Venture capital funds should be subject to less regulation than hedge funds, to listen to the Wall Street Journal editorialists this morning, who write, "Washington could let the SEC address any concerns simply by adding three questions to the form: Do you use leverage? Do you trade equities or debt? Do you trade derivatives? Anyone answering 'no' to all three would be free to go find the next Microsoft." The editorial is a stirring defense of the venture capital business, but it buys into the idea that federal regulators are capable of determining which hedge funds are systemic risks, and that that endeavor is worth subjecting hedge funds to all kinds of intrusive regulation. The editorial seems to imply that venture capital funds are valuable in fostering innovation, but hedge funds -- "high-rolling hedge funds," the editorial calls them -- serve a less socially useful purpose.
It's a flawed argument and a flawed distinction on several counts, beginning with the argument that trading debt or equity is intrinsically a more risky activity than investing in startup companies. What venture capitalists do, anyway, is trade equity -- they purchase equity in startup companies and then sell that equity for a profit. But it may well be riskier to buy equity in companies with no profits and short track records than it is to buy equity, or bonds, in long-established companies listed on public stock exchanges that have long histories of profits. The Journal's argument seems to imply that you deserve more regulation from the government if you are a "hedge fund" that buys ten shares of IBM or Wal-Mart stock and some Treasury Bills -- "debt" -- than if you are a venture capitalist buying shares of Pets.com or some outer-space interplanetary passenger airline before it goes public or has even opened for business. The "next Microsoft" is made possible not only by venture capitalists that invest at the early stage but by the knowledge of both the entrepreneurs and the venture capitalists that at the end of the road, in a success, is a very big payday in going public and taking advantage of the liquidity made possible by those same equity markets and hedge funds that the editorial seems to deride as high-rollers.
The Journal seems to want to disqualify those using "leverage" from finding the next Microsoft, making it sounds as if the fact "The typical venture capital (VC) firm has nine principals plus five support staff and doesn't use leverage" makes those funds somehow more virtuous. But there is nothing anti-capitalist or anti-innovation about leverage, as any entrepreneur who ever funded a startup payroll or technology purchase in a pinch using a company credit card or personal credit card can tell you. The Journal is owned by News Corp., whose balance sheet shows $6 billion in cash and $14 billion in debt, making it an odd source for a lecture on the evils of leverage. Sure, too much leverage, used carelessly, can be dangerous, and risky. But making the mere existence of any use of leverage a trigger for intrusive government regulation, and the absence of leverage a permission slip for a free pass out of that regulation, seems to be overdoing it.
The Journal's idea of carving out a special exemption for private investment partnerships that invest in privately held high-tech ventures rather than, say, in public debt or equity reminds us of the plan by some Democrats on Capitol Hill to tax the carried interest of hedge fund and private equity partners at higher rates than those of real estate or oil-and-gas partnerships. It's another example of the political class choosing one industry or group to favor over another, rather than relying on a consistent rule of law that applies to everyone equally. If excessive regulation is so bad for the venture capital business, maybe it's bad for all businesses.