Venture capital powered the tech revolution, but what powers venture capital? With his in-depth knowledge and coverage of the sector you’d be forgiven for thinking Sebastian Mallaby is a veteran of the Silicon Valley scene. The author of several books on finance and economics, Sebastian takes pride in understanding his subjects intimately (perhaps too intimately, if you ask his critics). His latest book, Power Law: Venture Capital and the Making of the New Future, sheds light on the small but mighty industry.
Sebastian joined Tyler to discuss why venture capital skills aren’t more replicable, the promise of biotech despite increased regulations, why venture capital remains concentrated in the Bay area even after the pandemic, the differences in risk-taking between East and West coast finance, the secret to Mike Moritz’s success as an investor, how Peter Thiel’s understanding of the power law set him apart, why he isn’t interested in becoming a venture capitalist himself, his predictions for the European tech ecosystem over the next ten years, the original sin of “too big to fail,” the major failure of Alan Greenspan during his tenure at the Fed, the Darwinian evolution of good hedge fund strategy, what Ray Dalio got right with Bridgewater, the finance topics he feels are undercovered, what it takes to be a good Substack writer, why he’s bullish on The Information, reasons to be optimistic about the innovative and entrepreneurial trajectories of Japan, the greatest living British historians, the future of the World Bank once China stops borrowing from it, what’s causing the decline in popularity of liberal capitalism, the zany appeal of The Grand Budapest Hotel, and more.
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Recorded January 31st, 2022
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TYLER COWEN: Hello, everyone, and welcome back to Conversations with Tyler. Today I’m here with Sebastian Mallaby, who is the author of numerous excellent books on economics, politics, and current affairs. He is a senior fellow at the Council on Foreign Relations, a contributing columnist to the Washington Post, and most importantly, he has a new, excellent, and very well-reviewed book out, called The Power Law: Venture Capital and the Making of the New Future. Sebastian, welcome.
SEBASTIAN MALLABY: Great to be with you, Tyler.
COWEN: Do the observed high returns to venture capital funds constitute a counterexample to the theory of efficient markets?
MALLABY: Yes.
COWEN: Why does it continue? Why doesn’t capital just flow into the sector and bid down the returns?
MALLABY: Well, maybe that’s what we’ve been seeing just in the last three years or so, with enormous amounts of money coming in during the pandemic. And quite possibly there will be a correction.
You’re asking, I guess, a more subtle question about whether, on a sustained basis, money would flow in and bid away the returns. I think the point here is that, any time we’re dealing with alternative asset managers — whether it’s hedge funds or venture capital — it’s the skill that you need. The money may be limitless, but the skills and the connections in Silicon Valley and what have you — that is not unlimited. Skill can continue to generate good returns.
COWEN: In that underlying mental model, the excess returns can stay more or less forever. More capital coming in won’t bid down the returns much?
MALLABY: I think that’s right. The returns have been pretty good, at least for the better venture capital funds. Here, we may want to come back to that caveat. Going back to the beginning of the story in the ’60s with Arthur Rock, the pioneer of venture capital, right through to today, you do see good returns. Sequoia, which I regard as the top venture capital partnership in Silicon Valley, has generated returns of about 12 times investors’ money this century. That’s 12x. That’s 1200 percent — pretty good.
COWEN: Why isn’t that skill replicable if the returns to replicating it are so high?
MALLABY: I think there’s an inefficient-markets thinking. There is a notion that you can assume away skill, and that if skill is good, you can just make more of it. That would mean you would compete the returns down. I think some of the skill is so far off in the tail of the distribution that it’s quite hard to replicate it.
A really good venture capitalist combines technical knowledge of what he or she is investing in — whether that’s biotechnology or computer science — plus business feeling, plus the skill of networking with people and putting teams together. And a phenomenal energy, because you’ve got to be out there getting up in the morning for one breakfast with one potential person you might invest in, and then doing 14 cups of coffee before you go to bed, and being that wired, you still sleep.
It is tough to find enough people like that. Maybe we’re going to discover that the last four or five years of boom have sucked in so much talent that it will be competed away. That could be true, but so far, it hasn’t happened.
COWEN: What do you think of the view that in recent years, there’s been a huge consumer retail tech boom? Basically FAANG stocks, right? And when that is over — it might be over now — the excess returns to VC will go away. If you look at venture capital for biotech, which has been hammered lately, as we’re speaking here, late January 2022 — and maybe venture capital is a limited model for one period of time, and otherwise, it just does okay. True or false?
