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Sunday, January 15, 2012

Lost in the Venture / Vulture Debate

As the Republican race for the 2012 nomination rapidly shifts from a battle between the improbables to a grudge match against the inevitable, one piece of economic jargon became fodder for two weeks of political theatre. In the process, the media had a chance to get into peak campaign shape by devoting even more hours of time covering the mudslinging and the spin of the mudslinging rather than examining the economic and social issues underneath the mud.

The Debate as Presented

The political and media debates of course focused on the relative degree of sainthood eligibility between those playing the role of "venture capitalist" versus "vulture capitalist" in the true American religion of capitalism. In one corner, Republican inevitable Mitt Romney presented his background as founder and long-serving CEO of Bain Capital as the ultimate qualification of someone who knows what government should do to foster job creation in a struggling economy. For months, Romney made claims of over one hundred thousand jobs being created as a direct consequence of the investments his firm made in a variety of companies.

In the other corner were Rick Perry and Newt Gingrich -- with presumably some of the other improbables crouching in the shadows, too afraid to offend their current political backers to enter the fray -- casting doubts upon Romney's actual job creation record and casting his role at Bain as a "vulture capitalist". Perry was the first to use the vulture term on the stump but, lacking any real momentum, it was up to Gingrich -- still smarting from a PAC funded stomping applied by Romney in Iowa -- to reverse his own "positive campaign" ethos and return fire on the Romney record. Gingrich's primary focus is on Romney's posturing as a conservative versus Gingrich's categorization of Romney as a typical "Massachusetts moderate" but had PAC ads aired to support Gingrich which dramatized some of the failures of the turnarounds attempted by Bain Capital.

After only two weeks of this "venture versus vulture" boxing match in the ring of the Republican primary process, lots of punches have been landed and both camps are likely to suffer some long lasting cuts and bruises, but -- true to form in the current political climate -- neither camp laid a glove on the real issues. More directly, it seems pretty clear that Rick Perry doesn't understand the true mechanics of a capitalist system and Newt Gingrich does understand the difference, but is more focused on settling his own score.

Capitalism, Creativity and Creative Destruction

The debate over the value of "venture capitalists" versus "vulture capitalists" makes about as much sense as arguing over whether sharks are good or bad. Unless you happen to be swimming off the coast of Nantucket while ominous cellos sounds are heard in the background, sharks aren't "good" or "bad" -- sharks just ARE. They are one small part of an extremely complex ecosystem and have evolved over time to fill a particular role in that ecosystem.

Capitalism as a theory of economic organization is akin to the theory of evolution in the biological world. Entities that efficiently use resources available to them can do more with less, allowing that competitive advantage to improve their own immediate situation but also the long term situation of the larger economy. Entities that use resources inefficiently or fail to react to changes in their economic environment will become vulnerable to "disruptions" that can weaken their position in the economy or wipe them out entirely.

Unlike evolution in the biological world, which relies both upon accidental changes to DNA and occasional freak changes in the environment to set a direction, evolution in a capitalist environment depends solely upon human creativity. "Venture capitalists" play a crucial role in supporting that creativity by providing funding that supports new technologies and business models that might provide exponential improvements over current products, Of course, incumbent entities providing current generation products and services have two choices when faced with such competition --- assume the competition might be on to something and investigate alternatives themselves or "focus on their knitting" and assume the competition lacks a viable combination of resources and know-how to pose any threat.

Venture capitalists make money by combining some expertise with the current state of the art (knowing where weakness to exploit might exist) along with expertise in upstart technologies that someone busy "sticking to their knitting" might be too busy to learn or appreciate. Of course, there are cases where some venture capitalists have so many resources at their disposal, they can afford to flat-out gamble on some new idea, without any detail analysis of probabilities or payoffs.

So-called "vulture capitalists" or private equity investors play a distinctly different role in economic evolution. Anyone who works in Corporate America knows how success breeds size which breeds hierarchy which breeds turf which breeds infighting which breeds enormous barriers to communications. These barriers seem particularly effective at slowing or completely blocking any communication involving the emperor's clothing or lack thereof. The human barriers to communication are compounded by technologies changing so fast that the expertise of many executives regarding core technologies used in their business is easily ten to fifteen years out of date. There are thousands of pages of articles in the Harvard Business Review over decades of time devoted to analyzing the defective decision making in companies which ignore signs of a sea-change in their competitive landscape at their peril and the peril of their investors, employees, customers and suppliers.

If one truly believes in the religion of capitalism, one has to believe that one of its cardinal sins is the mis-allocation of limited resources, Those limited resources might be raw materials, know-how or just time spent at work. Private equity investors exist to cut through management paralysis and incompetence that ROUTINELY leave companies drifting towards icebergs that everyone but local management can spot miles away. If management is squandering resources or failing to invest appropriately in an otherwise viable business and poisoning the firm's brand in the process, outside investors who understand those problems and have access to sufficient capital can buy control of the firm. With control, they can either make changes to management that eliminate the problem or provide enough of a cash infusion to improve the company's cost structure to compete more efficiently and get back into the race.

Of course, one technique applied by private equity investors is to only front enough money to gain control of a firm, then use that control to leverage the firm under its own signature even further. This is the business equivalent of having someone sidle up to you at the roulette wheel, toss in an additional $100 chip on your stack but telling the house you're in for another $10,000 then picking your number. When they bet on the right number, everyone's happy. When they're wrong, the damage is not equally distributed.

