In this episode, Paul talks with Josh Lerner, the Jacob H. Schiff Professor of Investment Banking at Harvard Business School. They discussed what the world might have looked like without the venture capital industry, then talked about current issues and potential changes in the industry.
In his position with HBS, Learner holds a joint appointment in the Finance and the Entrepreneurial Management Areas. He graduated from Yale College with a Special Divisional Major that combined physics with the history of technology, before working for several years on issues concerning technological innovation and public policy, at the Brookings Institution, for a public-private task force in Chicago, and on Capitol Hill. He then earned a Ph.D. from Harvard's Economics Department.
Much of his research focuses on the structure and role of venture capital and private equity organizations. This research is collected in three books, The Venture Capital Cycle, The Money of Invention, and the recent Boulevard of Broken Dreams (which was published by Princeton University Press as part of the Kauffman Series on Innovation and Entrepreneurship).
In the 1993-94 academic year, he introduced an elective course for second-year MBAs on private equity finance. In recent years, “Venture Capital and Private Equity” has consistently been one of the largest elective courses at Harvard Business School.
Kedrosky: I’m here today with Josh Lerner who is the Jacob Schiff Professor of Investment Banking at Harvard Business School. I thought it would be a great opportunity given that Josh is very active on a research front in the context of the venture capital industry to talk a little bit about the health of the industry, what’s going on, some of the dynamics we’re seeing and then some of the current issues that we can talk about. So, thanks for joining us, Josh.
Lerner: My pleasure; delighted to be here.
Kedrosky: So, let’s start at the highest level, and this is a bit of a softball. But, there’s an awful lot of discussion right now about sort of the role and the changing importance or maybe increasing importance of venture capital. What do we really know about the real impact and real importance of venture capital? In a modern economy, take the U.S. as an example, we get some of the over aggrandized claims and a lot of claims at the other end of the extreme that says it doesn’t really matter at all. What’s the truth of the matter?
Lerner: Well, it’s a great question. It’s obviously one not without a terribly easy answer. The most direct thing one can do is of course to simply add up, for instance in the stock market, the number of companies that are our venture gaps and look at that. And yeah, they are a pretty significant story. It’s somewhere in the order of 13 percent of all publicly traded companies and around 10 percent of the market capitalization is venture backed companies. But, that doesn’t really give us what we want to know which is not so much what kind of role venture capital, you know, what kind of company’s venture capitalists are associated with. But rather, we want to know really what does venture capital do in terms of causal impact? In other words if venture capital wasn’t there, would those same companies have been there or would they have not grown?
Lerner: Certainly, there are any number of reasons. You could make arguments you could make from an intellectual point of view as to why venture capital should play a positive role from overcoming information problems to dealing with being very good at dealing with companies that have very intangible assets, which clearly some events really struggle with. But in terms of really showing it, what you’d love to do is be able to do really an experiment where you say let’s have two worlds. One where there is venture capital and one where there isn’t and see how they unfold over the series of the next few decades. That’s obviously a little hard to do. The alternative is you might want to tell venture capitalists you fund this company, this company and that company. Don’t fund these other three. Let’s see how things turn out. Again, that’s a little tough to arrange. So as a result, you know a lot of the work that’s been done has been really more relying on indirect inferences. So for instance, doing things like looking at policy changes that have taken place. You know, so for instance in the United States in the late 70s, pension funds were opened up for the first time and given permission to invest in private equity, in venture capital, and sort of looking at what the consequences of that shift were in terms of the, you know, which of course led to a lot of additional money. But what happened in terms of innovation as a result? In any case, there’s, you know, a variety of econometrical approaches that people have taken, but the bottom line seems to be that, at least when it comes to spurring innovation, that the dollar venture capital seems to be about as powerful as three to four dollars of corporate R&D. So in other words, you know, for instance for much of the period of the 70s, 80s and 90s, venture capital was something on the order of three percent on corporate R&D spending. But during that period, it represented somewhere in the order of generating somewhere in the order of ten to twelve percent of all the innovations in the United States. So you know, viewed that way, it seems that even after adjusting for causality however perfectly, it still seems like there’s a quite positive role being played by these funds.
