Virtual Meeting

CFR Master Class Series With Sebastian Mallaby

Tuesday, August 4, 2020
Kim Kyung-Hoon/Reuters
Speaker

Paul A. Volcker Senior Fellow for International Economics, Council on Foreign Relations; @scmallaby

Presider

Vice President, Deputy Director of Studies, and Nelson and David Rockefeller Senior Fellow for Latin America Studies, Council on Foreign Relations; @shannonkoneil

Sebastian Mallaby discusses the importance of venture capital. Venture capital has been shown to speed the commercialization of science, creating wealth, jobs, and new products for consumers. How important is this contribution? What is the special sauce in venture capital that causes it to work? Does the rise of China's innovation hub indicate that venture capital is not a necessary ingredient?  

The CFR Master Class Series is a weekly 45-minute session hosted by Vice President and Deputy Director for Studies Shannon O’Neil in which a CFR fellow will take a step back from the news and discuss the fundamentals essential to understanding a given country, region of the world, or issue pertaining to U.S. foreign policy or international relations.

O'NEIL: Great, thank you very much everyone. Well, hello on this rainy, at least East Coast rainy afternoon, and thank you for joining us for another one of CFR’s Master Classes. For those of you who are participating for the first time, this is our opportunity to get beyond the headlines and focus in with a deep dive on a particular country, a region, or a topic. And today's will be a topic and that topic is venture capital—what it is and why it matters. We have here with us today Sebastian Mallaby. He is the Senior Fellow, the Paul A. Volcker Senior Fellow for International Economics at CFR, and he is a longtime observer of and writer about finance. He has held positions with the Economist, with the Washington Post, and he is a notable author of several books that touch on all ranges within the subject of finance. For those of you who haven't read them yet, there's no better history and understanding of the rise of hedge funds. In his book that's titled More Money Than God, that pretty much explains it. And then he is also the author, more recently, of a biography of Alan Greenspan called The Man Who Knew. So check those out. But today, we are very lucky to take advantage of his most recent work, where he's been doing extensive research and writing for a new book that is in the works coming soon that will look at venture capital. So that is what he'll be sharing with us today. So I'm going to turn it over to him for the next 10 minutes or so, to sort of set the stage and then we'll be opening it up to all of you with your questions. So please, Sebastian, go ahead.

MALLABY: All right. All right. So in today's CFR Master Class, I'm going to talk about venture capitalism, which is really the practice of investing in brand new or very young companies, which are usually trying to build a business based on some kind of technology-related innovation. I'll be drawing on my research for the history of venture capital, which will be published next year. And it's always good to air some of these ideas in advance and field questions from the smart group. So I'm grateful to Shannon, and to all of you who took the time to sign on today, and I look forward to your questions.

So, let's start with a question of why we should even care, why does venture capital matter? There are roughly speaking, two ways of generating expanded prosperity. The first one is for a society to put more into the economy, more inputs. So that could be labor—people could work more hours. Or it could be capital. You could spend money on more machinery to improve the productivity of the average hour worked. But the other way you can expand output is through innovation, deploying better ideas. And the great thing about innovation is that it's not burdening individuals, they're not required to work more hours. They don't have to save money to fund that additional investment in capital goods. Instead, because you're commercializing new ideas, people get better and cheaper goods and gadgets and medicines and so forth. They get a higher standard of living with no additional working hours or other sacrifice. So innovation is something we want more of, and experience shows that for a certain portion of innovation, venture-backed startups are the best way of generating it. And venture capital is not the best way to generate advances in fundamental science.

That's because fundamental science has no short term, commercial payoff. So it has to be paid for out of nonprofit dollars, which might come from government, might come from rich universities, might come from endowments and foundations. But when it comes to commercializing that fundamental science and turning it into practical products that are going to make a difference to people's lives, that's where venture-backed startups have proven to be highly effective. One good illustration of this is the internet. People sometimes say, well, the internet was invented by the government. And in a narrow sense that's true in terms of the Defense Department's DARPA Research Unit. But if you want to ask who turned the internet from a niche product, used by, you know, a few hundred scientists into a mass communications medium that fundamentally revolutionized how people live, the answer is that venture capital-backed entrepreneurs were responsible for carrying out that transformation. And relative to other kinds of private innovation, venture-backed companies have been shown to be highly effective. One measure of this is the generation of new patents. There's an academic study that shows that a dollar invested in a VC partnership generates at least three times more patents than a dollar of corporate research and development. Another measure of the superiority of venture-backed startups is in simple wealth creation.

