This response written to Warren Buffett’s editorial

First, Warren Buffet’s point about carried interest is arguably correct. Basically, it is a bonus to money managers that is tied to the long-term capital gains of the investors whose money they are managing. Just because it comes out of the long-term capital gains of investors does not imply that it is a long-term capital gain for money manager. The argument is that this 20% cut of the capital gains is not inflation protected over the several years it takes to earn it, so the lower tax rate is proper. Capital gains tax rates are often a catchall for intrinsically long-term investments that are not inflation protected even if they do not involve the investment of capital per se.

Second, venture capital — what fuels our technology sector — is extraordinarily sensitive to the supply of liquid capital rich people have on hand. Rich people are the Limited Partners (LPs) behind venture capital firms. Note that this is required by government regulation, if you are not wealthy it is illegal for you to invest in tech startups. The supply of venture capital is very volatile, varying by an order of magnitude on a year-to-year basis. In lean years many tech startups go bust because the LPs do not have enough liquidity to fund the venture capital firms. Why the volatility? It is because the pool of venture capital is extremely sensitive to the free cash of rich people. When you abscond with the money of the wealthy, it creates a magnified reduction in the supply of capital available for venture capital.

People argue that it is only 10% here or 10% there but it does not show up that way at all in the venture capital pool, it is massively magnified. Venture capital supply follows the expected real return in the market very closely and accounts for things like inflation and tax losses; a 10% increase in taxes can put venture capital out of the money in many cases. And since rich people are the only people allowed to invest for the most part, they are not a fungible part of the ecosystem. With apologies, a poor person never funded my company. Anyone that claims to support both technology ventures and increasing the tax rates on those that fund them is a damned liar. If they had their way, Google, Facebook, Twitter, and myriad other companies that were built with the free cash flow of rich people would not exist. There is no two ways about it; venture capital has a very strict expected rate of return calculus that is grounded in the kind of mathematics that one finds in reality.

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See more commentary about how venture capital works here: viewtopic.php?f=55&t=47912

Statistics: Posted by tortoise — Sun Aug 07, 2011 10:27 pm

Obama and the Democrats may have inadvertently forced this downgrade with the passage of the Frank-Dodd Act last year. If you will recall from a thread about a year ago, a consequence of the Frank-Dodd passage was that there was a period of time when the credit rating agencies withheld their ratings altogether due to new legal exposures that had not been quantified, causing consternation in the market.

The source of that minor interruption in the ratings market was a provision in the Frank-Dodd bill that repealed Rule 436(g) under the Securities Act of 1933. In times past, one of the privileges of being one of the few government-appointed ratings agencies (NRSROs) was that they were exempt from legal liability for the quality of their credit ratings, unlike the rest of the credit rating market. Many people know that NRSROs were putting garbage ratings on some debt but fewer know that those government-sponsored ratings agencies were uniquely exempt from legal consequences for doing so. This is why they were so easy to game — all upside, no downside.

Frank-Dodd repealed this special liability exemption for NRSROs, giving them legal exposure if they put dubious credit ratings in registration documents and prospectuses. Since last year the NRSROs — like S&P — can be sued for bad faith ratings like everyone else. They no longer have legal cover to paper over the government’s fiscal malfeasance. Consequently, multiple NRSROs are downgrading US debt to avoid legal exposure when they put their imprimatur on it.

I am pretty sure this is an unintended consequence of the Frank-Dodd Act for the Democrats. A year and some months ago none of the Democrats considered the possibility that a side-effect would be that it would restrict the ability of the ratings agencies to play ball with the political establishment when it came to US debt instruments or that US debt instruments would be in a position where they might be legitimately downgraded.

Statistics: Posted by tortoise — Sat Aug 06, 2011 3:17 pm