It seems to me that any wholesale reform of financial regulation has to prevent regulatory arbitrage. Right now, IIUC, banks and mutual funds and hedge funds and insurance companies and VC firms and non-bank mortgage companies are governed by different rules and supervised by different regulatory agencies, which allowed people with sketchy business plans to pick the corporate structure that gave them the most favorable regulations. (Thus, for example, non-bank mortgage companies were more lightly regulated than banks, and more deeply involved with subprime loans.)
We need to move towards a system with one common regulatory framework for everything (or at least, everything above a certain level of assets under management), so the people responsible for investing other people's money have an incentive to focus on choosing good investments rather than gaming the system.
Even if VC firms had nothing to do with the current financial meltdown, if they end up as the least regulated class of fund, then they will surely get drawn into the next meltdown.
Hmmm ... definitely a thought-provoking comment. Let me try to play devil's advocate.
> Right now, IIUC, banks and mutual funds and hedge funds and insurance companies and VC firms and non-bank mortgage companies are governed by different rules and supervised by different regulatory agencies, ...
Yes, but there is a good reason for this: these different types of organizations do different things.
> ... which allowed people with sketchy business plans to pick the corporate structure that gave them the most favorable regulations.
Is that a problem? For example, if I want to sell insurance, then regulations that nudge me toward forming an insurance company, can hardly be seen as a bad thing.
> Even if VC firms had nothing to do with the current financial meltdown, if they end up as the least regulated class of fund, then they will surely get drawn into the next meltdown.
I can't disagree with that, even in devil's-advocate mode. :-)
Yes, but there is a good reason for this: these different types of organizations do different things.
Well... not always. For example, both banks and mortgage companies issue mortgages, but the banks are subject to more stringent regulations on how they do it. Some of the esoteric financial instruments that are involved in the meltdown looked and walked and quacked like insurance policies, but regulators didn't account them as insurance policies.
I'm not a finance guy so I can't imagine what the details would look like, but I'd like to see rules along the lines of "if you borrow short and lend long, you are a bank and you are subject to these banking regulations, whether or not you have the word 'bank' in your company name".
My guess is that Obama just got finished with a terrible fight with the speculators involved with GM. He probably isn't thinking of the relatively small money tech VC system, he means them. This is borne out by the first quote:
"the plan requires hedge funds - “and other private pools of capital, including private equity funds and venture capital funds” - to register with the Securities and Exchange Commission (page 38)."
Requiring these speculators to come under regulation is more a response to their recent involvement with the worldwide financial meltdown and continued opportunistic obstructionism at attempts to solve it. Still, though, it'd be good to be careful with real VC funds involved in real investment, and not accidentally suck them up unintentionally. (See SOX and the IPO situation for a good example of how unintended consequences of this kind of regulation aimed at the big guys can accidentally sweep up the unfortunate.)
Let me get this straight. Certain players in private equity attempted to rely on the rule of law; in particular, existing bankruptcy/debt seniority rules. Now the government is going to impose new regulations on that entire industry (and related industries) in retaliation?
> Requiring these speculators to come under regulation is more a response to their recent involvement with the worldwide financial meltdown
Umm, they did significantly better than their more regulated bretheren, the various kinds of banks, insurance companies, and the GSEs.
I note that some of the "reforms" are supposedly aimed at investors who didn't know what they were buying. The most prominent were Fannie Mae and Freddie Mac....
When Obama goes after Fannie and Freddie, we'll know that he cares about finances. His current behavior, "reward friends and punish enemies", shows that he doesn't.
The dotcom bubble created a bear market for equities that dragged down mutual fund performance and cost general investors --- the "smart" ones, who weren't picking stocks, or even verticals --- hundreds of billions of dollars.
Hundreds of billions is tiny compared to what's at risk this time. I witnessed massive fraud in the dot-com bubble. Very little went punished. I have no idea what the new regulations need to look like. But they need to have real teeth and need a reasonable sized army of experts overseeing the regulations. The SEC of the last 10 years was woefully understaffed to deal with our financial industry's activity.
In defence of the dotcom bust, it had very little time to embed it's make believe assets into other parts of the economy. Perhaps if it had inflated slightly slower, it would have managed to affect non internety investments.
The dot-com bust, while perhaps having something to do with the wealth effect that jacked up asset prices, neither posed a systemic risk to the financial sector nor affected non-participants in the market (housing excepted, as always). To blame VCs for the dot-com bust is akin to blaming Jose Canseco for Barry Bonds.
As a former analyst at a venture capital firm, with all due respect, you have no idea what you're talking about.