Venture capitalists back only a fraction of 1% of the new firms that get started in the United States every year. And that's a tiny subset of the total, obviously, but it accounts for nearly half of the firms that eventually go public. And it's notable that this effect is not confined to the United States. The other great center for digital innovation today is China. And what's amazing when you look at the history of Chinese tech, is that all the famous early digital companies in China, were started with venture capital dollars, not because of the foresight of the Chinese government, which people sometimes cite. In fact, the opposite is true. The government was often frustrating attempts to start digital companies with regulation and restrictions on foreign investment and so forth. But all of them—Baidu, Alibaba, Tencent, Ctrip, Sina, Sohu, NetEase—as you go down the list, they all got venture capital, and indeed they got American venture capital. China very much conforms to the same law about the effectiveness of venture investing. So, the good news is that this productive form of activity—venture capital—is spreading.

I just mentioned that it has spread to China. It's also spread to Europe. There are other outposts like Singapore and Bangalore and so forth. Venture capital is also spreading in a different sense, that is not just geographically, but sectorally because more and more sectors of the economy, whether it's, you know, government technology, or, you know, transport if you think about Uber and ride sharing, or the hotel sector with Airbnb. More and more sectors of the economy are being disrupted by venture. So that is a kind of lateral expansion. And then there's also the expansion of venture capital in terms of the life cycle of companies because they're going public later and later. They're remaining private. That is they are unicorns to move a billion dollars of market capitalization without actually being on the market. And so, venture finance is becoming more and more important in governance terms and sometimes actually failing at that, in terms of companies as they get older and more mature and more consequential.

All right, so venture capital is important, and it's spreading. And so therefore, it is actually worth trying to understand what it does. And it's worth posing this question because it's not obvious how it works. That was, in fact, what drew me to the subject in the first place, because when you start to think about venture capital, it really doesn't operate by any of the normal laws that other types of investing seem to abide by. And this intellectual puzzle is kind of fascinating. So in public markets, the first thing you do when you try to figure out the value of a stock, or even a bond, or some other kind of security is that you discount the future cash flows. Well, in venture capital, there are no cash flows discount. You've got two, as one person said to me, “two-legged mammals walking into your office with a dream.” Right? There's no revenues yet. There's certainly no profits. So you can't discount the future cash flows because there's no cash flows to measure. Equally in public markets, you might try to value a stock by looking at the assets that the company controls. That's the book value. But venture is backing fledgling startups that have no capital, or offices, or other assets. So there's no book value that you can even look at. In public markets equally, investors generally believe in portfolio diversification.

In venture capital, the portfolio is highly concentrated. In public markets, the investor chooses the company to invest in. In venture, the entrepreneur is often choosing which investors should be allowed to put money into the company. So as it were, the security is choosing the investor, not the other way around. In public markets, if you don't like what's happening with a company that you've invested in, that's easy, you just sell it. But in venture capital, these things are not quoted on public markets. You can't sell it—it's illiquid. In public markets, if you really don't like what's going on, you can even bet against the company. You can short it. Well, there's no shorting of venture capital stocks because they're not publicly listed, again. So in all these ways, venture capital is very different.

Now I’ll just list the final one, which I think is actually the most important. And that is that in public markets, the returns that investors are seeking are normally distributed, almost like in a bell curve. That is to say, the tails of the distribution, the extraordinary events where, you know, a stock would either lose an enormous amount of its value or gain a massive amount of its value, are actually pretty rare. So Julian Robertson, one of the pioneers of the hedge fund sector, whom I wrote about in my history of hedge funds, used to say that a fabulous investment was a stock that doubled its value in three years. And that was actually more aggressive than most hedge fund investors would even dream of, you know. Lots of them were trying to make a few percentage points, or even basis points on lots of positions—that proverbial "picking up nickels in front of a bulldozer." Venture capital, on the other hand, is looking for returns of 10X or more than 10X. In other words, a return of 1,000% or more. And so it's in a totally different return profile, which leads to a totally different kind of investment behavior. Of course, to compensate, you know, venture capital investors need that 10X or greater return, because in so many instances, when you're backing a startup company, the company fails and the asset goes to zero.