Kedrosky: I think that’s a nice way of trying … at least for aiming at a high level. Maybe this lets us talk a little bit about the modern or the recent history of the industry. You know the industry is in quite a state of flux right now, and it’s sort of in a, you know, we’ve talked about this before. But, you know, this has been sort of a partnership flux as a lot of the name brand partners at some of the major firms are moving on. It’s kind of gone through a dry period from the standpoint of a performance flux, and in many ways, I’d argue it’s going through sort of a sector flux. That many of the sectors that drove most of the performance, certainly IT prominent among them, dating back to, you know, even the early 1980s are all sort of I’ll say at least changing if not disappearing or reducing in importance. I’m wondering, you know, in terms of looking at history and what it tells us about what the industry looks like going forward. What does all this flux tell us? Is this an industry that’s sort of in a state of dynamic disequilibrium, or is this an industry that’s actually, you know as some of its critics like to say, that’s sort of being disrupted from the bottom and really won’t look the same over the next few years. Let’s just sort of look at all these different sources of flux.
Lerner: Well, it’s a great question, and again, it’s probably not one with a tremendously easy answer. I think you can look at it, you know, from two perspectives. One of them is that this has been really from its very inception and certainly the 1950s, yeah, a tremendously cyclic industry where it’s had ups and downs. The basic pattern seems to be that, you know, during the periods when everyone is wringing their hands saying, you know, “Things are really bad; returns don’t look good, the industry is on its last legs and doesn’t work anymore,” with the benefit of hindsight, those usually tend to turn out to be the best times to be investing in it. So, there is this sort of a long, I guess you could describe it as self correcting, aspect to it in the sense that typically these periods lend, you know, this sort of spirit of crisis sets in when there’s twice been disillusionment are also associated with falling commitments to venture capital funds, groups having less money to invest, less competition for deals, lower valuations. Then four to five years later, you know very attractive returns. We’re talking about lack of competition. At the same time, one can make a case that, you know, this time is different. I think that were you inclined to do so, you’d highlight something that has really been taking place for at least the last decade but which has certainly accelerated fairly dramatically, which is this bifurcation in the venture capital industries. That following in the footsteps of investment banks and a number of other, you know, high end intermediaries, what we seem to be seeing is that there’s, rather than assuming a continuum of venture firms, we’re really getting this division between certain large groups with a lot of capital with often, you know, a whole family of funds geared towards Europe, or Asia, or later stage investing and the like on the one hand, and then much more targeted focus funds, sometimes dubbed super angel funds on the low end.
Lerner: It’s not as clear that there’s going to be as much stuff in the middle as much as, you know, sort of an industry which looks quite different in terms of distribution of … on sizes, [inaudible]. As I said before … I’m sorry, go ahead.
Kedrosky: No, I was going to say … I’m curious how you’d respond to this, but with that in mind, some friends of mine in the industry like to say that, you know, the industry tried an experiment over the last decade with mega funds. They tried … they called it the great decade long experiment in venture capital mega funds. Their argument is … and again, this is somewhat a self serving argument because it’s a smaller seed centric fund, but nevertheless, the point is interesting that the industry tried an experiment in mega funds and mimicking in many ways what happened in private equity and buyout funds. The experiment failed. Would you go along with that that it’s the industry tried an experiment in mega funds, and it turned out to be a failing experiment?
Lerner: Well, I think it’s really too early … it’s really too early to tell in the sense that … I mean we know that venture tends to be a business which … where to really get a good report card as to whether things work or don’t work one needs a somewhat more extended time frame, and let’s say in terms of assessing hedge funds and the like. That it tends to be much associated with, as you know, these periods where there’s this sort of … the market window opens and then a lot of stuff gets rushed out. Then you can sort of really take sport and see where things stand. I don’t think we can really tell what the answer is. My guess is that just as in the buyout side we’re probably going to end up in the equilibrium where you’ve got both kinds of funds … where you have very large funds and very small funds in that in some sense there’s going to be a clientele factor. There’s going to be certain clientele which wants certain kinds of investors who want each kind of fund. It may not be that their returns are equal. It may well be that the smaller and more focused funds do better, but that doesn’t mean that large funds are necessarily going to go away.
Kedrosky: You’re closer to the data on this than I am, but my impression, or at least the hearsay that I have on it is that most of the modern performance of the industry comes from funds with less than a $100-120 million under management. Is that right? Is that properly characterized?
Lerner: Well, I think that you have to be careful in several respects which is clearly one needs to control or, you know, looking at the relative period of the fund and its ways and many other considerations. But, I think the basic data suggests there is some sort of inverted U kind of shape that characterizes the industry, which is to say that once you control for the funds in Europe, or in the U.S., or Asia, or whether it’s early stage or more later stage, you know, just sort of start doing all the controls that you can think of and the [inaudible] it was raised and so forth, that neither the very largest funds go into various small funds as well as their peer group. It seems like that the sweet spot seems to be more the funds in the middle in terms of size which seem to have generally outperformed their peers. Presumably, the smallest funds, at least historically, they’ve been such substantial to this economy as a scale …
Lerner: … that you just need … this economy … there’s sufficient economies of scale or just economies being so small that essentially it’s been very hard to, you know, be really successful at running these very small funds. On the other end, it seems clear that the very largest funds run into their share of issues as well.
