April 16, 2010
By John Mauldin
First, Let’s Kill the Angels
Equal Choice, Equal Access, Equal Opportunity
Some Quick Thoughts on Goldman
La Jolla and Dallas
When you draft a 1,300-page “financial reform” bill, various special interests get language tucked into the bill to help their agendas. However, the unintended consequences can be devastating. And the financial reform bill has more than a few such items. Today, we look briefly at a few innocent paragraphs that could simply kill the job-creation engine of the US. I know that a few Congressmen and even more staffers read my letter, so I hope that someone can fix this. The Wall Street Journal today noted that the bill, while flawed, keeps getting better with each revision. Let’s hope that’s the case here.
Then I’ll comment on the Goldman Sachs indictment. As we all know, there is never just one cockroach. This could be a much bigger story, and understanding some of the details may help you. As an aside, I was writing in late 2006 about the very Collateralized Debt Obligations that are now front and center. There is both more and less to the story than has come out so far. And I’ll speculate about how all this could have happened. Let’s jump right in.
First, Let’s Kill the Angels
I wrote about the Dodd bill and its problems last week. But a new problem has surfaced that has major implications for the US economy and our ability to grow it. For all intents and purposes, the bill will utterly devastate angel investing in the US. And as we will see, that is not hyperbole. For a Congress and administration that purports to be all about jobs, this section of the bill makes less than no sense. It is a job and innovation killer of the first order.
First, let’s look at a very important part of the US economic machine, the angel investing network. An angel investor, or angel (also known as a business angel or informal investor) is an affluent individual who provides capital for a business startup, usually in exchange for convertible debt or ownership equity. A small but increasing number of angel investors organize themselves into angel groups or angel networks to share research and pool their investment capital.
Angels typically invest their own funds, unlike venture capitalists, who manage the pooled money of others in a professionally managed fund. Although it typically reflects the investment judgment of an individual, the actual entity that provides the funding may be a trust, business, limited liability company, investment fund, etc.
Angel capital fills the gap in startup financing between “friends and family” (sometimes humorously given the acronym FFF, which stands for “friends, family and fools”) who provide seed funding, and venture capital. Although it is usually difficult to raise more than a few hundred thousand dollars from friends and family, most traditional venture capital funds are usually not able to consider investments under $1-2 million.
Thus, angel investment is a common second round of financing for high-growth startups, and accounts in total for almost as much money invested annually as all venture capital funds combined, but invested into more than ten times as many companies (US$26 billion vs. $30.69 billion in the US in 2007, into 57,000 companies vs. 3,918 companies). (Wikipedia)
(Incidentally, angel investing got its name from people who invested in Broadway plays, and the term began to be used for investors in similarly risky startups.)
This has become a very big deal in the US. Angel investors put as much money to work as all the mainstream venture capital funds. And the internet has greatly expanded the network of angel investors. In 1996 there were about ten organized angel networks, most quite small. Now there are many hundreds, and some of them are quite large and organized, with some serious money amongst the members.
“Angel investors committed fewer dollars but increased the number of investments during the first half of 2009,” according to “The Angel Investor Market in Q1Q2 2009: A Halt in the Market Contraction” by the Center for Venture Research at the University of New Hampshire. Total investments in the first half of 2009 were $9.1 billion, a decrease of 27% over the first half of 2008, the study reports. However, 24,500 entrepreneurial ventures received angel funding during the period, a 6% increase from the first half of 2008. The number of active investors in the first half of 2009 was 140,200 individuals, virtually unchanged from the same period in 2008. (Tech Transfer Blog)
And according to a conversation I had with the very enthusiastic David Rose of Angelsoft this week in New York, the numbers are growing as the economy improves. If you assume that as many new ventures were funded in the latter half of 2009, then we are looking at 50,000 new businesses last year. At an average of (my guess) 10 employees a firm, plus all the business they contract for, that is at least 500,000 jobs, with the promise of many more for the firms that become viable.
Angel investors do more than just provide money. Many are successful businessmen, and they give guidance and often bring their networks of contacts and potential business partners to the new venture. While I can’t find the statistics, I will bet you that companies that are started with angel money are more successful than those that aren’t.