So, there are lots of ways in which venture capital is not like normal finance. And it's kind of a challenge to figure out how it really does work. And when you go and speak to venture capitalists, they're not always the best actually, at explaining what it is they do, beyond just getting lucky, which explains why a good venture capitalist might outperform a less skillful one. But as I talked to lots of venture capitalists, and after three years of you know, a few hundred interviews, I think I've distilled the art down to five basic skills—what it is that venture capitalists do, how they add value, and how they actually benefit society.

The first is that the venture capitalist is providing something that we might call liberation capital. When a talented individual is locked up inside a big company, sometimes he or she can't actually pursue the innovation that one might want because the boss doesn't see it the same way, because of office politics within the company or whatever. So the presence of a liberation capitalist who will provide the money for that person, the talented individual to spin out of the big company and set up a new one, that is providing an opportunity to sort of experiment, to try out a big idea in a way that might be stifled if bureaucratic companies were the only option for a scientist to work in.

The second is that venture capitalists have recognized the importance of only using equity and never using debt. In the early years of venture capital, as I discovered when I was researching my next book, the government tried to kickstart the sector by providing cheap loans. Well, that's the last thing you want to do, because when you provide a loan, even a cheap one, you expect some interest payments in return. But a growth company, like a technology company, isn't going to make any interest payments because the whole point is it's growing. It wants to plow all its revenues back into the operation and grow it. So, equity only as the second principle.

The third thing is that venture capitalists invest on a stage-by-stage basis. They don't just write a big check up front. They try to identify the biggest risks in a new company and give just enough money to test whether those biggest risks can be neutralized. And only when they have been neutralized and therefore the risk has been reduced, do the investors go ahead and provide the second tranche or the second round of financing. The next thing is that because, as I was saying earlier, you can't sell a venture position. A venture investor has to have a hands-on approach, to be activist, to roll their sleeves up and get involved with a company that they invest in. So if it's going off the rails, you actually force it back onto the rails by being an activist board member. And that's to compensate for the lack of that ability to just sell the position if you don't like it.

And the fifth, and very important point, is that venture capitalists are an absolute. They are the absolute masters of networking. There's a lot of literature on how clusters can be very productive, whether it's movies in Hollywood, or pharmaceuticals in New Jersey, or finance in Wall Street. Well, venture capital in Silicon Valley is another example of this cluster. And the way the cluster is productive is that ideas circulate around it, thanks to people who are incentivized to run around being the bees who pollinate the flowers. And those bees are the venture capitalists. They're the ones who make money by connecting up the ideas with the money, with the human talent, and shaping new enterprises. So I think those are the sum of the elements which make venture capital function, and which make it productive in terms of advancing innovation.

I'm running out of time, but let me just end with a quick observation on the contemporary backlash against big technology. As you all know, there was this hearing last week with the leaders of the four biggest tech firms who are being understandably criticized for sins that vary from being too big and too monopolistic, to abusing people's data, to allowing fake news to circulate, to doing things that might undermine the integrity of elections, and so on. But the idea I'd like to leave you with is that even if you have legitimate misgivings about big tech, it doesn't mean that you should be against venture capital. If you think big tech is too concentrated and faces too little competition, the best policy is to foster challenges to big tech and new kinds of technology ideas that might circumvent the incumbents. And the way to get those new ideas off the ground is to support venture capital. Equally, to the extent that unicorns, the big tech companies have proven themselves to be capable of government abuses. Whether that's WeWork or Uber at various points in its history, the answer to that is to have more forceful people on the board. So you would like, in that sense, venture capitalists to be more assertive, not weaker. So, I'll stop there and look forward to your questions, but please don't mix up the criticism of big tech with the attitude to venture capital.

O'NEIL: Great, thanks very much, Sebastian. So I will lead off with the first question and then we'll go on to the others. And, you know, as I was listening to you, and the great things that venture capital can do, and its returns are so much higher and all of this and it is expanding, but I think you said it's only 1% of the financing out there. And I guess this seems like a great arbitrage opportunity. Why doesn’t more money go into venture capital if it's so much more productive and innovative? Like is there something about the skills that you lay out that only certain people can take the risk or are these networks self-policing, they only let in a certain amount of people, or what is it that leaves it to remain a somewhat exclusive group even as it expands around the world, at least in terms of assets, but also maybe in terms of people?

