How Venture Capitalists Dig Their Own Political Grave

There have been many debates (to which I contributed some of my viewpoints, see for example peHub’s coverage of Barney Frank’s statements) as to the systemic risk of Venture Capital that is now dutifully looked into by our government to establish the amount of risk Venture Capital (as a sub-sector of Private Equity) poses to our economy, and to embed impending regulations in the Financial Reform Bill.

 

Venture Capitalists have dug their own political grave. Their disingenuous stance is formed by how on one hand they claim to be crucial to the economy (and falsely pat themselves on the back how they create thousands of jobs), and proclaim on the other hand that Venture Capital does not pose a systemic risk (because of its limited size, compared to other asset classes).

 

Neither of the argument mentioned above is valid, as you can glean from my previous articles. Yet they deployed their lobbying organization, the NVCA as the ultimate protector of VC downside, into action and collected 1,700 General Partner signatures in an attempt to persuade the Senate not to impose on Venture Capital the impending regulations put on big daddy Private Equity. A feeble attempt.

 

VC is the financial derivative, not the producer of innovation
Thankfully Barack Obama is smarter than most politicians and demonstrates his ability to separate financial derivatives from producers of value with a single statement: “We understand that start-ups and entrepreneurs are the keys to leading the US out of the recession.”

Notice the subtle distinction in his statement to emphasize the value of innovation versus the value of its financial derivative. The distinction Barack alludes to is that for too long, this country has valued the power of financiers higher than the ability of the producers of the product.

With our financial system eleven times the size of production, our financial system is just too large, and our economy is too dependent on the fragile promise of gamblers. And while Barney Frank appears committed to protecting the financial derivative without really understanding the merit of that financial instrument, Barack Obama is vowing to protect the producers of value.

Related to Venture, the NVCA attempts to protect the power of VCs (as the financial derivatives), while I aim to preserve the future of entrepreneurs. A crucial distinction.

 

VC has not made the point it deserves special treatment
The biggest problem with Venture today is that it has no political leg to stand on to demand an exemption from the rules imposed on Private Equity. Contrary to the self-serving rhetoric of NVCA members, Venture – fully loaded by commitments from Limited Partners the last twenty years – should have produced absolute returns that outpaced technology adoption (7% growth in the worst of our economy) and emptied out a greenfield of 80% of the world’s population that still does not use technology to its advantage.

Venture managed to produce returns below the carriage it rides on. Even by their own statistics, Venture generated less than 10% IRR, lost around $1.7 Trillion in opportunity cost, yielded fleeing numbers of Limited Partners, and embodies an in-transparent market mechanism (in-transparent to all marketplace participants) to which we can only fantasize what financial improprieties will surface when that pandora box is forced to open up.

 

Nothing ventured, nothing gained
Venture Capital was created some forty years ago as a particular sector. A sector that deployed significantly greater risk and rewards than Private Equity. Unlike Private Equity, Venture Capital was meant to take the early risk of a company before it has been proven to deliver market value, on the left-side of Geoffrey Moore’s chasm and managed to move it miraculously to a massive deployment on the right side (see the chart at “Redefining Capital Efficiency“). That required a unique foresight only beholden to a specialized investor with relevant experience. A lot has changed since then.

On the whole, Venture Capital, as the financial instrument to support groundbreaking innovation is dead. Today it can best be described as micro-PE or, as we describe here often, as subprime VC (explained in last year’s article in support of Vinod Khosla’s assessment of the sector). Unfazed, General Partners still rake in cushy management fees (plus micro-PE carry, if at all) defined using rules from the early incarnation of the sector, and blame the lack of results on anything else but themselves. Meanwhile, the key stakeholders in the Venture ecosystem, entrepreneurs with groundbreaking ideas and Limited Partners with a substantial commitment, suffer from diminished deployment and return of risk.

So with Venture Capital predominantly operating in micro-PE mode, it is only natural for it to be painted with the same regulatory brush as Private Equity by politicians who do not see a significant difference in role, performance, and economic relevance.

 

Venture born again
But to assume that innovation is dead because of an underperforming financial instrument that controls it is foolish. And to suggest that innovation will suffer from regulations put on VCs is even more ridiculous, where else would their GPs go where the downside is more staunchly protected than upside? And it would be easy to replace most of them with better performers.

We have incredible entrepreneurial resources that, once supported by a proper financial instrument, will prove their value in gold again. Venture needs to prove its merit as a valuable financial instrument to support the outliers of innovation and the creation of real socioeconomic value.

The way to escape impending regulations is to offer to the President a new market model in which the merit of the sector is appropriately and authentically represented. A market model that promotes taking Venture risk and promotes upside and punishes downside. A marketplace in which the merit of investors, as individuals, can be openly challenged and their rewards appropriately and dynamically adjusted.

 

Manage our own “backyard”
The approach the NVCA takes is once again that of protecting the downside, but doing nothing to promote upside. It makes nothing but empty promises (based on futile arguments about extrapolation or cyclicality of a glorious past) for a better future based on the changing tide of our economy that is supposed to float all boats again.

Sure, IPOs will increase a little bit, but little socioeconomic value will be created, which will yield disappointing post-IPO performance and further erosion of public trust, let alone significant LP returns. The NVCA’s protectionist stance, therefore, is actually hurtful to the investors, as the preponderance of evidence shows that Venture cannot operate in the same way it worked yesterday.

We need to step in and fix our ecosystem unless we want our government to step in and do it for us. The NVCA needs to change its agenda if it wants to preempt government intervention.

 

I disagree with the President’s approach to financial reform
Most reading the above would, therefore, assume I agree with the President on financial reform, and I do with a twist.

I believe financial reform cannot be established by attempting to curtail all improprieties that occur in our current system that is not a free-market system.

Our financial systems (including Venture) are decidedly not free-market systems as they are not transparent to all marketplace participants, are artificially arbitrated, favor the deeply entrenched, and do therefore not support a meritocracy. And that means no matter how many great products we invent, even under the “watchful eye” of regulations, the complacency of incumbent investors will severely dampen the economic value of those products.

So, the top priority of the President as the head of government (and supported by Larry Summers) is to construct the meritocracy of our financial system, so that all of its future participants can act as watchdogs (or better yet roman geese), establish investor merit and flag improprieties that need escalating and further refinement of law. Venture would be a fantastic sector to implement that new market system first.

 

Regulating the current market system is just a waste of precious time and money
Until we see the development of such a system, I side with many VCs and even the NVCA, albeit for less altruistic reasons. Without a real free-market system implementing regulations, the industry will quickly establish workarounds, and no significant improvement in the support for groundbreaking innovation can be expected.

Subprime Venture Capital will not change to prime by simply adjusting the incentives or applying a plethora of regulations; it requires a market model that allows new investors with an authentic ability to spot groundbreaking innovation to join the marketplace and refresh those that have become stale. Even private markets should be transparent (just not publicly investable yet), so the merit of its inherent socioeconomic value is established before the company transitions to a publicly investable entity (IPO).

With the proper free-market construct (as defined in The State of Venture Capital), no longer can over-inflated valuations, ramped up by VCs and settled under cover of darkness by investment bankers, erode the trust of the public.

So, dear President, stop tinkering with useless regulations and let’s fix the systemic risk of our financial systems first.

 

Let’s lead the world by example with new rigors of excellence we first and successfully apply to ourselves.

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