MALLABY: False. I say that because, in a cyclical sense, you might be right, but I think there’s a deep structural shift, which is really important. That is that intangible capital has become more and more important in our economy. The nature of intangible capital is that it’s hard to measure it in financial reports.
To understand whether a particular software investment, for example, is worth a huge amount or, really, nothing, you need to understand what that software development within the company is doing. You need to be hands-on. You need to have the technical skills to evaluate that software project. The more that intangible capital rises as a share of new GDP creation, the more this venture-style hands-on expert investing is going to be valuable.
COWEN: Your explanation — if I understand it — to me seems to suggest that venture capital for biotech won’t work very well. You’re portraying it as something that’s very, very hard to do, a very limited skill, so you’re going to be wrong a lot of times. That means the times you’re right, the product has to be scalable very rapidly.
But in biotech, there are regulators. You often need a sales force. It’s not scalable in the way that, say, LinkedIn or Netflix are scalable. Doesn’t that mean VC will just stay limited to a very small area of those things that are super rapidly scalable? Or if you think it’s pretty easy to pick winners, then you have to think the rents get exhausted.
MALLABY: [laughs] Yeah, this is a version of, actually, a wider debate which goes beyond biotech, which is the claim that venture capital is really only good for software projects, that software can be scaled very, very fast; there are network effects once you get product-market fit, and you don’t need much capital. The marginal cost of serving one more customer is pretty much zero once you’ve built the Google search engine. People will argue, “Look, that’s all that venture capitalists do.”
That is, for sure, historically inaccurate. There’s a long history of venture investing which was more about hardware than software. It was about Apple computer. It was about U-Net building the pipes of the internet. It was about compact computers. It was about semiconductor firms and so forth. We know the software version of this argument — that venture capital only does cheap to-scale software. That’s just wrong.
Biotech, I agree, is a tougher example. It’s more regulated. Historically, there have been cases early on, like Genentech, which went public in 1980 with the first artificial insulin. Huge, huge venture return really set Kleiner Perkins on the way to dominance over the next two decades in Silicon Valley in terms of venture investing. But that’s an outlier, and it’s true that healthcare investing has been tougher and less profitable, and a lot of companies have withdrawn from that.
But I think the past isn’t necessarily a guide to the future. The fun thing about venture is that you have to be watching to see where basic science is generating innovation that can be commercialized. The thing that didn’t necessarily do that for a long time might be the thing that does it in the future.
Now you’ve had a bunch of innovations, from gene sequencing to CRISPR, which makes it faster and easier to develop new drugs. Those drugs can have huge consequences. The coronavirus vaccine from Moderna is a good example of this. I think that it would be wrong to rule out the idea that even a pretty capital-intensive, regulation-intensive sector like biotech — I think it might still work.
COWEN: What then, in your mental model, does limit the size of venture capital? Because as a percentage of entire capital flows, it’s pretty tiny, much smaller than private equity. What, at the margin, makes venture capital not work?
MALLABY: You’re right, it’s small. The paradox is that the impact is big. Just a couple of numbers on that: Fewer than 1 percent of companies that get formed every year receive venture capital backing, but if you look at the years since 1995, half of all the companies that go public got venture backing, and three-quarters of the market cap from those companies derived from venture-backed companies. Tiny share get the money — less than 1 percent — but three-quarters of the market cap is the result.
That’s the first point. Just because it’s small, it doesn’t mean it has low impact. I think, at the limit, to answer your question directly, there are things which are either so capital-intensive — like building a new semiconductor fab — where you’re really in the billions from the get-go, where that’s . . . Venture doesn’t do that. It’s about starting —
COWEN: Why not? Capital is not that scarce, right?
MALLABY: Yes. Venture’s advantage maybe helps to answer why sometimes it has a disadvantage. One of the advantages is the idea of stage-by-stage financing. You give the company a bit of money, and then if it fails early, it fails cheaply because you haven’t given it a huge check right from early on.
Something which is going to definitely take an enormous amount of money up front — like a new semiconductor fab — is not the right . . . In terms of comparative advantage, venture conceivably could raise that amount of money and could conceivably go finance that. It just wouldn’t be the natural sweet spot, and it would be better to leave that to TSMC or Samsung or some established maker of semiconductors.