Kedrosky: This kind of leads into this discussion, and it’s kind of in the headlines right now. But, this discussion of sort of the structure of venture capital compensation and sort of this alignment or misalignment between VC’s and their investors, limited partners, you know the current headline issue is this discussion of carried interest taxation. Some are arguing that these mega funds, which obviously if you’re just to have grossly generalized, if you assume that they’re getting management fees on the order of two or some sliding scale around two percent of assets under management that there’s kind of a misalignment problem kicks in and that, you know, because you can become quite fairly wealthy just off management fees without having to produce carried interest. And then on the other side, there’s an incentive from the standpoint of limited partners that we want our investors to be really focused on carried interest and to be paid out of this carried interest this bonus that they get, if you will, out of successful investing. The current discussion in Congress has been about changing the tax treatment of carried interest such that it would be taxed instead of being taxed as capital gains. It would be taxed as ordinary income. Let’s just sort of talk through this a little bit about maybe the genesis of it to the extent that you know. How did it become originally treated as capital gains taxation and then where we’re going now?
Lerner: That is a great question which I don’t fully know the sort of history of it. It’s find outable. My sense, again this is sort of inexact. It’s like a lot of other stuff which was sort of done in the early days in the industry. This sort of treatment emerged in a time when the stakes were a lot lower in terms of what was being fought over.
Lerner: As a result, it didn’t probably get the attention and scrutiny that it might have. You know playing things forward you can imagine a couple different ways that it could play out. We certainly can imagine one scenario which is where the groups that are sort of most affected by this, who have the most market power, would basically end up, you know, essentially saying we want to [inaudible] the same carried interest, or we need to have the same carry of interest as we did before, so we’re just going to increase our carry so that the post tax carry is the same that it was before. That would be a case where you’d essentially get, you know, essentially the limited partners bearing the brunt of it … the tax because essentially they would now instead of, let’s say, getting 80 percent of the cadence now be getting …
Kedrosky: Right, 60 percent or something.
Lerner: … 40 percent of something.
Kedrosky: Right, right.
Lerner: Exactly. So, that’s certainly one possible scenario you could imagine playing itself out. Another possibility is that, you know, given the weakness of the industry in many respects, the general partners could just end up eating it and just basically saying we’re going to charge the same carry. It’s just going to be on a post tax basis but substantially less. And then the third scenario which is where they’re somewhere in between, so they essentially raise the carry by a few percentage points which lead to essentially [inaudible] deterioration of the economics for the limited and the general partners. I think that as you think about these, you know, you play their … there’s several things which the implications of it … clearly, one is that if limited partners find themselves bearing more of the, bearing a significant fraction of the tax, it clearly will make the returns from venture capital less attractive and presumably reduce their willingness to invest in VC as an area. If, on the other hand, the general partners end up bearing the bulk of the tax, there would at least be some degree of worries that, you know, some degree of worries that this would lead to reduced incentives for them to do the right thing. If anything, even more focused on management fees and asset gathering rather than on sort of creating value. So, I think none of these are … neither of those two scenarios are terribly appealing in many respects.
Kedrosky: How do you feel about … I mean I’m sort of public on this, so I’ll put my cards out in terms of how do you feel about the argument that fundamentally if you think about the role of capital gains taxation as an incentive, I suppose, a subsidy towards capital providers to lay out their capital especially in the sort of longer term and riskier investments that really the GP’s aren’t the providers of the capital. They’re being paid as a fee through management fees and then a bonus on top, and so it really never made sense unless we were to consciously try and create an explicit subsidy because we believe that there was some kind of externalities from venture capital that were so important that we could justify paying them this kind of subsidies or in a sense the subsidized tax rate. From a pure equity standpoint, it’s easy to understand why you might want to change the taxation here.
Lerner: I think this is one of these issues that you know the log journals are just full of in terms of debating what constitutes the reasonable … whether we should characterize as income or characterize it as capital gains and the cases for each and so forth. I think a lot of these arguments are sort of full of, as we say, sort of almost more philosophical or ethical arguments around it, pro and con. I think they’re interesting. I don’t really … I mean frankly I find it hard to sort of wrap my own head around how to interpret it. Maybe this just simply reflects my lack of legal trading in terms of really being able to parse the law and really figure out what was the intention of it and so forth. I think it’s an interesting question. It’s just one which doesn’t have an easy answer to it.
