As a professional money manager working in public markets, I love watching how we are portrayed in popular culture. Sometimes we are the card-shark poker player staring down an opponent a la Billions, sometimes the swashbuckling economist like Jack Ryan (who does surprisingly little economics). Thankfully, however, the job is never portrayed as it actually is. I can forgive script writers who exaggerate for dramatic effect. Watching someone stare at Excel for hours on end would not make for very good TV.
The job is exciting in its own way, of course! Finance is a world where knowledge and wisdom matter, and both are applied daily. Modern financial theory is rich and complex, often leading you to conclusions you wouldn’t initially expect. Professional investors spend years learning the theory, then years learning to apply it in the real world. Contrary to the popular entertainment view, an investor who relies on gut and shoots from the hip has a short career.
That’s why the recent article from Wells King of American Compass struck me as hopelessly naïve: arguing that hedge funds, venture capital, and private equity are a net detriment to society. Rather than a professional and well-researched view of financial markets, American Compass argues a TV show version of finance. Entertaining though it may be, it is hardly represents the how the world actually works.
In his analysis, King compares the returns of hedge funds, private equity funds, and venture capital funds to the S&P 500 Index over the past 10 years.
That’s it. That is the extent of his analysis.
From that astonishingly shallow investigation, American Compass concludes that because returns have been lower than those offered by public companies in the past decade, these funds “erode the socially vital savings of pension funds and non-profit endowments,” “embed excessive risk throughout the financial system,” and lead to the destruction of “established industries while failing to build sustainable businesses in their stead,” among numerous other bewildering claims.
These conclusions are as rickety as Mr. King’s analysis. What’s more, they belie an abject ignorance of modern finance that would be laughable if only it weren’t coming from people who tug the ears of policymakers.
For starters, Mr. King would do well to note that much of the returns offered by private equity and venture capital funds come from “side car” investments. As a portfolio company grows, there arise investment opportunities that the fund cannot participate in due to various self-imposed restrictions. These investments are offered to the fund’s investors directly and usually with no fees. Investing in the fund, then, is the price of accessing these unique opportunities. These side car investments are not included in the fund’s reported return, but it is a freshman mistake to exclude them from an analysis.
It is also widely known in the industry that most of the returns come from a handful of funds, especially in Venture Capital. Much of that business is being in the right networks, and these funds have built a competitive edge in their niche—recruiting the best talent and the best deals. The Pareto Principle predicts this in all industries: just a few firms are responsible for most of the success (public markets are the same way, in fact).
It is the threat of competition, however, that keeps these successful funds in check. They know that if they begin to falter, there are hundreds of other firms ready to take their place. I’m sure we would all agree that competition is healthy in any industry. The price of that competition in finance is that many firms deliver below average returns. An overly broad-brush analysis, then, simply reveals what we already knew: 80% of the results come from 20% of the firms.
Yet even if all funds delivered below-average returns, there are still numerous rational reasons to invest in these funds. Modern portfolio theory places a high value on low correlations—the tendency of investments to move differently. Indeed, the theory shows that a rational investor is willing to sacrifice return to own an investment that zigs when everything else zags. That is why people own low-return investments like gold or bonds; this diversification benefit has even been called the only “free lunch” of investing.
My own peer-reviewed research reveals yet another benefit of high-variance, low return investments. With respect to their aspirational goals, people should be willing to give up returns in exchange for a wide dispersion of possible outcomes. We can readily observe this behavior when people buy lottery tickets. No one buys a lottery ticket as a retirement plan, a lottery ticket is a low cost way to try for those wishes we all have. Within the context of some investors and some goals, it may be perfectly rational to allocate wealth to low-return, high-variance investments—like venture capital or hedge funds.
And let us not forget, the past generation has seen the Federal Reserve move interest rates steadily lower—often much lower than is justified by sound economic theory. Our most recent decade has been characterized by lower rates and a steadily increasing supply of easy money. This environment has yielded “easy” stock returns, with passive indexes outperforming almost allactive investment managers, whether in public or private markets. To extrapolate the future from only this past decade is a rookie mistake. Bain & Co ran a more professional analysis and found that the past decade in private equity is an outlier, and unlikely to be repeated. An analysis of only the past decade, with the dangerous implication that this decade is representative of all possible futures, is hardly firm ground for sound policy.
On our current path there are numerous economic dangers. Interest rates are near zero and the negative interest rate experiment has not yet been successfully completed by any country in the world. In professional circles we talk about “The Fed Put”—basically the assurance that bad markets push the Fed to lower rates or increase the money supply. A generation of portfolio managers has outsourced risk management to the Federal Reserve, eroding the foundation of prudent investment management. All of which has caused a significant rise in the market share of zombie firms in our economy—companies which do not even make enough revenue to cover the costs of their debt. The past decade is not normal, and the economic dislocations seen by American Compass are not the result of a free market, they are the direct result of government interference.
It is likely that many current private equity, venture capital, and hedge fund firms would not be competitive under a more laissez faire economic policy. Ironically, the remedy to American Compass’ perceived problem is not to double-down on current policy, it is a move toward freer markets.
Just as the American Compass article is light on analysis, it is equally light on remedy, though one could easily infer a policy position. A ban or curtailment of these funds would not yield a healthier society, but a poorer one. As Mr. King rightly points out, some of the smartest people in the world work on Wall Street. If these funds were indeed yielding negative economic returns, I should think there are no better analysts to determine this than the host of brilliant people working in finance today. Clearly, if it were so, no ban would be necessary—Wall Street, in its own greed and self-interest, would see these funds starve for capital.
There is also a whiff of cronyism at play in the conclusions of American Compass. Disincentivizing venture and private equity funds would create structural barriers for young companies seeking capital. It is the constant threat of disruption that keeps larger, established companies on their toes. Without it, established companies have less incentive to invest in research and development, in efficiency and long-run strategy. Large companies would also be one of the few sources of capital left for start-up entrepreneurs. In such a landscape, it would be considerably easier for large companies to simply “buy and squash” start-ups they deem threatening.
Yes, start-ups, fueled with cash from venture capital, threaten established companies and industries. As much as existing enterprise would like to eliminate that threat, the gale of creative destruction must blow on. It is not arcane investment strategies that are at risk, it is the very infrastructure of innovation.
When weighing the social benefits of any industry in an economy, a deep, balanced analysis is due. American Compass finds itself short on that and rather long on unsubstantiated conclusions. Even worse, the policies implied by their emotional appeal are more of the same policy that endangers the long-term health of our economy today.
I can forgive script writers for the ample dramatic license taken to portray my industry on television and movies. Dramatic license, however, should have no claim on actual economic policy. Any real financial professional would be quick to dismiss the “analysis” of American Compass as amateurish. It is laughable that anyone could use it to advocate for the tearing-down of our innovation infrastructure.
By: Franklin J. Parker, Policy Analyst