Darkened Angels: A Peek Into Financial Reform Sausage-Making

Watching private equity’s efforts to protect its regulatory turf is like watching a political version of Bill Murray’s Groundhog Day. This week, Sen. Jack Reed (D-RI) put the registration of venture capital and private equity firms back on the negotiating table. The controversy of carried interest keeps rising like Dracula from his coffin and the NVCA is petitioning – once again – to fend off those sharp teeth. And, peHUB has learned, two amendments critical to the community of angel investors are due up for discussion later this week.

What gives? A cynic might say that Washington is looking for a new category of campaign donors in the private equity world before November’s elections, given the trend of legislators earning more contributions from those industries they attack; senators who oppose bank reform, for instance, seem to get awfully large piles of cash from banks.

But the cynic wouldn’t capture the whole story. The truth is, the past two years have been a chaotic mix of private investment troubles and fraud – Ponzi schemes ranging from Bernie Madoff to Allen Stanford to Provident Royalties and placement agent troubles have highlighted the worst apples in the private investment industry as a whole. For Congress to not react would be strange.

That doesn’t mean that the reaction is always rational. This is particularly true in regards to angel investors, whose deals often fall under the same rules as private placements. Congress wants to impose rules on private placements, but in the process angels are getting swept into the new rules.

A strange irony resulted: Congress may be riding a populist wave of enthusiasm for reform, but the legislative solution to the problem of Ponzi schemes and other troubles is surprisingly elitist: Washington wants to raise the financial bar to becoming an accredited “angel” investor so that only the truly rich can fund startups. In the financial reform bill, wannabe angel investors can no longer claim the value of their homes towards the $1 million net-worth requirement to becoming accredited. They’ll need $1 million in actual cash and securities.

Requiring angels to be richer – in a recession, in particular – may not make too much sense. After all, anyone who has worked in financial markets knows that “rich” doesn’t necessarily mean “not easily fooled” and it certainly doesn’t automatically translate to “ethical.” And for entrepreneurs looking for money for their startups, any barriers on angel investment means just one more bricked-up door to financing: They can’t use their credit cards – a financing option for one in four startups – because credit-card reform will eviscerate their ability to borrow. Small-business lending is nearly nonexistent. Most new businesses don’t even get to the size where venture capital is an option; in a study for the Kauffman Foundation last year, Paul Kedrosky found that “only a tiny percentage (less than 1 percent) of the estimated 600,000 new employer businesses created in the United States every year obtain venture capital financing.”

So the fact that the pipeline of available angel investors might be shut down frustrates many in the business. One vocal critic is sometime angel Jeff Joseph, a peHUB contributor who wrote this week:

The opportunity to make a private investment in a private venture should be every investor’s right. The ability to invest in a new business should not be an exclusive privilege bestowed by politicians upon persons of a certain economic class.

Joseph told us in a conversation this morning, “This bright-line standard of using wealth to determine economic sophistication is faulty. Why should someone who’s knowledgeable in sector expertise be prevented from investing in an asset class? Why would you take that vehicle for wealth creation away for those who aspire to create wealth?”

To bring the discussion down to earth, Joseph used the example of a cook with 12 years experience who might want to open a restaurant.

Joseph, like other angels we’ve heard from, is particularly irate about the perceived inaction of the only lobbying group for accredited angels, the Angel Capital Association. He believes that the ACA rolled over too easily for financial reform. Joseph also points out that non-accredited angels – essentially, people with a lot of money but no official papers – have no one to represent their interests, because they’re not organized.

We called the ACA to find out how they lobbied for this, and whether the organization felt it had given up too easily. What they told us is an interesting look inside the inevitably dissatisfying business of lobbying in a time of financial crisis.

“You need to think of this in the context of politics,” said ACA spokeswoman Marianne Hudson. “We were lucky to get what we got. It was not our first choice and we did start trying to make changes, but that wasn’t going anywhere.”

The ACA got wind of potential reforms to angel accreditation last Thanksgiving, but didn’t really kick into gear until around March, when the Dodd bill started to take specific shape. By then, the organization found that it had a powerful rival on the other side of the lobbying fight: the North American Securities Administrators Association, or NASAA, which represents state securities regulators. Pursuing what it calls a “pro-investor agenda” for financial reform, NASAA had urged legislators to increase the net-worth of angel investors to $2.5 million – adjusting for inflation from the original $1 million level struck in the 1980s. The financial reform bill also reflected another NASAA idea: requiring angels to wait up to 120 days, or four months, for the SEC to review their investment ideas.

ACA argued against the requirements as too draconian, but the specter of Madoff funds and other fallout compromised the lobbying council’s position, Hudson said.

The ACA started to negotiate downwards, not expecting a total rollback. The $1 million requirement stayed at $1 million, although legislators pushed to exclude the value of the angel’s primary residence from the calculation.

The initial bill also said there would be an automatic increase in the net-worth number every five years based on an index tied to inflation. The ACA negotiated with the SEC to get an agreement that the agency would only review the matter every five years, without an automatic uptick.

The initial bill also called for the 120-day review period for angel deals, which could end up costing entrepreneurs and angels a lot of money in legal bills. The ACA argued to get rid of the waiting period – which was successful. As a compromise, legislators agreed instead to prevent “bad actors” – those with previous evidence of fraud – from getting involved in private placements. Legislators also wanted to give state securities regulators a larger say in regulating these deals; the ACA argued for “federal pre-emption,” or essentially keeping the SEC as the primary regulator.

Overall, the ACA decided to fight the part of the battle that it could, then attack the issue again in the future when political and public outrage diminishes. “You need to think about this as a short term issue,” Hudson said.

It may well be, but there is a long-term issue here: Can private equity interests ever speak the same language as Washington?

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