Private equity investors also serve another vital role in capitalism. For all of the same reasons that prevent management from reacting to obvious threats or opportunities, managers are also notorious for failing to recognize the end of the line. If PowerPoint had existed in 1915, I'm certain the PowerPoint from the sales team at Acme Buggy Whips pointed to nothing but smooth sailing ahead, even though Henry Ford had been selling Model Ts for seven years at that point. If Acme Buggy Whips had been gradually reducing its labor and management staffs as the buggy whip market declined, no one would have a problem with management. If instead its executives reacted to a decline in buggy whip sales by investing in new automated buggy whip making gear, outside investors might be able to "profit" by stopping such an ill-timed "investment" and simply preserving current profitability. If Acme Buggy Whips instead just stood pat with 200,000 square feet of manufacturing space occupied with buggy whip makers that could have been filled with equipment making carburetors for Model Ts at twice the margin, outside investors have a definite interest in trying to work with management (or take it over) and select a more profitable use of that capital.

The private equity industry itself exists because enough people with enough money believe they possess the insight needed to

* identify under-performing businesses
* identity a sub-set of under-performers available at a discount to their already dangerous position
* identify a sub-set of that set where investors actually understand what needs to be fixed

It also exists because these same people realize these opportunities never stop arriving. The same management mistakes are made over and over by new generations of executives who may be too immersed in the day-to-day decision making of their existing business to see the patterns that outsiders see from looking at dozens / hundreds of companies across multiple industries. Equally important, the industry exists because there are many people who made a lot of money doing something else and think they understand WHY they made that money and how to apply that know-how elsewhere. They may or may not be correct in that assumption.

In other words, the private equity industry isn't "good" or "bad" --- it just IS. Its existence is an inevitable consequence of a capitalist system bent on "efficiency" and the most effective allocation of capital while being operated by fallible humans with different ideas and motivations.

What IS Worth Debating?

So if calling Mitt Romney a "vulture capitalist" is about as productive as diving into the water and attempting to shame a shark ---- "BAD shark!" -- what WOULD be productive to debate in a discussion about entrepreneurialism, economic efficiency and job creation?

Why not debate the crippling effects of an understaffed patent office and outdated framework of patent law on innovation? America's patent system was created to optimize the tradeoff between allowing inventors to profit from their ideas for some period of time -- thereby encouraging more innovation -- while also ensuring those same ideas are fed into the larger economy for re-use and further invention -- thereby producing MORE innovation. The system only works when the balance between the window of exclusivity for the inventor and the release of that idea into the larger economy is just right and when the invention itself is actually worthy of protection.

All patent law in the US hinges around key criteria involving the novelty (has someone done this before?), utility (come on, does this do anything USEFUL?) and non-obviousness (could someone with average skills in the field have devised this by extrapolating "prior art"?) of the proposed invention. It's the third category -- non-obvious -- that's melting down businesses of all sizes. Did you know that a cell phone maker who wants to show a picture of the caller when their calling party number arrives has to LICENSE that capability? Sony owns a patent on that "technology." (Google patent # 5907604). The patent was filed on March 25, 1997 and issued May 25, 1999.

At the time this patent was filed, approximately 300 million Americans were already familiar with a different land-line telephone feature that displayed one piece of information (a caller's name) based upon another piece of information (the caller's 10-digit number). That "technology", better known as "Calling Name Delivery" pre-dates this patent filing by at least six years, when telephone companies began deploying SS7 in the early 1990s. That technology has an international patent trail dating back to 1969 in Greece. So how does mapping a picture to a telephone number qualify as "non-obvious" when it is identical in concept to the prior art?

It doesn't. The USPTO should have rejected the patent but didn't. Sony wound up owning the patent and has sued other cell phone makers for infringement, tying up millions of dollars in multiple companies and doing nothing to improve service, reduce costs or otherwise enrich anyone in the economy except the patent holder and an army of lawyers. This is happening ALL THE TIME in the technology field because "algorithms" can be patented and the USPTO cannot keep up with the pace of innovation. The results of this LACK of proper government regulation are ANYTHING but "pro-business":

* companies filing bogus patent claims to bolster their reputations for "innovation"
* companies filing "defensive" patent applications to avoid someone else from capturing the bogus patent
* companies filing "strategic" patent applications to guard their turf from encroachments by startups
* companies ("patent trolls") purchasing existing bogus patents as "intellectual property" then going on lawsuit sprees hoping settlement will be more attractive than litigation for defendants
* hundreds of small and large companies spending MILLIONS of dollars fending off bogus infringement lawsuits

None of the above do anything to foster a healthy economy or support entrepreneurs developing truly innovative technologies that can form the basis of tomorrow's job creating industries.

Why not debate the abuse of bankruptcy law within the realm of "private equity" takeovers and discuss how changes to the priority / standing of different creditors of a firm in bankruptcy have actually ENCOURAGED private equity investors to OVERBID for firms and borrow the money to do so? The net effect in many cases has been to shift those second-round bondholders ahead of prior creditors including PENSION OBLIGATIONS, shifting under-funded pension obligations from private investors to the public via the Pension Benefit Guaranty Corporation. That's not an efficient use of private sector capital and it's absolutely not productive public policy to privatize profits in private equity deals while shifting losses to taxpayers.

Why not debate the treatment of profits earned by private equity firms and their owners as capital gains with significantly lower tax rates? As stated above, no one is saying private equity investors shouldn't exist or aren't serving a useful function in the economic system. However, there's nothing in the religion of capitalism that puts private equity investors AHEAD of other players in the system in the sainthood pecking order. Why should our bankruptcy law and tax system?

There's no shortage of legitimate topics to debate regarding capitalism, job creation and tax policy. There's only a shortage of politicians able to debate those issues -- and possibly a shortage of citizens, taxpayers and voters willing to listen.