a position to go public today (go with us on this hypothetical), we would have to think very carefully about whether we were interested because it’s time-consuming, very expensive, distracting, causes irrational management behavior to drive short-term results over long-term strategy, and carries heightened risk. The cost to society of all of this includes that these companies may not achieve their full potential, early investors often lose what used to be a promising path to exit, and the general public loses out on the possibility of investing in such companies.

After the bailout of Long-Term Capital Management, it was harder to argue that large hedge funds that create systematic risk in the economy shouldn’t be regulated. However, requiring VC’s to register as investment advisers or to be subject to whatever other regulations ultimately may be adopted likely will result in a net negative. Venture funds pose little to no threat to the economy or the average citizen, so there’s really no upside to the registration. They are effectively self-regulated by the fact that the LPs that invest in them are often larger and arguably more powerful than the venture funds themselves. Those LPs will sufficiently police operations without the need for government involvement. On the liability side of the equation, this registration will cost the funds money that could have been better deployed, will distract management to the extent that they have to pay attention to these issues, and could (if burdensome enough) cause some individuals who would have otherwise been good venture investors to look for other lines of work.

The challenge, of course, in drafting any legislation is how to distinguish a typical venture firm from a private equity firm, hedge fund, or other entity that possibly is large enough or engaged in investments that could pose macroeconomic risk. Tough question, but that’s what the exceptions to any regulations should do. Regulators shouldn’t lump venture funds into the same scheme simply because they don’t want to do the work of figuring out where to draw the line.