Leveraging venture capital

July 11, 2012, 6:21 PM UTC

FORTUNE — When the carried interest taxation debate was really raging a few years back, venture capital made a concerted effort to cleave itself from private equity. Then we saw a replay during the Dodd-Frank process, in which venture capital didn’t want to be burdened with certain registration requirements.

In short, venture capital cast itself as the job-creating white knight, compared to private equity’s job-agnostic black hat. Not surprisingly, private equity tried to hold on tight to its more popular sibling – arguing, in part, that VC and PE fund structures are virtually identical.

Ultimately, tax treatment on carried interest remained intact for everyone. And the SEC would create definitions of “venture capital” and “private equity,” in order to satisfy Dodd-Frank.

But I rehash all of this now because of a meeting I had yesterday afternoon with Manuel Henriquez, co-founder and CEO of venture debt provider Hercules Technology Growth Capital. He mentioned how a lot of top-tier VC funds – you know, the ones who can dictate terms to entrepreneurs, rather than the other way around – are using venture debt in follow-on rounds for their portfolio companies. And how, in many cases, the involvement of firms like Hercules is never disclosed.

The idea is basically to maintain pro rata ownership percentages by supplementing debt for some of the new equity portfolio companies were planning to seek in Series B or Series C rounds. Decrease the round size, make it cheaper/easier to fulfill pro rata. One top-tier VC tells me that his firm does this is between 1/3 and ¼ of its portfolio companies, typically in the Series C round.

This relates to the VC vs. PE arguments because venture capital talked about how a key structural differentiator was that it didn’t use leverage. To be clear, I’m not suggesting that widespread use of venture debt creates a systemic risk of anything (nor, to me, does private equity). But if VCs are regularly using leverage to juice their returns, how is that so different from the PE model (save for scale, and minority vs. majority stakes)?

Moreover, the SEC’s definition of “venture capital” doesn’t actually address the debt issue. It only says that VC funds must “invest primarily in qualifying investments, which generally are equity securities directly acquired by the fund.” Well, it’s not the VC fund making the debt investment. It’s a third party, for VC funds indirect benefit. The SEC also says that a “VC fund may not borrow or incur leverage in excess of 15% of a fund’s capital.” When does a VC fund itself ever incur leverage, except perhaps in the case of an HRJ-style warehouse loan?

I’m not proposing any sort of policy changes here, or that VC firms and entrepreneurs shouldn’t avail themselves of firms like Hercules (so long as they don’t over-leverage). Just pointing out that one of the key distinctions between VC and PE isn’t necessarily so distinct…

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