For the first time, I listened in on a live interview by members of Congress with members of the Private Equity and Venture Capital community recently. I was surprised and-then-not that Congress, who closed its eyes and ears to the malaise of our financial systems for so long, is now also buying into the arguments from the participants of that malfunctioning marketplace that there is no systemic risk in Private Equity’s Venture sub-sector. Duh!
Massive systemic risk, financial and spiritual
- Less than 10% IRR produced by VC for the last ten years makes many Limited Partners wonder why they should put their money in Venture Capital, and rightfully so. The result of some of the LP’s withdrawal results in a lack of support for the sector, even if miraculously VC would get its act together. The cultural advantage we have to produce an endless stream of innovation is (and has been, some argue) suppressed by an underperforming financial system that sits on top and squeezes the air out of it. Our competitive advantage as a nation is at stake.
- $2.9 trillion in spin-out revenues (as reported by Polaris Ventures in its public address to Congress) produced by VC over the last thirty years is about to significantly deflate as a result of lack of exits over the previous ten years. The Venture business has produced very few real companies in the last ten years or so, resulting in a massive erosion of spin-out revenues.
- Roughly $297B in yearly venture commitments is hoping on “external factors” to recover, ignoring that subprime (or micro-PE) VC tactics are preventing the intake of genuinely disruptive innovation that would have had the potential to create significant returns. And that while early-stage innovation is very resistant to economic aberrations and in many cases thrives because of it.
- We agree with some of the Titans in the VC business (Mike Moritz, Vinod Khosla, etc.) that Venture Capital has been broken for 20-years, meaning we are steadily amassing a deficit of 40 years of investing in the wrong innovation, further deflating our competitive advantage as an innovative economy.
- The participants in the venture business (see “How to fix VC once and for all”) with real assets, the Limited Partner (money), and the disruptive entrepreneur (idea) are unhappy with the artificial arbitration of Venture Capital, yielding a departure and declining entry of both. So, despite great spin-stories and self-congratulatory statistics from VC lobbying organizations (such as the NVCA), we are witnessing the net outcome of a severe decline in venture job creation and value.
- It is dangerous for Congress to rate our systemic risk low because of the sheer size of our financial system, proudly described by one member of Congress to be larger than that of China, India, and Europe combined. I surmise that is because our financial system is bloated with derivatives, currently eleven times the size of production. We have become a nation of gamblers in derivatives rather than direct investors in the creation of disruptive innovation. The size of our in-transparent and a mostly derivative financial system is an unstable and unsustainable foundation for our economy.
If I had the resources of The White House at my disposal, I could come up with a much larger laundry list of negative spin-out from the underperforming venture business for those who still need it.
Does Congress matter?
Clearly, Congress does not understand the venture business, as it interviewed in that recent session only the derivatives of the venture business, the VCs who hold no assets. If Congress had read my blog “How to fix VC once and for all” as some of its peers in Washington have, it would have invited the real asset holders, Limited Partners (money) and Entrepreneurs (innovation) to verify the actual effectiveness (see “Why do we keep listening to VC as the barometer of innovation?”) of the matchmaking service we refer to as venture capital.
Healthcare reform has been on the books for a long, long time until a new and smarter president (Barack Obama) decided to pull it through the bureaucratic system and deploy free-market principles that expose merit and long-term save us all a ton of money. The (often hidden and recurring) cost of a weak and artificially arbitrated market is much higher than the price of transforming it into a free-market once and for all. But there is a cost, nonetheless, the cost of change.
I count on the President
It is the same leadership that finally allows us to transform the health care system to a free-market and expose the merit of its participants that is needed to reveal the merit of the venture business and our financial system as a whole. Our dependency on a bloated financial system, riddled with derivatives, and artificial arbitration is what blurs the creation of real value.
I do not believe Venture Capitalists are bad people. But the venture business has simply adopted a financial system, with all its impurities, that allowed it to get away with unverifiable merit for too long.
Less regulation is more
As we can learn from Cesar Milan (The Dog Whisperer on National Geographic) that the behavior of a dog is the responsibility of its owner, so is the behavior of those running our financial system the responsibility of our government. Just like any dog can be rescued, so do I believe our financial system can be. That is if we have a pack leader.
Our government needs to institute free-market principles (a few simple filing regulations maintained in a central database) as described in my blog so we can ensure that transparency exposes merit. The merit of which VC (by General Partner denomination) is indeed the expert in spawning and monetizing disruptive innovation he claims to be and at what expense. The transparency of the investments to all marketplace participants (including Limited Partners and Entrepreneurs), will quickly and continuously separate the weed from the chaff. And like free-markets are known to do, they create unique marriages between the outliers of innovation and the outliers of investors.
When the free-market of innovation is in place, and only then, should we evaluate getting rid of costly regulatory compliance such as Sarbanes-Oxley, FAS, and others that were created to curtail the bad behavior of the old artificially arbitrated market? With the erection of free-markets, less regulation can then indeed be more.
A free country is built on free-markets
Capitalism without verifiable merit means we are fooling each other, and the bottom is falling out of our economy because of it. I believe we can rejuvenate and re-authenticate capitalism by deploying free-market principles in our financial system, starting with the venture business. In a free market, those who have merit will become the capitalists, who will then be able to discover and support others with merit. The engine of innovation is revving up again.
I remain at your service, Mister President.