US Treasury: Stay away from Venture Capital!
I don't often agree with the editorial page of the Wall Street Journal, but yesterday they got it right. There is no reason for the US Treasury to regulate the venture capital industry. As the editorial points out, VC is too small to create systemic risk for the US economy. If you look at the industries that have done so (banks, investment banks, insurance, perhaps), they all have the common thread that they are funded with debt. Their actual equity capital is a small portion of their holdings. When they have to write down their assets by more than the value of their equity capital, then the banks are insolvent. This is explained very well on NPR's This American Life if you feel like you need a primer on why banks fail.
Venture funds, and their investments, don't have this problem. Venture funds take on very little debt, if any. Usually, they may take on some short term debt to pay expenses between capital calls. It's pretty minor. And, their portfolio companies also take on only modest amounts of debt, as described in the editorial. The loss rates in this type of debt is very low, probably 1% or less.
So, you have investors, entrepreneurs, and bankers that are working with risky companies with their eyes wide open. If the company fails, the investors lose their money, the employees lose the time they have put in, and, rarely, the banks lose a portion of their debt. This sounds like good old American risk taking, with the hope of big rewards in the case where the company is successful. There are some very poorly performing VC funds that have lost most of their investors' money. It's too bad for them, but this doesn't lead to systemic risk. Even if all the start-ups failed, I don't see how it can bring down the economy.
I think that the regulators don't understand the VC business and are lumping it in with hedge funds (which can employ significant leverage and can lose much more money much faster). I don't like the idea of the government regulating either one, but a fair question for the government to ask is about leverage ratios. It would be reasonable to ask VC funds and hedge funds how much they have borrowed against their portfolio, and the cumulative borrowing of their investments. I don't think we should keep people from borrowing, but some level of borrowing is excessive and should be made transparent.
Venture funds would definitely be under any reasonable threshhold of risk. So, they could check that box and be on their way. The government shouldn't then have to worry about them. Perhaps some major hedge funds could be big risks depending on what they invest in. If your whole fund is in credit default swaps or other toxic assets, maybe that should be made more transparent.
All of this goes to say that if the government is going to put regulation in place, I'd like them to start with reporting and transparency, rather than restriction. If AIG had to report the level of risk they were taking with the credit default swaps, their stock price would have taken a beating. And, the executives wouldn't have gone down that path because they would have feared the disclosure. That's a healthy form of regulation that doesn't try to anticipate all of the reasonable ways that people can make money.
Thanks to Jeff Bussgang for being the first person to point me to the WSJ editorial.