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First,let's killtheangelsjohnmauldin
1. First, Let’s Kill the Angels
First, Let’s Kill the Angels
Equal Choice, Equal Access, Equal Opportunity
Some Quick Thoughts on Goldman
La Jolla and Dallas
By John Mauldin
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.
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2. First, Let’s Kill the Angels
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.
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3. First, Let’s Kill the Angels
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
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4. First, Let’s Kill the Angels
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
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5. First, Let’s Kill the Angels
“…. 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
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6. First, Let’s Kill the Angels
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.
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7. First, Let’s Kill the Angels
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
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8. First, Let’s Kill the Angels
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!
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9. First, Let’s Kill the Angels
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 Mauldin
9 Saturday, April 17, 2010