Sorry, Venture Capital Needs To Be Regulated Like Everything Else

Venture capital has managed to maintain a decent reputation, even as the crisis has turned other areas of finance into public enemies.

It’s because venture capitalists are seen as breathing life into the great firms of tomorrow, whereas hedge funds use client money to exploit arbitrage opportunities, and PE funds are seen as picking apart once-great companies.

In a NYT op-ed, New York VC Alan Patricoff (SAI #5) and former NY Insurance Commissioner Eric Dinallo urge Obama not to include VC funds under new, proposed financial regulations.

Unfortunately, however, with good intentions, the Obama administration and some members of Congress are aiming this legislation at all pools of private capital. That includes venture-capital funds, which pose no systemic risks and which, especially now, should be kept free of any new reporting rules and allowed the freedom to flourish.

But this just doesn’t fly. We’re long past the day in which you can just declare, without any caveats or explanation that VC funds “pose no systemic risks.” Sure, no VC funds have blown up or triggered a systemic meltdown, but are we really just going to accept a claim like that at face value?

Of course, it’s not obvious now how a VC fund could cause a blowup — but then, very few people saw any blowup coming prior to the crisis. As we’ve learned, our inability to foresee a crisis doesn’t mean it can’t happen.

What’s more, we know money will flow to where it’s not regulated. So a fresh raft of regulations on hedge funds and banks will likely push more money to VC funds, which (emboldened by their regulation-free status) will find ever-more clever ways to invest it, perhaps stretching the definition of what’s really VC investing. This has the potential to incite regulatory arbitrage writ-large.

Even if there’s no “crisis” per se, this kind of market distortion could, over the long term, lead to its own kind of bubbles, causing no less damage (though perhaps less spectacularly).

In an effort to play up the warm and fuzzy feeling about VCs, Patricoff and Dinally conclude note:

The names of companies financed by venture capital are legendary: Cisco, Google, Facebook, Apple, Federal Express, Staples, Yahoo, Amazon, Genentech and on and on. The privately purchased equity securities that helped start these companies supported new technological and scientific ideas, all of which led to new jobs.

But this is just survivorship bias in action, and we shouldn’t be led astray by it. Sure, there are some great, beloved PE-backed firms (which is to be expected over the life of an industry), but there a tons and tons of busts as well. That some companies have thrived does not in itself vindicate the industry in its current form.

Regulation won’t kill the VC industry — we’ll still have future Googles and Twitters and Facebooks — but let’s not be so daft as to leave a huge part of finance unregulated, and then, down the road, look back and wonder why we left that hole wide open.

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