Prof. Hilary Allen On Venture Capital

After writing Predatory Pricing, via David Gerard, I found Prof. Hilary Allen's Interest Rates, Venture Capital, and Financial Stability. In the abstract she writes:

This Article illuminates one path through which the prolonged period of low interest rates from 2009-2021 has impacted financial stability: it traces how yield-seeking behavior in the wake of the Global Financial Crisis and Covid pandemic led to a bubble in the venture capital industry, which in turn spawned a crypto bubble as well as a run on the VC-favored Silicon Valley Bank.
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It argues for increased monitoring of the venture capital industry by financial stability regulators, given that venture capital is well-positioned to generate asset bubbles now and in the future. More specifically, it argues for more aggressive enforcement of the securities laws to tamp down on the present crypto bubble, as well as for structural separation between crypto and the traditional financial system.

Prof. Allen describes yet another of the many ways the current venture capital industry is malfunctioning, and calls for increased oversight of these risks to financial stability. Below the fold I discuss this and one of the papers it cites.

The fundamental problem is that, for understandable reasons, after the financial industry blew up the world economy in 2008 money was too cheap for too long:

Interest rates are one of the most important policy tools that exist to deal with the aftermath of financial crises, but the aftermath of the 2008 crisis made it clear that accommodative monetary policy won’t always be a complete response to the harms of financial crises. Furthermore, if accommodative monetary policy inspires yield-seeking behavior that causes a subsequent round of financial instability to erupt before interest rates have been meaningfully increased, traditional monetary policy won’t even be available as a crisis response because interest rates won’t have any room to go lower.

Source

Another way of describing "yield-seeking behavior" is that investors don't adequately price in risk and, as a result, pay too much for their investments, thus blowing a bubble. Until recently interest rates had been at historic lows for 14 years, almost one-and-a-half times the span of a typical VC fund. The result was that investors blew a bubble in VC funds:

Charts from the Financial Times ... show that in the United States, both the number of VC deals and the dollar amount invested in VC increased at a reasonably steady pace during the post-financial crisis era of low interest rates, with a significant spike in investment in 2021. “The scale of the most recent venture boom has dwarfed that at the end of the 1990s, when annual investment peaked at $100bn in the US. By comparison, the amount of cash pumped into American tech start-ups [in 2021] reached $330bn. That was twice was much as the previous year, which was itself twice the level of three years earlier.”

At some point the bubble pops as investors come face-to-face with the risks they discounted. It was not surprising that, once interest rates started their recent rise, investors discovered that they had discounted that risk:

And then there are financial stability risks associated with exiting a prolonged period of low interest rates. It is hard to say whether and when these stability risks may be significant enough to justify deviations from inflation-fighting monetary policy, but it remains true that once easy money ceases to be available, that can prick bubbles created as a result of increased yield-seeking behavior during the low interest rate period. Although not all bubbles cause financial instability, financial stability will probably be impacted if banks and other leveraged financial institutions are significantly exposed to a bubble that pops.

VC funds are not at an obvious risk of runs similar to banks:

Fortunately, the end of a VC bubble is unlikely to have any immediate financial stability implications: a VC investor cannot withdraw their money from a VC fund before the end of the fund’s term, and so we need not be worried about runs on VC funds. Even if individual VC funds end up closing at a loss at the end of their 10-year terms, the financial stability implications are likely to be muted. Investors in a VC fund could end up with negative returns at the end of a fund’s term if the fund were not able to exit profitably from enough startup ventures to deliver positive returns to its investors, but those losses would only impact the stability of the broader financial system if the investors were unable to absorb these losses and started to engage in destabilizing behaviors like fire sales of other assets. Such outcomes are unlikely if investors are well diversified.

But Silicon Valley Bank (SVB) and Silvergate were "significantly exposed to a bubble that pops". When SVB suffered a run, the Federal Reserve decided there was enough risk to financial stability that they bailed everyone out, including the VCs that triggered the run, and the USDC stablecoin. SVB was bought down by "herd behavior" among the VCs and their startups that provided the bulk of the bank's deposits.