Kedrosky: Right now … I’m just before moving on to something else. The current bill, I suppose, that made it through the House that now has to go to the Senate kind of, you know, speaking loosely, kind of cuts the baby in half as I understood it. It passed on a narrow vote and proposed I think it was a 75/25 split in terms of taxation of carried interest. Does that solve any problems or does that just make things more complicated?
Lerner: I don’t think it necessarily makes things more complicated per se. I mean I do think that in general this thing will play out. I think the legislation is going to face some degree of challenges in terms of implementation. This has been an area that’s gotten a lot of discussion, but I guess I … the process of trying to figure out how to tax venture capitalists at ordinary income rates while not taxing entrepreneurs at the same rates, allowing them to take advantage of capital gains …
Lerner: … does open a door to any amount of gamesmanship in terms of what can be done along these lines. I know they’ve tried to head off this by including a provision for very punitive penalties if one is caught gaming the system in some way. I still would not be surprised to see a lot of creativity in terms of working around some of these provisions.
Kedrosky: Do you know what the situation is elsewhere in the world from a … it just crosses my mind. I’d never even really thought about it before, but how do other countries treat it?
Lerner: Well, I mean essentially this is an area which attracted a lot of debate in other places as well, so this is an ongoing discussion in the UK right now. It’s also a discussion in Australia where the tax authorities have been basically … this is not so much legislatively but in terms of just interpretation of tax authority [inaudible]. There’s a major dispute between the Australian government and TPT as to what the capital gains and when their successful investments should be taxed at.
Kedrosky: So, everyone is wrestling with this?
Lerner: Yeah, exactly.
Kedrosky: Let’s move on a bit here and start segueing over into your most recent book here, This Boulevard of Broken Dreams. But I wanted to talk a little bit sort of on the way getting there, about the role of government and about sort of from a policy standpoint. One of my persistent frustrations and I was just on a panel about, I don’t know last week, talking. There were a bunch of LP’s and others on the panel. We got into one of these inevitable discussions about I’m first quartile, you’re first quartile, we’re all first quartile, which you know has become kind of a, you know, a sort of almost a standup joke in the industry is that everyone’s first quartile from LP’s on down to GP’s. Other than the obvious answer which is it helps everyone protect the status quo, why is there this incredible inability in the industry to put together some kind of coherent performance metric such that it's sort of defensible and understandable and everybody doesn’t get to claim to be first quartile and everybody doesn’t get to sort of claim, you know, performance that they really, in any meaningful sense, don’t have. What exactly is going on? Why have we no inability to do anything about it?
Lerner: It’s a great question. I think it sort of comes down to really a couple things. I mean one is clearly that many general partners don’t see a great need for it. You know again, it’s sort of set up today where entry is extremely difficult and the sort of information problems surrounding it make it probably favor the incumbents in many respects. Secondly, you know it’s in an industry which is characterized by, you know shall we say, a lot of, you know, maybe disorganization on the limited partner side, right, in the sense that, you know, for many of the large limited partners it’s been a lot of turnover over the years. It’s very hard for the many states, and pensions and others to hold onto the best and brightest for extended periods of time. They tend to sort of, you know, leave after a few years to go work for fund-a-thons or work for a private equity group in investor relations kind of role, which, of course, limits temptations to want to rock the boat while you’re at the private equity; while you’re at the private equity limited partner. I think the other aspect is that many of the established limited partners are into the endowments. They feel that in some sense, the path to via the industry actually favors them because they have a better sense as to what’s going on. So, I think all these considerations and combinations lead to a situation where there isn’t a lot of incentives for anyone really rocking the boat and changing the practices.
Kedrosky: Is there … I mean what’s the … given that, given that the incumbents in many sense … I mean, you know, it’s somewhat glib, but it’s a feature not a bug on both the GP and LP side. What’s the prognosis here? Is this something where, you know, is there a certain inevitability to seeing the SEC or government step in? I mean what should we look forward to here, and if the answer is nothing I suppose it’s nothing?
Lerner: Yeah, I think it’s a great question. I mean there have been periodic efforts over the years to systematize a lot of practices from valuation to deal terms and so forth. It’s been remarkable how little success they’ve had until now. What generally seems to happen is the … there’s sort of a pendulum. The pendulum swings one way to a situation where the market goes into retreat. The LP’s have lots of power. They propose all these things and the pendulum swings the other way, and then basically most of that stuff goes out the door. Unless we see a wave of government regulation tackling this or we see some sort of fundamentally different and more profound cycle, it seems unlikely that anything dramatic is going to happen.