COWEN: As you know, Sequoia has changed its rules so that it can now hold investments for much longer-term periods than had been the case. If you extend this to its logical conclusion, you could imagine a future ten, fifteen years from now, where hedge funds, VC firms, a lot of other financial intermediaries are all blended mixes of doing varying combinations of similar things. Ten to fifteen years from now, what do you think will be the unique feature of venture capital? Or do you think everything will be a blend?
MALLABY: That’s a great question. I would say that the useful definition of venture capital is that it is an early-stage venture, an adventure, in fact. When you get to investing in companies which are more than about $500 million in market cap, that’s a different thing. That’s growth equity. I don’t call that venture anymore.
The reason I picked $500 million as a number is that when Amazon went public in the late ’90s, its public market cap when it IPO’d was between $400 million and $500 million. Now what’s happened is that the IPO point has been delayed because you’ve got this ability to raise late-stage growth capital, and more and more checks have been written — $100 million, $200 million, $300 million — into companies that are worth $1 billion, $2 billion, $10 billion.
That is being grafted into traditional venture partnerships like Sequoia Capital, so I write a lot about Sequoia. One of the amazing things is how much franchise risk they’d be willing to take. They were a traditional early-stage investment shop in 2000, and then they grafted on this growth equity business. They grafted on a hedge fund business. They built an endowment fund on top of that.
Now, as you say, they’ve got permanent capital, so they’re going to end up with multiple business lines. It’s a bit like Goldman Sachs has multiple business lines. I think the venture capital portion of Sequoia’s business will remain the early-stage part.
COWEN: Even after the pandemic, it’s striking to me how much venture capital remains concentrated in the Bay Area. The major deals are mostly done there. What’s your mental model for that?
MALLABY: I think the lesson of Silicon Valley is that agglomeration effects and clustering effects are actually even bigger than economics as traditionally explained. In other words, economics . . . Just reading when I was writing my book about economic geography and that whole literature, the traditional story about why a cluster is a productive thing is that you get better matching between the skills of workers and the needs of companies when you have a very deep labor market.
So, if you’re talking about coding, and a company wants to hire a particular database engineer in a particular database software, in Silicon Valley, there will be the precise type of engineer that you want. Whereas if you’re in a less deep pool of labor, you won’t find that. The same argument goes for suppliers. If you want to have a supplier that provides a particular kind of bespoke semiconductor, you’re more likely to find that supplier locally and be able to go visit them if you’re in Silicon Valley than elsewhere.
COWEN: That would be why the start-ups are clustered. Why are the venture capital deals clustered? Furthermore, in a funny way, they’re anti-clustered. They’re not all in New York, which is our major financial center by a long ways. San Francisco is not that. It’s a mix of anti-clustering and then some extreme clustering for this set of deals that have some particular features.
MALLABY: I think that shows you why venture capital is fundamentally different to the other kinds of capital that are going on on the East Coast and in Greenwich — New York and Greenwich and so forth. It’s just a totally different thing. I always like to say the postwar, archetypical financial companies on the East Coast — the archetypes were Prudential and Fidelity, and their names tell you a lot about their attitude to risk — they were about stewarding capital and not losing it.
This high-risk, power-law return, grand slam business that emerged in venture capital on the West Coast is utterly different. So, it’s not surprising that we would have an anti-cluster, a different center for that kind of financing. But I think it clusters because this is a business where people syndicate into each other’s deals. One venture capitalist will lead the Series A around financing a company, and then another one will lead the Series B, and another one, the Series C. Often, a single run, like the Series C, will have multiple investors in it.
It’s just economical for the entrepreneurs to be able to visit a whole bunch of different VCs and pitch to 10 of them without having to get on a plane and fly around. I think there are clustering effects. Also, just the circulation of ideas, people, and money within the clusters — which is something that venture capitalists facilitate — works better when it’s concentrated geographically.
That’s why, at least until the last 10 years, when perhaps we’ve gotten to the point with Zoom and remote work and so forth where this is less driven than it used to be. I think the agglomeration effects were really very, very powerful, and venture capital needed to be clustered to be most effective. That’s why you got the Silicon Valley dominance.
COWEN: When is venture capital more effective versus when is angel investing more effective?