In the tightly connected world of Silicon Valley, herd behavior is not new. It is endemic among VCs. For example, Nvidia was started in one of the Valley's regular downturns. It was the only hardware to be funded that quarter, but it was pitched to three top-drawer VCs and funded by two (Sutter Hill and Sequoia). Six months later we knew over 30 startups attacking the same market — 3D graphics chips for the PC. Nvidia's pitch had become known and the VCs who missed out on the deal figured that they needed a similar deal. FOMO in action. Why are VCs so vulnerable to herd behavior? Prof. Allen quotes Peter Lee's Enhancing the Innovative Capacity of Venture Capital:

[h]istorical evidence reveals several trends of “hot” technologies receiving significant VC funding and then losing favor. Perhaps owing to the close-knit, socially connected nature of the VC-startup ecosystem, information signals from a few key decisionmakers can steer significant shifts in funding trends.

And observes that:

Lee notes his interviewees’ observations that this herding “creates significant waste and overlooks promising innovations outside the mainstream.” One such interviewee commented that “there’s just countless examples of that, where poor quality innovation is what actually makes it to market, ’cause of the team, the network, the location, the hype, the everything.”

Ain't that the truth! Prof. Allen details some of the reasons for VCs' habit of "spraying and praying". First, the fact that most of their investments will fail:

It is entirely expected that VC funds will see many of their investments become worthless, and so those funds won’t worry about failures in the same way traditional financiers would. Instead, the focus is on the possible exponential upside of a new business, even if its success seems somewhat unrealistic, on the assumption that “the future is best discovered by means of maverick moon shots” – it is these maverick moon shots that will deliver the funds’ returns. Optimism is therefore structural, and not just a matter of groupthink. This is exacerbated because it is difficult to express pessimism in startup investment – short- selling of startup shares is not possible in any meaningful sense, and so there is a pronounced and asymmetric preference for optimism over pessimism.

Second, the way that optimism, as with Sequoia and FTX, leads to inadequate due diligence:

Low levels of diligence can contribute to the growth of bubbles, as they allow more and lower quality startups to enter the market. These limitations of VC oversight may also persist after VC funds first invest in a project: “the board [on which VC interests are represented] typically invests little in compliance and internal controls...because...the company is usually still figuring out if it can even make an innovative product or service that people want and develop a strategy to bring it to market.” If the project goes well, then VCs “need the company’s valuation to keep going up in order to raise another round of financing and not get significantly diluted, and eventually to reach an exit that generates returns.” The desire for exponential growth and profits certainly provide an incentive for VC firms to refrain from being too critical of their investments, as does the clubby natures of the relationships between VCs and founders (VCs are sometimes too worried about scaring away founders to exercise real oversight).

The flood of too-cheap money exacerbated these problems:

VC firms had a glut of money which they had to deploy somewhere: as one industry commentator put it, with money flooding into VC funds, things “quickly went from not enough capital to not enough ideas for the flood of capital to fund.” In such an environment, it would not be surprising for herding to intensify, startup valuations to increase, and diligence standards to suffer:

After discussing the failure of SVB, Prof. Allen turns to the cryptocurrency bubble, arguing that:

the VC industry has played a central role in both building, and sustaining, the crypto industry. While the fact that the crypto industry has not failed completely might superficially seem like good news from a financial stability perspective, in the longer term, keeping the crypto industry going could prove negative for financial stability – especially if the traditional financial system embraces crypto in that longer term.

The attraction of cryptocurrency investment for VCs is the way List And Dump Schemes provide much faster liquidity than developing a startup to the point of IPO or acquisition (hat tip to Fais Khan). The leader in exploting this was A16Z:

As of May 2022, a16z had funded more than $7.6 billion in crypto and Web3 ventures ... A16z’s first crypto investment was in the crypto exchange Coinbase in 2013, and it has since launched several dedicated crypto venture funds, backing at least 75 crypto/blockchain companies. As one industry publication put it, “[c]rypto has become central to a16z’s business, and the firm plans to own large portions of the digital world.” A16z therefore has a vested interest in the success of the crypto industry.

