Market failure in financial markets - the case of plentiful venture capital

Venture capital is the hottest and glitziest part of the global financial markets. The narrative goes that it's the place where nerdy and enterprising entrepreneurs meet smart and visionary investors to create the technologies of tomorrow.  

Venture capital is the institutionalised form of risk capital financing for new and emerging ideas. Historically, there has always been a market for financing such businesses. The big difference is that unlike earlier times, new and emerging ideas are dominated by knowledge-based industries where physical capital is far less salient. There are no large buildings and plants, equipment and hardware, and inventories. It's today therefore about investing in humans and their ideas, and software (which can quickly reveal itself to be vapourware). This is largely non-collateralised lending and investing.  

This creates a big problem. How does one validate the claims being made by entrepreneurs?

Scott Galloway's this weekend's post is about the issue of entrepreneurs selling ideas through fanciful stories which border on fraud. 

The Valley’s “always tell the truth” sermon is reductionist and hypocritical. It ignores the fact that many of our nation’s most valuable companies are priced on promises of technologies that don’t exist. The entire venture capital industry, in fact, is predicated on promising things that don’t exist. Microsoft, perhaps the most successful tech company in history, got its break when Bill Gates sold IBM an operating system he didn’t have... Allegedly, an engineer at the company coined the term “vaporware” a year later. Promising something that doesn’t exist is as central to the Valley ethos as late-night coding sessions, hoodies, and the hallucination that the public has asked you to solve the world’s problems vs. just do less damage... 

The line between vision and fraud is only drawn in hindsight. We set arbitrary deadlines for entrepreneurs to deliver on their vision, and their vision only becomes fraud when we say time’s up. What if Holmes, with five more years and another billion dollars, shipped a working product? Or pivoted to a home-testing machine for an acute respiratory syndrome?... When valuations are overwhelmingly driven by stories, things can get ugly. Investors will do whatever it takes to defend their narrative — their investment depends on their flocks screaming “heretic!” at anybody who questions the scripture, as the foundation doesn’t hold up to more modern orthodoxies (i.e. math)... Swarming anyone who questions the narrative is a built-in feature of stocks and sectors that have gotten too far out over their skis.

This is a real hard one. There is no way to distinguish and police fraud. The line between vision and fraud is blurred, and it's inevitable that entrepreneurs take advantage and push agendas. 

It's almost become second nature for entrepreneurs to knowingly exaggerate the claims about their innovations and ideas. From there, it's a tiny step to present those claims as facts. This is all seen as acceptable within the broad boundaries of marketing one's ideas. In a different world, not too long back, several of Elon Musk's claims and forecasts would have been seen as being atleast deliberately misleading. 

Logic is a beautiful servant. It can be deployed to justify almost anything. Even if Trevor Milton did indeed push the truck down the slope, Nikola's promise was enough to condone this indiscretion as an enterprising action to attract capital to very promising idea. If Nikola becomes successful, this fraud would become sanctified and become an important part of VC folklore. 

The attitudes and behaviours of a generation of youngsters watching starry-eyed at the venture capital industry, either as aspirants or as junior professionals, are likely shaped by this environment and its prevailing culture. 

Venture capital's value proposition is its ability to identify and finance promising ideas and entrepreneurs.  Investing in new ideas have always demanded risk appetite. This was a three-way trust game between investors, venture funds, and entrepreneurs. Financiers were generally careful and discerning enough to screen out the frauds. When capital was scarce and competing demands too many, entrepreneurs were chasing finance. This imposed a natural discipline to financing and investment decisions. It also shaped the expectations and behaviours of entrepreneurs. 

But things changed when capital became plentiful enough to start chasing entrepreneurs. Investors searching for yields had limited opportunities. Venture capital was packaged by consultants and other industry boosters as the most promising opportunity. Capital flooded into venture and other alternative finance vehicles, so much so that deploying them productively with reasonable due-diligence became a problem. Compounding matters, as analysts and opinion makers sang its praises, fund managers could not afford to miss out on the next big idea. And there were so many such big ideas. Almost anything could pass off as a great idea. 

Worse still, once invested, the sunk cost fallacy meant that fund managers are loath to cut losses. Their incentives are aligned to overlook the emerging evidence about the innovation and maintain the pretence to keep capital coming. And more the investment made, greater this incentive alignment. Finance loses its disciplining powers.

In more general terms, the plentiful cheap capital has distorted incentives all round, and financial discipline has become a casualty at all levels.