Regulation doesn't make VC any less attractive for LPs, who provide the funds. As long as there are people who want to commit to the asset class, there will be VC funds willing and available to take their cash.
Furthermore, registration with the SEC increases paperwork, but not in a way that does anything other than provide additional transparency. It's a bit of a pain in the ass, and maybe it means the CFO has more work to do, but to say this is dumb or will kill innovation is misguided. It's the same damn paperwork that every mutual fund has to file. It won't make or break any decent-sized fund.
Everything the NVCA says in their position paper is right (http://www.magnetmail.net/images/clients/NVCA/attach/VCandSy... [PDF]), but excluding VC funds from regulations when you want to look at PE and hedge funds - which can and do pose systemic risks, as we saw with LTCM - is impossible given that all three share the same basic legal structure: LPs and a GP, where the GP is the manager of the fund.
The societal cost of overextending mere registration requirements to VC funds is far outweighed by the cost of not having greater transparency into their PE and hedge fund siblings.
As a sideline observer (but one with a lot of exposure to hedge and VCs) I think it may also be good for the beneficiaries of the capital - 'start as you mean to go on', and all that. As you say, it's not like you're going to have to get some bureaucrat to approve your investment decisions.
Have family and friends in the SEC and OCC, and know some corporate cats who deal with Sarbanes-Oxley. The SEC doesn't want to be dealing with investments for accredited investors, since they already have too much on their plate. On the business side, nobody wants to fill out paperwork, which consumes time and money. IPO on one of the American exchanges used to be a total no-brainer for most companies except a couple industries and geographies. Now London is getting greater play, more companies are staying private, and there's less IPO's on American exchanges - I'm not sure about Japan, Dubai, Hong Kong, or China, but I'm going to guess they're picking up some of the slack too.
Marginally more USA regulation on venture capital = marginally less VC in the States. Marginally more regulation on VC = marginally less SEC time spent on investments for unsophisticated investors, who probably need more protection. You could make a case for it, but I think it's probably an overall slightly to mediumly bad thing.
In a vacuum, I'm not in favor of registration requirements for VC firms - but we're not in a vacuum. We're about mitigating systemic risk to the system. Given that the legal structures are the same, how do you propose to regulate the people who use leverage (PE and hedgies) and leave out the VCs?
Furthermore, if you don't think the SEC is getting a massive influx of capital, I'll be happy to sell you a bridge. Over the East River, Chicago River, Mississippi River: take your pick.
Good comment/questions. I don't have a hardcore finance background, as my background is more business/project management/hint of technology. But two things that really jump out to me -
> We're about mitigating systemic risk to the system. Given that the legal structures are the same, how do you propose to regulate the people who use leverage (PE and hedgies) and leave out the VCs?
Leverage is inherently risky and if you let people leverage to the hilt, they'll find a way to break something. I'm not so much in favor of putting a leash on the leveragers as increasing the cost of money quite a bit. We've been handing out money basically for free for the last ten years. Raise interest rates, take the hit that comes with that, print less, and do a mix of cutting government spending and increasing taxes at least until the budget is balanced. Then do something about the crazy trade deficit. I don't think you can effectively regulate tons and tons of free money. Free money finds a way to cause problems.
> Furthermore, if you don't think the SEC is getting a massive influx of capital, I'll be happy to sell you a bridge. Over the East River, Chicago River, Mississippi River: take your pick.
At its core, the SEC works like a law enforcement agency. No matter how big it is, it'll won't nail every criminal. Any task assigned to the SEC means less time on other tasks. You could triple the SEC's budget and staff, and they'd still be nowhere near fully covering everything. Probably sensible to limit the scope of the agency to the most important parts of the finance sector - VC is accredited investor only, who are people who tend to be financially literate and can afford risk. As for systemic risk, stop handing out free money. Raise interest rates, reserve requirements, balance the budget. I guess that's kind of radical-crazy-go-nuts thinking these days.
The way Obama is currently conducting his presidency has a lot of parallels to what happened when Rosie O'Donnell took over McCalls magazine. The magazine was a strong brand and publication for 117 years. Drastic changes were then applied, including re-branding as "Rosie Magazine", and was destroyed in 17 months.
We need to move towards a system with one common regulatory framework for everything (or at least, everything above a certain level of assets under management), so the people responsible for investing other people's money have an incentive to focus on choosing good investments rather than gaming the system.
Even if VC firms had nothing to do with the current financial meltdown, if they end up as the least regulated class of fund, then they will surely get drawn into the next meltdown.