MALLABY: Yes, Shannon that's a great question. I think, you know, the first thing to be said is that some startups, many startups, don't have the ambition to generate that 10X return, which a venture capitalist wants. And so, you know, a lot of startups in the country are going to be, you know, fairly modest. They aim to generate a decent income for the person starting it, but they're not going to multiply their size 10X in five years. And so you have to take those off the table to begin with. Venture capitalists in a way are sort of sifting through all the startups that exist and seeing which are the ones which could be induced to grow at this supersonic speed. And sometimes, the entrepreneur who starts the company doesn't quite see it that way. They think they'd like to grow gradually and in a comfortable way. And the venture capitalists has the function of persuading them, hey, you could be more ambitious.

If I give you this capital, I take away various obstacles; I find you, your first five great hires; I give you my brand so that you can go and sell to other companies better. Then you would expand faster. So the set of companies that can expand at the appropriate speed isn't fixed and can be expanded by venture capital, but there is an upper limit on it. And so that's the first point. The other point, though, is I think, what’s sort of at the back of your mind—the arbitrage opportunity. Surely, if it can be done in Silicon Valley, it can be done elsewhere as well. Surely you could have an equivalent system, ecosystem in Detroit, or Milwaukee, or wherever. And I think that's actually an experiment that's being run, kind of as we speak. You know, there's been attempts for a long time now, to set up equivalent things, whether it's, you know, Silicon Alley in New York, Silicon Glen in Scotland, there's just you know, lots of these experiments. And for a while there, none of them seem to work. But I think bit by bit, the secret sauce is becoming easier to bottle and to spread around because information has been let free, you know. I once talked to a Scandinavian entrepreneur and I said, "How did you come up with a structure, the way you run your company, which is a very flat hierarchy?" And he said, "Well, Netflix explained its management model in a deck, which I downloaded from the internet, and then I copied it." And I said, "Well, where did you get your capital?" He said, "Well, first of all, I got a little bit from family and friends, and the Finnish government gave me a tiny bit, then I got a bit bigger. I went to London, raised some money, then I went to Silicon Valley, raised some more money and then I went to Japan and got money from SoftBank." So the whole system, because of better communication, thanks to the internet, is becoming more globalized. And I think that will have an effect, the arbitrage that you suggest, of spreading venture capital and it will get bigger.

O'NEIL: Great, let's go ahead and take our first question.

STAFF: We will take the first question from Jay Vogelson.

Q: Thank you very much. I mean obviously a venture capital firm gets lots of offers. Lots of people come to seek money. How does the venture capitalist decide on which company to invest in? Or do they pretty much tie themselves to a particular area of commerce and seek to know all there is to know there, and to pick out the probable winners and losers?

MALLABY: Yeah, that's also a great question. I mean, the answer has changed over time. At the beginning, you know, and I'm talking about, you know, the '60s and '70s, it was very much a cottage industry on the West Coast around Palo Alto. You know, two of the first pioneer venture capitalists rented a pair of Pontiacs and just drove up and down a couple of roads, which were called Commercial Road and Industrial Road, which is pretty unimaginative. And whenever they saw a company sign which said Onyx or something in the name, they would knock on the door and say, "Do you need any capital?" So this is just you know, very much locally driven—the geographically driven, the sifting process. But as the sector expanded, it became more sectorally specialized. And so you started by the '80s, having companies that said, okay, we're just going to do healthcare, or we're just going to do computer networking equipment, or telecoms. And over time, that specialization has grown. And in order to really be able to judge what is a good proposal, and distinguish it from a bad one, obviously, it's very helpful if the individual venture capitalist knows the science and knows the space pretty well. And so specialization has been a trend. And in that specialization, you have interesting geographical niches that occur, which could be—I’m the person who bridges Israel and Silicon Valley. Or, I'm the person who bridges China and Silicon Valley. You get a lot of this kind of, you know, I'm going to invest, not just in early startups, in fact, I'm going to be the person who doesn't do the early ones. I will do the Series D or Series E, the later one, because I know about scaling up from the first stage into the more mature phase of a startup's life. So there's no simple single answer to your question. But most VC's do try to specialize, because otherwise you don't have an edge.

