The 100 LP rule is a problem that needs solving

Follow me @samirkaji for my thoughts on the venture market, with a focus on the continued growth with the emerging manager landscape

This week, I’ll be joining a panel on Diversifying Capital Allocators at the 40th annual SEC small business forum, which The Office of the Advocate for Small Business Capital Formation spearheads. It’s a great effort to empower investors and small businesses by discussing trends and policies that can foster future growth.

The JOBS act of 2012 represented a significant moment in history when introducing substantial changes to general solicitation, crowdfunding, and Regulation A. The act has made it easier for businesses to attract capital from a wider audience of investors.

However, while investing in startups is more accessible, the irony that exists today is that the safer and generally more responsible route of investing in expert-led venture capital funds is much more challenging.

Venture capital funds typically raise in a manner that allows them to be exempted from some of the required reporting and filing requirements accompanying full registration. To do this, fund managers rely on the 3(c)(1) or 3(c)(7) exemptions contained within the Investment Company Act of 1940, which come with specific stipulations. The latter requires that individual investors have at least $5MM of investable assets (not including primary home equity), which of course, is a small part of the investing population.

Instead, many smaller funds raise through the 3(c)(1) as it allows them to take on the broader supply of accredited investors (who must meet specific income or asset levels) who don’t quite meet the investment asset test for being a Qualified Purchaser. However, for fund managers raising more than $10MM, 3(c)(1) limits the number of beneficial owners, or LPs, to 100 (250 if <$10MM).

Because of this limitation, managers routinely set minimums of $250K-$500K for prospective investors in part to avoid running out of spots, and exceptions are typically made only for those highly networked in the industry. [Note: there are some concerns of managing too many small checks, but there are many ways to automate and reduce the pain of adminstration].

This minimum check creates a virtuous cycle that benefits only very high net worth retail investors or industry insiders, leaving most investors unable to participate (while taking away a substantial capital supply for fund managers).

For example, someone with $2.1MM in investable assets that wants to place 10% of their capital into venture would not meet the minimum of most funds (and even if they were able to invest at $210K, only one fund investment wouldn’t provide that much diversification).

Even someone with $5MM-$10MM is unlikely to build a diversified portfolio of venture investments unless they put most of their capital in the asset category, which generally wouldn’t align with most sound asset allocation strategies.

This of course is also a problem for Fund managers and even more pronounced for underrepresented managers who often don’t have access to typical ultra-high net worth circles. Not accessing the broadest population of qualified investors creates a significant fundraising impediment for diverse managers (who are statistically more likely to fund diverse founders).

While the 100 LP rule was well-intentioned, it is clear that the consequences of the 100 LP limit significantly impact critical capital formation while limiting the benefits of the asset category to a small minority. It also creates the unintended consequence of forcing those that want venture exposure to directly invest in startups themselves, which is far riskier for most investors.

While I know many people in the industry have spoken about this topic and are actively working on changing this provision, more voices are needed to drive the next era of innovation to its maximum potential.