Thursday, November 26, 2009

Venture Capital

This BusinessWeek article on venture capital describes why the process of capital formation and nurturing of new ideas is not working as well as it should or it has in the past. Historically, venture capital in the United States has helped us to be very good at the creative part of the creative-destruction process.

It's my view that all the energy that is put into things like proprietary trading and other related non-productive financial activities is damaging to the US. It saps energy and talent away from the higher calling of matching dollars with good ideas to support innovation and entrepreneurship.

Well venture capital is definitely not one of those non-productive financial activities. We need more of it done well and a whole lot less pure speculation and gambling.

Unfortunately, according to the article, venture capital is not working all that well these days.

Some excerpts from the article:

"In the era of the financialization of everything, corporate and public pension funds got in the game."

"Since institutional investors are under pressure to show short-term returns, VC funds are trying to keep them as investors by going for maximum liquidity, creating early payoffs via premature 'exits' (selling some startups in their portfolios within three years, say). Instead of working to make their best startups strong and independent, they're 'flipping' them..."

"In other words, today the traditional VC fee structure promotes haste in putting money to work rather than skill in developing new enterprises..."

The article closed by saying...

"History attests to the importance of capital sources willing to fund unknown companies exploring uncertain innovations. The sooner we revitalize the stale relationship between VC funds and their investors, the sooner the industry can again support America's entrepreneurs."

So venture capital isn't working very well and Wall Street's brightest expend all kinds of energy on things like prop trading instead of using that same energy in more useful ways. In his most recent letter, Jeremy Grantham noted the following:

"As we ponder the problem of prop trading, let us consider Goldman's stunning $3 billion second quarter profit. It appeared to be almost all hedge fund trading."

Things like less than effective venture capital process and too much emphasis on prop trading is a net loss for the US and, at least, partly explains some of our current problems. It comes down to poor allocation of capital and other resources. When capital is poorly allocated there might be a non-sustainable economic "sugar high" while better ideas goes unfunded or gets underfunded (think of all those "dot-bombs"). Long-term, this reduces wealth and living standards.

More from Grantham's letter:

" is worth remembering that every valued job created by financial complexity is paid for by the rest of the real economy, and talent is displaced from real production, as symbolized by all of the nuclear physicists on prop trading desks. Viewed from the perspective of the long-term well-being of the whole economy, the drastic expansion of the U.S. financial system as a percentage of total GDP in the last 20 years has been a drain on the health and cost structure of the balance of the real economy."

Whether it is the current state of venture capital as described in the Businessweek article, prop trading or other related non-productive financial activities, the world would better off if incentives/disincentives were put in place to change the balance. The brainpower being utilized to develop complex trading schemes could certainly be better utilized elsewhere.

Let's just say it's a good thing Brin and Page didn't go to a hedge fund.


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