NB – I have been unfairly general with the term “hedge fund” and “banker” in this piece and I hate myself a little bit (just a little bit) for doing that. Sorry in advance.
It’s fashionable these days to hate on bankers. And at the same time it’s glamorous to be a venture capitalist. Which is weird because these businesses are extremely similar. For instance, I was amused by the recent ranting of a venture capitalist on Twitter who was criticizing the “usurious” fees that banks charge borrowers. He was arguing that it’s unfair for banks to charge high fees to lend money. I thought to myself:
Well, isn’t this rich. A bank is an entity that lends money for a fee. And a venture capital fund is an entity that lends money for a really high fee.
There really isn’t much difference in the business model there except that venture capitalists actually charge more onerous fees than banks do. Remember, a venture capitalist extracts the most expensive thing an entrepreneur can have – their ownership. Of course, the reason an entrepreneur goes to a VC in the first place is because a bank usually won’t lend to this high risk borrower. VC’s know this and so they charge a premium on their loans. Of course, extracting equity isn’t technically a “loan”, but make no mistake, equity or debt, they are lending money for a fee and expecting a positive rate of return just like banks do.
That’s all well and good. I am not your biased or politicized spectator of lending. I come at all of this from an operational perspective and I know that lending is a vital function in the economy. Banks serve an important purpose in the economy as do venture capitalists. But there is a strange association of goodness with venture capitalists that you won’t find with hedge funds and bankers despite the fact that they’re often engaged in the same business.
My guess is that this idea exists because VC’s are viewed as funding “unicorns” and so many of the Silicon Valley companies that are viewed as productive innovators. But this is nothing more than a case of extreme bias as VC’s finance a relatively tiny amount of all business investment. For instance, according to PWC, in 2013 VC’s invested just $29.6B in 3,995 deals. Of the small businesses in existence, fewer than 1% rely on VC funding. Banks, on the other hand, financed $268B in small and micro loans to small businesses in 2013. So, banks play a much more important role in greasing the engines of the economy than VC firms do. And since banks generally charge interest on debt (rather than extracting equity) it’s a near certainty that their form of lending is less costly to small businesses.
Additionally, when we compare VC’s to hedge funds we find all too many similarities. Both charge high fees and both consistently fail to beat public markets. According to the Kauffman Foundation 62% of VCs fail to beat a small cap index consistently. Of the biggest funds, just 4 of the 30 funds with over $400MM beat a small cap index consistently. Venture Capitalists are just high fee active managers with a different legal structure than what we usually think of as high fee active managers.
On the other hand, one of the big differences between many hedge funds and VCs is that the VCs are actually funding investment while many hedge funds are just flipping stocks back and forth all day long pretending to have some black box that will generate superior returns. The latter is almost certainly a waste of time while the financing of investment is absolutely critical to the health of the economy.
The point here is not to argue that VCs are bad for the economy, but to highlight that they serve a function that is quite similar to so many other much maligned financial firms. But we should be clear – starting a company is hard work. Failure is the expectation in most cases. Yet we need sources of funding so we can fail and fail before we succeed. This is how the process of innovation works. The key point here is that we should applaud these lenders who risk capital in exchange for fees and help finance the engine of capitalism. It’s become too easy to demean financial firms these days, but they are the circulatory system in our body and without the competitive flowing of capital in that system it would have died long ago.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.