And remember, that is 50,000 new businesses or more every year, as 2009 was not exactly a banner economic year. This is the very heart of the job-creation machine in the US. It is what keeps this country competitive. And the Dodd bill places this at severe risk. Let’s look at how it would handcuff potential investors.
Here are a few quotes from Venture Beat, a publication of the venture industry. (http://venturebeat.com/2010/03/26/angel-investing-chris-dodd/)
“There are three changes that should have a particular effect on angel investors, a catch-all category which includes everyone from friends and family members who invest in a startup, to unaffiliated wealthy individuals, to side investments made by venture capitalists acting on their own.
“First, Dodd’s bill would require startups raising funding to register with the Securities and Exchange Commission, and then wait 120 days for the SEC to review their filing. A second provision raises the wealth requirements for an “accredited investor” who can invest in startups – if the bill passes, investors would need assets of more than $2.3 million (up from $1 million) or income of more than $450,000 (up from $250,000). The third restriction removes the federal pre-emption allowing angel and venture financing in the United States to follow federal regulations, rather than face different rules between states.”
This is not a partisan issue. Let’s look at what former Google employee, angel investor, and Obama supporter Chris Sacca has to say:
“Obviously, I’m deeply concerned about Senator Dodd’s proposal to place these restrictions on angel investing. I think angel investing is undeniably one of the largest engines for job creation as well as innovation and competitiveness on the global scale for the United States. There’s no doubt about it that the restrictions that he’s proposing would absolutely chill investing.
“Specifically, one of the things we need to take into account is while 10 years ago it may have taken years to build a company, companies are now built in a matter of weeks. So this 120-day waiting period is frankly ridiculous. I have companies with tens of thousands and hundreds of thousands of users that are built in a matter of weeks. They’re generating actual dollars of revenue, creating jobs, investing in real estate office space, capital equipment, etc. If they had to wait 120 days to actually apply for the ability to obtain financing it would absolutely just crush that market.
“I think this is a very short-sighted proposal. It seems far afield from the problems that the banking committee is actually trying to address.”
Additionally, allowing states to set the rules rather than having one set of rules that governs business startups, is guaranteed chaos and adds another layer of costs. Which state will require what rules and how will they conflict? Will a startup have to register with each state where there might be an investor? Aaaggghh! Seriously?
So why is it in there? Let me offer an informed speculation. Remember when I was writing about four years ago about the SEC wanting to raise the accredited investor standards to $2.5 million? I provided a link to let readers comment on that proposal, and about 400 of my readers made 99% negative comments. It went away. And the SEC also lost the ability to regulate hedge funds, through a court decision that said the agency didn’t have appropriate Congressional authority.
So, what’s a regulator to do? Get the language you want inserted into a 1,300-page bill, and add a few extra dollops of authority just to see if you can get it. (And someone from some state regulatory organization had to have lobbied for removing the federal exemption. Those things just don’t appear without someone pushing them.)
During the last contretemps, the SEC had a carve-out (if I remember correctly) for venture capital and private equity funds, as far as the accredited investor qualifications were concerned. They left the limits at “just” $1 million for venture and private equity, while appropriately acknowledging that they had no wish to hurt the venture capital or angel investing mechanisms in the US.
I testified before Congress that the limits should be removed altogether with regard to investments like hedge funds. My argument is philosophical in nature. Quoting from my 2007 testimony (the entirety of which is here: http://www.2000wave.com/article.asp?id=mwo012607):
“Why should 95% (or maybe soon to be 99%!) of Americans, simply because they have less than $1,000,000 (or $2,500,000?), be precluded from the same choices available to the rich? Why do we assume those with less than $1,000,000 to be sophisticated enough to understand the risks in stocks (which have lost trillions of investor dollars), stock options (the vast majority of which expire worthless), futures (where 95% of retail investors lose money), mutual funds (80% of which underperform the market), and a whole host of very high-risk investments, yet deem them to be incapable of understanding the risks in hedge funds?”