O'NEIL: Let's take another question.

STAFF: We'll take our next question from Dee Smith.

Q: Sebastian, thank you very much for this very, very good summary. I was wondering what you think the rise in protectionism and particularly sovereign concerns about technology transfer and that sort of thing, which is, you know, a global trend now, will have on investments across borders of venture capitalists, A., and B., on venture capital, even within countries like, you know, the countries that are heading in an authoritarian direction—Hungary, Poland, Brazil—what have you, whether you see effect in either or both of those domains. Thanks very much.

MALLABY: Sure. Well, I mean, the obvious case study here is China and the U.S. right, which increasingly are going their separate ways in terms of technology and being increasingly suspicious about each other's technology firms. Now it's coming from a base where, as I was saying earlier, at least the consumer-facing portion of China's digital economy has been very much backed by American venture capital. The biggest and most successful venture operated in China is Sequoia China. The biggest and most successful venture operator in Silicon Valley is the parent company Sequoia Capital. So these worlds are very closely linked. And indeed, as you might have seen recently, this app TikTok, a short-form video app owned by a company called ByteDance in China, has been in the news because the U.S. operations of TikTok are not going to be allowed to function, it seems, in the U.S. unless the company is sold to an American owner. Microsoft looks as if it wants to buy it. President Trump is tweeting that he would like a piece of the action for the government. We'll see how that works out. But clearly, this is a big deal for cross-border investors and indeed, one of the main backers of ByteDance, again, is Sequoia. So we've grown from a world in which capital flowed fairly freely—actually in both directions—with some Chinese capital coming into Silicon Valley, as well as vice versa, to a world where there's going to be more and more separations between what is China tech and what is U.S. tech. And we'll see how that gets unscrambled. For the moment, it's more obvious in terms of the company's operations. In other words, you know, Huawei is not being allowed to sell equipment into the U.S. and also is not being allowed to buy inputs in terms of semiconductors from the West. But that's less an inhibition on flows of capital, and more inhibition on the actual operating companies. I think it will be interesting to see whether capital flows become the next frontier in the separation between China and the U.S.

O'NEIL: Next question, please.

STAFF: We will take the next question from Bill Reichert.

Q: Hey, Sebastian, thanks so much for doing this. This is Bill Reichert with Garage Technology Ventures. I seed early-stage venture firms here in Silicon Valley. And I got to say, just in commenting on your earlier comment about entrepreneurs who aren't ambitious enough, I got to say, I have hardly ever come across (laughs) an entrepreneur who is not ambitious enough. I mean, almost, almost always the problem is that the entrepreneur is delusionally ambitious in terms of optimistic, assuming that they, of course can be twice as big as Google. But that's okay—that’s okay. There are plenty of entrepreneurs that are plenty ambitious. Well, I actually wanted to ask you about is, you know, your research into the evolution of venture capital, the picture that you paint is somewhat more like venture capital as it kind of used to be, you know, when I was a lad and I came to Silicon Valley and I was an entrepreneur. You know, these days, hardly any startups are funded by venture capital firms. Almost all of the startups that get launched are getting launched out of accelerators and angels and angel funds. And there are some super angels. There's this whole new ecosystem of stimulating innovation, and what we measure as venture capital has now overwhelmingly become late stage capital, in, you know, in a venture capital sense, late stage capital going into these unicorns. And you know, I'll tell you it's frustrating down here on the forest floor, that so much capital is going into overpricing these unicorns. And there is not enough capital for the startups who are looking to do more diverse innovations, sort of across the country and across the world. Do you have a point of view on that evolution in the venture capital industry?

MALLABY: Sure. I mean, I completely agree with the evolution that you described, or at least mostly agree, and I think the tipping point is I look at the history, you know, was probably the late '90s, where, you know, the first million or so, as I recall, that Google raised was from angels like Andy Bechtolsheim. And thanks to that, when Google got around to going to see the two VC firms that did the Series A, are Kleiner [Perkins] and Sequoia, they were in a pretty strong position to negotiate extremely good terms. And that's why it was the most expensive valuation that those VC's have ever confronted. And after '98, without financing, exactly as you described, that area of angels and super angels and incubators, definitely thickened out, became denser, became more active. And the founding of Y Combinator in 2005 was the next big inflection point where the business of really early financing was shifting from what one might hace traditionally called a venture capital company. It was a different shape of company that was doing it. But I think, I kind of broadly agree with the change that you're describing.

