State’s Limits on Capital Access Funds Mean Missed Opportunities

The state government may be muffing a chance to help the owners of tens of thousands of California businesses who scratch for relatively small amounts of outside capital--say, $50,000 to $500,000--to grow their companies.

As of July 1, a new state law gave the Department of Corporations authority to license capital access funds organized to invest in small and mid-sized California businesses much like venture capital funds invest in high-tech start-ups.

So far, however, not one fund has applied for licensing, and the chances don’t look good that the legislation will work as intended.

Why? As you might expect, the devil is in the details--that is, in the law itself and in the regulations written by the Department of Corporations to implement the law. For one thing, the details limit what a manager could earn from a successful fund, and for another, they throw up a procedural roadblock that seems counterproductive.

All of this makes it hard to see why anyone would want to take advantage of the law. Although the Corporations Department appears to hold the power to make the regulations user-friendly, it remains to be seen whether it will.

If it did, owners of many promising businesses in California would breathe a sigh of relief, as the law could greatly increase the supply of capital available to such companies. So would thousands of well-off people who might jump at the chance to invest in small and mid-sized growth companies on the chance that, like traditional venture capitalists, they could grow their capital at 25% or more per year.

Passed by the Legislature and signed by Gov. Pete Wilson last year, the law seeks to create a new pool of capital for California firms by allowing people of ample but not extraordinary means--”accredited investors,” meaning individuals earning at least $200,000 or possessing a net worth of $1 million or more--to pool their resources in investment funds targeting the financing needs of small and mid-sized businesses. According to one study, the number of accredited investors in California alone may hit 600,000, and their assets may total $8 billion.

Traditional venture capitalists ignore such investors, raising most of their funds from institutional investors such as insurers and pension funds. Indeed, by one estimate the number of individuals investing in venture capital funds may total no more than 2,000 nationwide.

In addition, because venture capital funds chase the high-tech industry, they leave owners of many promising low-tech businesses begging for outside capital, and if these people don’t qualify for conventional bank financing to grow their companies, they often have no access at all to outside capital.

The result? Among small and mid-sized businesses, the demand for capital far exceeds the supply, and the California economy does not grow as it might. This is particularly true for the economy of Southern California, which is dominated by low-tech, not high-tech, industry.

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The capital access law might solve this problem by giving accredited investors the chance to earn more on their money than they get from publicly traded stocks, which, over the long haul, earn maybe 11% or 12%, on average.

They may not get that chance, however--and here we come to the devil in the details. The new law requires that the manager of a capital access fund be a registered investment advisor, as defined by federal law, or a licensed investment advisor, as defined by state law. Since the federal and state laws in question govern mutual funds, this restriction, in effect, limits the compensation available to the organizer of a capital access fund to the 1% or 2% of invested assets commonly earned by mutual fund advisors.

You can bet that the organizers of venture capital funds earn a whole lot more than that, and it’s hard to see why they would take the trouble to organize capital access funds for less.

In addition, the regulations require that fund organizers gather at least $5 million from their investors before seeking a license from the Department of Corporations. In essence, this forces investors to commit to a high-risk enterprise without knowing whether it will gain the blessing of the state--awkward at best, and maybe enough to persuade some investors to seek opportunity elsewhere.

The U.S. Small Business Administration, by contrast, routinely issues “go forth” letters giving the organizers of small-business investment companies--SBICs, which are roughly analogous to capital access funds--the SBA’s blessing before, not after, they raise their capital.

William Kenefick, acting commissioner of corporations, defends the regulations as rooted in the capital access law itself and necessary if the state is to protect investors from dubious investment schemes. In essence, he says, the law treats capital access funds as mutual funds to hold their organizers liable for fraudulent acts.

But Lee Petillon, the Torrance attorney who drafted the original legislation, argues that the law also gives the Department of Corporations the authority to go slow in regulating capital access funds in the interests of carrying out the intention of the law--namely to make a new pool of capital available to California growth companies.

Encumbered by regulation, the law may not accomplish anything at all, Petillon says.

Federal law, he notes, exempts venture capital funds from the regulations applied to mutual funds on the grounds that venture capitalists don’t need the protection of the government in assessing the risks they take.

“The managers of venture capital funds aren’t going to subject themselves to regulation as mutual funds just to put together a capital access fund,” Petillon says. “Why should they if they have so much opportunity in financing companies without that regulation?

“And they aren’t going to knock their heads against the wall for 1% or 2% of invested assets. Venture capital funds pay their organizers for performance, and I think capital access funds should too.”

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It’s a forceful argument. In exempting venture capital funds from zealous regulation, Congress sought not to correct an abuse but to promote a good--namely the formation of a new economy based on technology. In regulating capital access funds, on the other hand, the California Department of Corporations seeks to prevent an abuse before it happens. It’s a good idea, but it threatens to prevent capital access funds from forming in the first place.

They should form, because they could do some good in the world.

Petillon knows of only one venture capitalist even considering the establishment of a capital access fund, and Kenefick himself has seen no formal applications. That’s too bad, because the idea had promise, and it’s going nowhere.

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Juan Hovey can be reached at (805) 492-7909 or at jhovey@gte.net.