Equal Choice, Equal Access, Equal Opportunity
“…. If you were to tell investors that they would be discriminated against because of their gender or race or sexual preference, there would be an outcry. To put it simply: it is a matter of Choice. It is a matter of Equal Access. It is a matter of Equal Opportunity. Congress should change the rules and allow all investors to be truly equal, at least as to opportunity.
“I believe it is time to change a system where 95% (and maybe soon to be almost 99%) of Americans are relegated to second-class status based solely on their income and wealth and not on their abilities. It is simply wrong to deny a person equal opportunity and access to what many feel are the best managers in the world, based upon old rules designed for a different time and different purpose. I hope that someday Congress will see to it that small investors are invited to sit at the table as equals with the rich.”
Let me sadly acknowledge that it is likely that the accredited investor limits will be raised. The handwriting is on the wall, as regulators seem to really want that and have the ear of the bill writers. I hope that is not the case, but I fear that it is. It is not the end of the world, but rather more of a point of personal liberty to me.
But that is not the case in respect to venture and angel investing. There, the difference between the definition of an accredited investor, at a level of $1 million vs. $2.5, million is absolutely critical to the national enterprise. Think of it as a wide pyramid. The number of individuals with a net worth of over $1 million was about 4% of the population a few years ago (it may be less now). The percentages then drop fast for each increase of a million dollars. By raising the standards to $2.5 million, we would be cutting out millions of potential angel investors.
Unless I am missing something, I hear no cry to protect angel investors from themselves. This is a relatively seasoned group. They know that the majority of their angel investments will fail, which is why they get larger portions of the companies they do invest in. The risks are high.
It is not enough that we are going to raise taxes on angel investors. Do we also need to restrict their activities?
Registering an offering with the SEC can be VERY expensive. Legal and accounting bills can mount up to a $100,000 before you know it. And does the SEC really want to monitor 50,000 additional offerings each year? Do you think there would be any hope of a 4-month response time? The most a poor regulator could do would be a cursory reading to make sure the proposal checked all the boxes. I can tell you that an angel investor does more than cursory checking before he puts in money.
Let’s do a back-of-the-napkin cost analysis. 50,000 new ventures times $100,000. That’s $5 billion. That is a hefty cost burden to put on risky new businesses, many of which are raising less than a million. And angel investors typically will not pay for that cost. That will have to be borne by the entrepreneurs, who don’t have the money to being with. Otherwise they wouldn’t need the angels. This will kill many new businesses before they can even get launched.
Quite frankly, I think when the SEC commissioners look into this they will realize the disaster that would be visited upon them if this became law. Their budgets and man-power are already stretched. A little pushing and prodding from those who can should go a long way. If you can make a few phone calls, please do so. I know I will.
Here’s what needs to happen. Get rid of the disastrous rule requiring filing with the SEC. It makes no sense and will cost hundreds of thousand of jobs and divert the SEC from their main tasks. Angel investing has not been a problem to date, and there is no need to fix something that is not broken.
Second, if you really think we need to raise the accredited investor limits, then carve out an exemption for venture capital.
And keep the clause that gives startups federal exemption.
And, if you really want to create jobs, then cut capital-gains taxes on new ventures and angel investing to 10% or less. Let’s create some incentive to get America moving!
Some Quick Thoughts on Goldman
Goldman Sachs is all over the news after being charged with fraud. The way I see it, this is essentially a charge that there was not full disclosure. And it appears to me that that is true. It also is true that Goldman will argue (or I think they will) that only very sophisticated investors who signed very lengthy offering documents were involved, and they should have known better. They were also reaching for yield.
But this is just the tip of the iceberg. I was writing about these “CDOs Squared” in late 2006, and many of these were done in 2007. It was obvious to me (and others) that they were going to blow up. I often wondered who was buying the equity tranches of these synthetic CDOs.
Last week I read a very interesting report from propublic.org about a hedge fund called Magnetar, which basically did the same trade as in the Goldman deal. And they did those deals with nine banks.
I should apologize here and note that I intended last week to send you the entire, if lengthy, article as an Outside the Box, but for the first time in years just got overwhelmed in New York and did not have the time. You can read the whole article at http://www.propublica.org/feature/the-magnetar-trade-how-one-hedge-fund-helped-keep-the-housing-bubble-going.