I think it's a bit messy as a story because, as you know, there's a blurring of the boundaries between the traditional venture companies and the seed companies. So, you know, Sequoia, for example, you know, put money into Y Combinator, follow-on funds as a scouts program to do seed investments. And that's, I think, replicated in lots of other traditional VC firms. They try to, you know, do some seed investing in order to sort of have a good grip on the pipeline and what might be coming through. And, you know, whether you call something a seed or a Series A is, you know, the industry adopts different definitions at different times. And I'm not sure there's a fixed one that would withstand scrutiny over a decade or so. But I think I'm not too worried that, I think your last point was whether this leads to a sort of shortage of seed stage financing because all the venture capital companies are more interested in the later stage. I think that, in that sense, the system is pretty efficient that lots of startups do seem to get off the ground. Seed money is available if venture capital funds retreat from seed and do Series A—slightly bigger check sizes. It's because angels are abundant and they're taking care of the problem. So perhaps you see it differently, but that's my feeling.

Q: No, that's fair. That's fair. (Laughs.)

O'NEIL: All right. Let's move on to the next question.

STAFF: We will take the next question from Hani Findakly.

Q: Thank you very much. Can you hear me?

MALLABY: Yes.

Q: Very good. Excellent, Sebastian, and thanks for the summary. I have a question about the average returns that investors and venture capital have. And since many of them go through funds or through sort of blended investments, how is the average return for venture capital early seed investors? Compare, for example, on a risk-adjusted basis, investors and later stage private equity funds, and maybe you can explain to us a little bit about the difference between the two since there seems to be a little bit of a blurring of the boundaries between one or the other. And to what extent have the exit strategies impacted those returns for these kind of investments?

MALLABY: Sure, well, so on this question about the boundary between private equity and venture capital, you're right, there is a blurring. So they're both a type of finance that invests in private, i.e., not on the stock market, not public companies. Private equity is investing in larger established companies. Venture capitalism has to be doing early stage—the establishment of the company. But over time, and particularly in the last, I'd say 11 years dating from a famous investment in Facebook in 2009 by the Russian investor, Yuri Milner. Venture capital companies have been interested in doing much bigger check sizes, i.e., what they call growth capital. And so that starts to infringe on the traditional remit of a private equity investor, and equally the private equity companies have been excited by tech, by Silicon Valley. And they've been willing to write smaller checks than they would normally write in order to get a piece of the action in the exciting tech sector. So there is that blurring.

In terms of the returns, venture capital is a mixed bag. It's, you know, one could joke that it's one of the few areas of finance, which, as economists would say, has positive externalities. In other words, the normal rap on finance is that you have banks, shareholders may make some money, the senior staff at the bank certainly make a lot of money. But society as a whole doesn't do very well out of them, because anytime there's a crisis, the taxpayer bails them out. So in that sense, there are negative spillovers for society. Venture capital, on the other hand, creates this wonderful innovation—lots of wealth for society. But the private investors in venture capital don't always do so well. And when you look at the returns, compared to investing in public equities, there's a sort of public market equivalent, PME measure. It goes through waves. There are some cycles where venture capital outperforms the public market equivalent, and lots of times when actually you'd be better off owning public equities. So it's not a slam dunk, but it's a great investment for private investors. It is a diversification source. So if you're running a large endowment, I think it does make sense to have a chunk of your money in tech and in private equity and in venture capital. But it isn't a slam dunk. And the last thing to be said is, there is this strong persistence in return. So the top quartile or so of venture capital funds, which have the best networks and the best brands and the best "first look" at the most exciting entrepreneurs, they do tend to consistently do better than the rest. It's not locked in as an iron law that that's always the case. Kleiner Perkins is a remarkable proof that you can be absolutely top of the Silicon Valley pile in the 1990s and then completely underperform in the next two decades. So it's not a lock, but there is a stronger persistence of performance in venture capital than there is in any other kind of investing.

O'NEIL: Let's take another question.

STAFF: We will take our next question from Welby Leaman.

