What if you went to the doctor’s office with a sore wrist and she proposed bandaging your ankle?
That’s how I feel about the government’s proposal that venture capital be regulated along with other private capital pools including hedge and private equity funds. See this Mercury News story, Venture Capital Needs Transparency Not Regulation, for background.
I’m no financial expert, but far as I can tell, the root causes of our current financial crisis are:
- Leverage. Investment banks and hedge funds building 30:1 levered portfolios (and somehow managing to only get 8-10% returns on them). Kind of reminds you of buying on margin as a root cause for the crash of 1929.
- Financial system interlocking and the too-big-to-fail problem. Like it or not, as a citizen and taxpayer, it does seem to me that many of these firms/funds are indeed too big to fail and the government was correct to use my/our money to stop the collapse.
- Agency problems and excess compensation. Basically, you had very smart people who could make $10M+ per year by taking excess risk. When viewed from their perspective, put undiplomatically, who cares what happens to their employers? It doesn’t take many years (e.g., one) of $10M income to become permanently wealthy so senior managers had huge agency issues (where the interests of the owner and the agent diverge) which seemingly were left unchecked both by the companies’ own boards and by government regulators.
- The housing bubble and the conflicts of interests among loan-originating banks, assessors, developers, and mortgage brokers. Arguably, the root cause here is the securitization of mortgages combined with the next point.
- Conflicts of interest in the ratings system. I never knew this before, but the people who pay ratings agencies are the issuers of debt, not the buyers. This would be like Sony paying Consumer Reports to rate their new television sets. Perhaps this is how a portfolio of zero-down, floating-rate mortgages on overpriced houses in Stockton gets rated AAA.*
- The lets-insure-each-other problem associated with credit default swaps. In a tightly interlinked system where each player is too big to fail, this strikes me as a mathematical hallucination designed to make it look like each player is taking less risk. But, in reality, it seems like a bunch of people living on the same street in Florida insuring each other against hurricanes. The question isn’t when will the insurance system fail, but indeed will it ever work — i.e., will there ever be a hurricane that wipes out only a few of the houses in the pool?
- Lack of regulation to control / keep in check the amount of risk, leverage, ratings, and agency issues.
I’m sure I missed some and if you think I got anything wrong in this laundry list, feel free to comment. Because my primary point is that nowhere on this long list will you find anything related to venture capital.
In fact, as I’ve previously argued, venture capital looks quaint by comparison. VCs buy and hold the shares of start-up companies on 5-year, plus or minus, timeframes. No leverage. No ratings agencies. Investment professionals (e.g., foundation managers) are typically the only investors, so there’s no duping of John Q. Public.
Yes, venture returns are down over the past decade. Yes, there are probably too many VC firms and a shake-out is imminent. Yes, VCs make lots of bad investments. Yes, VC is increasingly a “hits business” where the biggest winners in the portfolio account for a disproportionate share of the returns.
Yes, VCs can make a lot of money. (And yes, I view carried interest as income and not capital gains.) And yes, there is probably an element of Fooled-by-Randomness / increasing returns inherent in the VC pecking order.
Sure, there are lots of flaws, but overall, I believe the VC system works. Much as you might say democracy is the least bad form of government, VC strikes me as the least bad way of driving innovation in the economy.
It wasn’t part of the problem, so let’s leave it out as part of the solution.
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* I know the ratings problem is more subtle and involves mixing loans of various quality to stay just-within the bounds of a given creditworthiness level. Nevertheless, I’d argue a “good” rating system would differentiate between a basket of all-solid loans and a basket which mixes solid, semi-solid, and wobbly ones. As an aside and largely from a position of pure ignorance, I’m amazed that someone hasn’t raised some venture capital and tried to challenge the ratings industry with a new consumer-focused model.