They and other cryoptocurrency VCs were able to use the flood of too-cheap money to pursue their "vested interest" by means other than success in the market:

A16z has used money invested with it during low-interest rate periods to aggressively lobby regulators and legislators. It is no secret that a16z has been pursuing this kind of strategy for some time: as one New York Times article from 2021 put it, “[d]elivering significant returns on all this investment, executives at A16Z quickly realized, would necessitate playing a major role in shaping rules for these companies.” A16z has sent numerous letters to federal regulators, hired a significant number of former government officials, engaged in campaign financing, and organized fundraisers for elected officials: one article reported that “a16z’s leaders have given millions of dollars to pro-crypto candidates and PACs that wound up supporting them.” Overall, the crypto industry is spending amounts on lobbying that are roughly comparable to the defense and pharmaceutical industries, although it has not yet been able to secure the bespoke legislation it seeks.

Perhaps this is because the defense and pharmaceutical industries, for all their rapacious rent extraction, do actually create socially useful products?

Peter Lee's Enhancing the Innovative Capacity of Venture Capital is a fascinating read, full of deft observations such as:

Empirical research on unicorns—private companies with implied valuations of over $1 billion—is consistent with herding behavior among VCs. Tellingly, approximately 40% of VCs had invested in a unicorn, and over 90% of VCs believe that unicorns were overvalued. While numerous theories could explain why many VCs seem to be investing in companies that they believe are overvalued, such behavior is consistent with herding.

And:

Further exacerbating herding is significant concentration in the VC industry; in 2019, the ten largest firms raised a third of all new VC funds.

And:

Study participants describe herding as a sociological phenomenon that often entails following recognized leaders. According to a scientist who has worked with several startups, “I will tell you, from my perspective, there’s a few probably lead venture capitalists, then a lot who follow. And some people will come in early and are risk-takers on things like that. Others will kinda wait and see how things develop.” ... Part of this following mentality arises from a desire to free-ride on the due diligence that lead VC firms have already conducted. One technology transfer official noted that “nobody wants you ‘til one actually is ready to take the lead, then all of a sudden they’re all, all there. Somebody did all the diligence.”

The fact that a small number of high-profile VCs effectively direct the flow of funds to startups is an instance of the "Problem of Twelve" that affects the economy in general. Robin Wigglesworth's The ‘Problem of Twelve’ — redux explains:

Last summer Alphaville wrote a list of the dozen most powerful people of the investment world, inspired by a paper written by Harvard University’s John Coates that argued that “in the near future roughly twelve individuals will have practical power over the majority of US public companies”.

Coates is now back at Harvard Law School after a stint at the SEC, and the original Problem of Twelve article from 2018 has now become an entire book.

Wrigglesworth notes that:

Measured by assets under management, the roughly $4tn in private equity is dwarfed in size by the approximately $20tn or so that resides inside index funds (though a small but growing chunk of this is in bonds, not equities). But the real power of private equity is magnified many times its AUM by the leverage the industry uses.

Together, they are a force to be reckoned with. Coates estimates that index funds and private equity collectively control about 30 per cent of US corporate equity, with private equity actually owning more than index funds.

And while index funds by their nature own a little bit of every public company, a private equity firm’s control over the companies it takes over is total. The Harvard professor therefore argues that the explosive growth of private equity could be even more problematic.

Wrigglesworth quotes Coates, and provides emphasis:

Private equity funds, such as Apollo, Blackstone, Carlyle, and KKR, are doing as much if not more than index funds to erode the legitimacy and accountability of American capitalism, not by controlling public companies, but by taking them over entirely, and removing them from the SEC’s disclosure regime. Private equity funds are creating their own problem of twelve.

. . . Private equity firms have moved beyond the buy-strip-sell model of the 1970s and 1980s to become a permanent, parallel capital universe. They now trade businesses among themselves, and have gathered assets at a rate that outstrips growth by public companies and the economy. While index funds are coming to dominate Berle and Means — style companies, private equity funds are shifting increasing amounts of wealth out of those companies altogether, into a separate system of ownership and control.

Private equity is in part a long-term strategy of regulatory avoidance. Private equity funds are intentionally structured so as not to trigger disclosure laws. The private equity industry helped shape those laws, with lobbying and political influence. Once a private equity fund acquires control of a business, the business goes “dark.” The results are less known to researchers and private equity professionals, much less to the public. General assessments of private equity are necessarily tentative. Yet we know enough about private equity to identify another problem of twelve in the making.

The VCs also have effective control over their startups, avoid regulation, and lobby for them; the same problem at a smaller scale.