6 steps to regulate a VC fund [Opinion]

Know your rules. (Image via Pixabay)

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As an angel investor and venture capitalist, most of us actually transact in offshore jurisdictions when making investments due to better regulatory frameworks and more venture-friendly laws. Key setbacks in MENA’s investor regulations include not recognizing different share classes and rights attached to it (with the exception of Kuwait as its commercial law recognizes share classes), shareholders agreements are non-binding at the event of dispute, outdated bankruptcy laws (if any) and finally, no VC-specific asset class investment guidelines with regulators for managing fiduciary money (with the exception of the UAE).  

In the light of the growing number and the size of investments being deployed in the MENA’s technology sector, which are estimated to cross the $1 billion threshold in 2017, and sovereign funds investing money to the VC asset class in the region, there is a need to have  improved and specific guidelines for VCs.

Sovereign funds should also have specific guidelines for VC managers. They should be different than the ones for a VC as this industry is relatively nascent and can’t have the same criteria adopted for selecting a real estate fund manager for example.

Thanks to the UAE, there is a precedent for having such guidelines in the region like the local regulator Abu Dhabi Global Market, which is why it’s prudent for us to share with local regulators to adopt in their local financial services authorities.  

VCs play a vital role in the local and regional economy, nurturing the entrepreneurial ecosystems by providing value-add capital to startups seeking to launch or grow their businesses. As such, there are developmental and economical benefits for local regulators to govern the activities of VC managers and funds. Below is an attempt for regulating VCs in the region, based primarily on my previous learnings from private equity fund management, being an entrepreneur, angel-investing and regulating SMEs:

1- A clear management policy  

VCs should be managed by either a management company or a general partnership (VC manager) to carry on the regulated activity of managing a collective investment fund.

2- Evaluating risks and exits

VCs typically invest in small, minority equity stakes in startups (unlisted private companies) with the purpose of innovating new products or services in large markets. Given the startups’ maturity and risk profile, many of them might go bankrupt and some will exit and generate significant returns, making the entire VC profitable over the life it.

3- Being financially involved   

VC managers are required to invest their own financial resources in the fund, alongside their investors (at least two percent of the VC fund size) to align their interest with their investors over the life of the fund.

4- Covering personal expenses   

VC managers will earn management fees (typically two percent of the VC fund size) to manage their ongoing expenses and they are entitled to Carried Interest (typically 20 percent of VC fund returns to investors) at the end of the VC fund’s life.

5- Adapting valuation, governance and reporting

Given the nature of VC investments, traditional governance and reporting structures may not be appropriate or relevant for a VC manager. Take the example of valuations. Most early-stage fund investments may not be generating revenues or may not yet be profitable for a while. Thus, the investment decisions of a VC manager may be subjective and depend on qualitative assessment and expert judgment of the professional individuals, rather than conventional financial models. Valuation of startups is typically subjective as well, and is to a large extent determined by investors’ appetite during the actual funding rounds of startups. It will be hard to apply traditional fund managers’ valuation requirements for interim reporting requirements on a VC fund.

Governance is also an area that has significantly improved in the MENA region over the past five years. Having different officers perform risk, investment, KYC (know your customer) and admin functions is important, so is having hierarchies in the decision making through committees, advisory board, board, independent members. But that’s not the real value VC managers bring. VCs focus more on value creation, which is why most of their income is invested in value creation teams rather than admin, support, and governance.

6- Meeting the VC manager qualifications  

To qualify as a VC manager, the potential candidate will need to demonstrate that they have in-depth knowledge and experience in the following areas: entrepreneurship and startups, private equity, venture capital, asset management, angel investing and SMEs.

The VC manager will be required to submit the following documents to the local regulators:

  • An annual audited financial statements and audit reports;

  • An annual (at least) VC fund report to investors and regulators;

  • Demonstration of the fund’s ability to meet its liabilities as they fall due, having adequate financial resources to manage its affairs prudently and soundly, and providing its market outlook for the upcoming year.

Long before oil was discovered, Kuwait didn’t have much natural resources but was a major trading hub given its geographic position at the tip of the Arabian Gulf. People made a living by trading goods from up north in Iraq to the rest of the Gulf countries, all the way south east to reach India. On the way back, they would pass by east Africa before finally making their way back to Kuwait. Society was primarily composed of: Merchants with money (investors), captains sailing ships that used to manage merchants’ money (VC managers) and workers that used to do the actual trading goods (entrepreneurs).  Ship captains actually received fees from merchants to manage their investments and pay for the workers, and were incentivized by sharing a percentage of their profits from each trip they made (carried interest); Capitalism at the heart of Adam Smith from the 17th century in Kuwait.

The merchants, captains and workers of our society still exist, we just need to apply this relationship in a way that fits today’s market conditions.

Going back can move you forward.

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