Kedrosky: That’s an unhappy thought. Let’s jump forward in the last … we’ve got about four or five minutes left … and talk a bit about, you know, some of the work you did in This Boulevard of Broken Dreams which is, you know, I’ll [inaudible] it, and you can feel free to correct me … but about public efforts to sort of drive entrepreneurship and venture capital. So, what government has tried to do given all the things we’ve talked about and the role of entrepreneurship and the role of venture capital to get more of that thing, you talk about what it’s succeeded at and what it’s failed at. Can you sort of summarize on both sides what useful things government and policy can do and what it shouldn’t be doing?
Lerner: Right, so I mean there is … I mean first off I talk about there is a tremendous amount of interest today in this topic. It’s not just simply, you know, places like the US or UK which are trying to get out of their deficits and sort of jump start our economies. But even markets like, you know, China and Saudi Arabia where it’s less, you know, perhaps necessarily the, you know, a trade balance or something else they need to address, but it’s more about concern about generating employment and seeing high potential entrepreneurship as a key mechanism for doing that. I think you can certainly make a compelling intellectual case for why public intervention makes sense. Certainly when you think of saying, you know, if you’re the first clean tech entrepreneur in Riyadh, you’ve got a big, you know, a heavy load to haul. It’s challenging. If you’re going to do it, you’re probably going to have all these sort of plow on benefits for those who come after you. You’re generating basically all these positive externalities from having done so. So as a result, the basic [inaudible] that governments have tried to reach and then do this, certainly, we point to places like Singapore, and like Israel, like China where there’s actually been a fair amount of success from having done so. It seems to have very much catalyzed the growth of the industry. That being said, for every successful one, there’s clearly been any number of unsuccessful ones. That’s certainly one of the enduring challenges. I think when you look at why is it that so many of them fail, a big chunk of it has been these governments didn’t know what they were doing or because people within the government basically were directing the funds to their, you know, their buddies, their friends and family rather than to the people who really need the money and likely to make a big difference from it.
Kedrosky: So, is there anything the rest of the world can learn from the US experience specifically in terms of, you know, whether it’s driving sort of these pockets of venture capital, driving sort of this … emboldening people to take more risks and fail? Is there anything we can walk away with and say, “You know what? There’s lots of things we’ve learned that don’t work. Here’s two things that do.”
Lerner: Yeah. I think there’s three things you can really highlight. First is not just focusing on providing money to companies. I think governments just love handing out money to companies. It’s fun.
Lerner: And all that stuff. Essentially, all those handouts, whether it’s companies or venture firms, whatever, it’s just going to be waste if the environment for venture capital and any type of potential entrepreneur stuff isn’t a favorable one. You better really start by saying what’s the environment that entrepreneurs face, and how can we ensure that this is attractive as possible. Clearly that has a bunch of implications in terms of taxation, regulation, you know, technology transfer, any number of things, getting that, setting the table, as it were, for entrepreneurs is really clearly the critical first step. A second thing is you’re really focusing on matching funds. A lot of times governments sort of go and do this thing of saying, “Ah, you know, clean tech’s really the place to be. Let’s go and put a lot of money into it.” It tends to be a lot of trend chasing, going for the hot areas or got anymore of yesterday’s hot areas, rather than producing the region he has the most advantages in. So one way to address this is to essentially insist that venture firms, for instance, that get funds essentially be in the position of raising net private sector money as well which can validate the decisions that the government is making in terms of handing out that capital. And then the third thing is really sweat the small stuff to get the details right because again, while you see, you know, many examples of cases where, you know, there’s sort of [inaudible] or programs set up where either the fund is way too large relative to where the, what the country is, what the country is like, where there’s all these rules that limit people’s ability to get profits which end up souring people on the program, where there’s no evaluation of what’s taking place. Companies get funded forever even if they’re under performing. There’s just any number of things that can go wrong in terms of details which are extremely important to address.
Kedrosky: That’s super, thank you. Just one last one for you before I let you go. It’s real quick. If you could sort of wave a magic wand and get any sort of piece … this just struck as we were talking that you and I are both kind of data junkies in this regard. If you could wave a wand and get some piece of data that would really help you in your research as you look at the impact and performance of the industry, what’s a piece of data that you really wish you had that you don’t have?
Lerner: Well, I think that certainly getting a really good fix on how groups are doing in a timely manner I think would be certainly something that would allow much better assessments from a research point of view as well as, I think, for the limited partners in terms of making their investment decisions.
Lerner: I think certainly that’s one of the ways in which performance is reported and so forth is really one of the major limitations that the industry faces today.
Kedrosky: Great, okay. Thanks very much, Josh. Josh Lerner, Harvard Business School talking about venture capital and sort of the outlooks and performance thereof over the last decade and longer. Appreciate you doing this.
Lerner: That sounds very terrific.
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