Q: Thanks again for this great discussion. Dani Rodrik and other economists have argued that one of the sources of increasing social unrest around the world is this notable increase over the last few decades, or a couple decades, and the relative return to capital versus the return to labor. So if that's the case, does venture capital's demand for a notably higher return on investment than many other models, exacerbate this trend? Or does its generation of innovations which create competition actually tamp down the trend?

MALLABY: Yes, well, so the way I like to think about this kind of question, which comes up with hedge funds as well, you know, are hedge funds exacerbating inequality, is venture capital exacerbating inequality, is to say, you know, you can separate it out. You know, on the one hand, you ask a question, is this good for the financial system? In the case of hedge funds, in my book, I argue that if you don't like too-big-to-fail banks, small-enough-to-fail hedge funds are better. In the case of venture capital, I would argue that if you want innovation, venture capital is extremely productive. So I'm in favor of both of these styles of allocating capital as being good for financial markets and good for innovation. But I do care a lot about inequality. And the answer is to tax the people who make a lot of money from this. Right? And so higher tax rates, it seems to me are the answer. I'm not in favor of the carried interest loophole, which gives partnerships, whether they're real estate partnerships, venture capital partnerships, or hedge fund partnerships, a big tax break. I think that should be eliminated. And I think that, in general, people who earn lots of money could afford to pay more tax and that would include people who make a lot of money out of venture capital. So I think you can separate Dani Rodrik's legitimate concern from one stance on innovation, which I think should be pro-innovation.

O'NEIL: Great, I think we have time for one more question.

STAFF: We will take our last question from Daniel Gilmer.

Q: Yes, hi Sebastian. This is Daniel Gilmer, CFR term member. Thank you for the clear overview of venture capital purpose and approach you covered. As you alluded to, we're at a very challenging moment now with government debts increasing worldwide. I wanted to ask about how venture capital decisions are impacted by the point you just raised, you know, a matter of taxation both in the U.S., but just as importantly around the world. So you know, on one side, you hear the assertion that markets can solve all our problems. On the other end, you hear people saying that no one innovates taking into consideration the tax rate. Of course, the optimal approach is somewhere between no tax and no consideration of tax. So I was just wondering if you could comment on the necessary government funding of science, education, security, infrastructure—such that there is a solid bedrock for VC to build upon, and at what qualitative level might one tax innovation out of a system or tamp it down?

MALLABY: Yes, that's a great question to end on. So I think that, you know, you're right, that it's, you know, I think there's an underinvestment in government, physical science. You know, some of my colleagues at the CFR have worked on this, but I believe that there's pretty good funding for human sciences, health sciences, NIH [National Institutes of Health], and all that. Whereas physics and engineering and related fields have been shortchanged. And if you want to, you know, sometime—one criticism of venture capitalists is that, hey, it doesn't do certain types of very important things like alternative energy. And you know clean technology investing was a big thing in the 2000s. It proved to be unprofitable for most of those who tried it. So venture capital has now retreated from that space for the most part.

Wouldn't it be nice if venture capital could do something socially useful, like save the environment by innovating around alternative technologies? But if you want them to do that, then government investment in basic science, from which, would generate ideas that venture capitalists can then commercialize is, I think the right way to push venture capital into that area. So I would be in favor of more government spending on basic scientific research, that you then need to pay for that as you point out. And at what point should you be taxing innovation? I think the thing is not to tax the real innovators but to tax the people who say they are innovative. (Laughs.)

Often that's the case with the more mature tech companies. I mean, it's a famous scandal how Apple and other companies are able to arbitrage around tax regimes by locating their intellectual property in Ireland, or what have you, so that they pay Irish corporate tax rates, which are very low, rather than the tax rates of the countries in which they are actually selling, or creating the product. And I think that kind of international arbitrage is not a pro-innovation thing. It's simply a tax optimization strategy by a big multinational. So I think that's the kind of thing that I would like to be targeting, not something that genuinely reduces innovation.

Okay, well Sebastian, thanks for that. And thank you really, for this more masterful tour of this particular part of the world of finance. I know myself and everyone else will have, you know, several months from now, we have the chance to learn much more when Sebastian's book comes out. So everybody, keep an eye out for that. And until then, thank you very much for your remarks.

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