Let me quote a few paragraphs.
“From what we’ve learned, there was nothing illegal in what Magnetar did; it was playing by the rules in place at the time. And the hedge fund didn’t cause the housing bubble or the financial crisis. But the Magnetar Trade does illustrate the perverse incentives and reckless behavior that characterized the last days of the boom.
“Magnetar worked with major banks, including Merrill Lynch, Citigroup, and UBS. At least nine banks helped Magnetar hatch deals. Merrill Lynch, Citigroup and UBS all did multiple deals with Magnetar. JPMorgan Chase, often lauded for having avoided the worst of the CDO craze, actually ended up doing one of the riskiest deals with Magnetar, in May 2007, nearly a year after housing prices started to decline. According to marketing material and prospectuses, the banks didn’t disclose to CDO investors the role Magnetar played. [emphasis mine]
“Many of the bankers who worked on these deals personally benefited, earning millions in annual bonuses. The banks booked profits at the outset. But those gains were fleeting. As it turned out, the banks that assembled and marketed the Magnetar CDOs had trouble selling them. And when the crash came, they were among the biggest losers.”
Look at the charts below. The financial institutions are once again soaring on new profits, with almost 30% of total corporate profits and a huge proportion of the growth in profits coming in the last 12 months.
Side bet: Goldman and at least 8 other banks are going to have serious litigation costs, if they don’t actually have to eat the losses of the investors in these synthetic CDOs. Understand, these were not securitizations of actual mortgages. They were securitizations of derivatives that acted like these mortgages, and the worst tranches of them to boot. On top of their loan losses, there could be tens of billions of losses to investors in the CDOs they sold. This will play out over years.
As Pro Public noted, the hedge funds did nothing illegal. If the housing market had continued to go up another year or two, most of them would have imploded while waiting for the market to break. More than a few funds did. It can be a difficult thing to bet on the end of the world and then have to wait.
The issue is disclosure. I wonder if the ratings agencies knew. Would that have changed their views?
I hope someone writes an in-depth investigative book about this. I’ll buy it.
La Jolla and Dallas
Tomorrow night I am going to a birthday party for the publisher of this letter, Mike Casson, who will be 65. Mike and I have been close friends and business associates for 40 years. We can’t remember how many deals we have done together over the the decades. But there was one thing in common with all of them: we have never had a piece of paper or a contract. It has all been done by handshake. My grandfather was born in Texas in 1859, and he taught my Dad who taught me that in Texas a man’s handshake is his contract. Mike is a true Texan and a true friend. Without him, you would probably not be reading this letter. A man could not ask for a better friend and partner.
This week has been a whirlwind. After a speech on Tuesday in New York, I appeared on Bloomberg and Fox Business, and then the next day did Yahoo Tech Ticker, along with meetings and an in-depth interview with Steve Forbes at his office, which will be up soon, as well as a turn on Canada’s BNN, remote from the Nasdaq. (I am sure you can Google the others if you care to.)
Then a dinner with Art Cashin (of CNBC fame) with Tiffani and son-in-law Ryan. Art was in rare form, and we learned a lot. (Art, you can’t waffle on me on Maine! You have to be there!)
This week I fly to La Jolla for my annual Strategic Investment Conference, co-sponsored by my partners at Altegris Investments. As usual, we are sold out and I have a few upset friends who could not get tickets. I think we will have to move it to a larger venue next year. It is quite the all-star lineup. Niall Ferguson, George Friedman, Lacy Hunt, Paul McCulley, David Rosenberg, Gary Shilling, Jon Sundt, Mike West and your humble analyst. Seriously, I think we do the best conference in the country. I will report back!
And the Mavericks start the playoffs on Sunday. I think there are half a dozen teams that could win it. We have been doing well lately. I am looking forward to being home most of the next six weeks, and I’m hoping the Mavericks go deep into the playoffs (and win?!?).
It’s time to hit the send button. Have a great week. I know I am.
Your ready for the weekend analyst,
John@frontlinethoughts.comCopyright 2010 John Mauldin. All Rights Reserved