MALLABY: Angel investing wasn’t really a factor until the mid-late 1990s. Once it became a factor — and that happened because Silicon Valley had reached a point of maturity, where there were enough rich, exited entrepreneurs who had made money starting their own companies, and then wanted to turn around and fund some younger people who looked a bit like them. That’s what happened with Google. Google could raise $1 million in 1998 before going to any venture capitalists because angels had become a thing.
One of them was Jeff Bezos of Amazon, and the other was Andy Bechtolsheim, who had started Sun Microsystems some time before. Once you get angels, then I think entrepreneurs are going to want to use them because they’re friendly, they’re typically people who know a lot technically and that you relate to, you look up to when you’re a founder.
I think angels are useful for the first round of money, the first amount of mentoring. Then when you get a bit further along on your company, you want the Series A, which means more money, more formal company structuring, and a tougher, clearer sense of what your next milestone is that you have to reach — otherwise, you’ll be shut down — then you go to the proper VC.
COWEN: True or false, good CEOs make good VCs.
MALLABY: Not always true. As a generalization, I would say false. The premise of Andreessen Horowitz, the venture partnership set up in 2009, was that to be a good venture capitalist, you had to be an entrepreneur, and you had to have run a company and understood what a start-up is like from the inside. That just turned out to be false. Andreessen Horowitz has now given up the rule that to become a partner at the company you have to have been a former founder of a company yourself because it just isn’t the best way, necessarily. It’s one way you can choose a good venture capitalist, but it’s not the only way, by any means.
COWEN: Why has Mike Moritz been so good at VC?
MALLABY: That’s a great question. I think he was willing to do two things. When it came to company founders, he had the ability to enlarge their sense of themselves. He could intuit what they were doing. He could get on people’s wavelength and not only understand them, but understand them better than they understood themselves, and see more potential in their project than even they saw when they looked at it.
The first example of this is Yahoo, where Jerry Yang and David Filo were in their port-a-cabin on the Stanford campus. They thought they were building a hobby-type thing, and they were proud of Yahoo as a directory of the emerging internet. But Moritz showed up, listened, understood, and said, “This is the new Apple. You are going to make something with a quirky name. Apple was quirky, Yahoo is quirky. You’re going to have a brand, and you’re going to be the face of a new phase in tech history.” He enlarged their sense of themselves.
He was just great at delivering that kind of call-to-greatness speech. He sat down at PayPal with one of the founders of PayPal, who was resisting the idea of a merger with the Elon Musk rival, which was called X.com. He said to him, “Listen, if you do this merger, I will never sell stock in the company, and you will build something that makes history in the Valley.” That call to greatness was inspiring. That’s one thing, that EQ [emotional quotient] to get the best out of people and make them be even more ambitious than they already were.
The other thing Mike Moritz did is, he risked the franchise of Sequoia. He did, a bit, what I was talking about before. He was willing to go into China, which was a whole different challenge, go through a period when he had to fire the co-founder of Sequoia China because it wasn’t working out, but stick with it. If you ask the question, what is the top venture capital company in China, the answer is Sequoia China. It’s the same as the answer to the question, what’s the top venture capital company in Silicon Valley? It’s Sequoia. Mike Moritz was able —
COWEN: But that’s a bit anti-clustering, that point, right?
MALLABY: It is, yes. China requires a whole . . . and in a way, it’s a confirmation. You’re going to say I’m twisting the argument here, but China, of course, is its own ecosystem when it comes to technology because the government erects these barriers, which makes it tough for US companies to compete there. So Chinese giants have dominated Chinese tech.
They’ve been funded — at least in the early phase of the digital economy in China — almost always by American venture capital companies. Sina, Sogou, NetEase, the early web directories in China — all funded by Americans. Then you’ve got Baidu, Alibaba, Tencent, Ctrip. All of these companies are backed by Western VCs.
What it shows you is that, just in the same way that, in Silicon Valley, the VCs came in and built this cluster which had great circulation of ideas and people and money around the ecosystem, so too, they repeated the same trick in China, and they built anew. It’s not really quite as tight of a cluster because it’s split between Hong Kong and Shanghai, and even Hangzhou and Beijing. So, it’s not like Silicon Valley. It’s multiple cities.
It is a China cluster unto itself, but interestingly built with the same Silicon Valley DNA, the same lawyers, incorporation in the Cayman Islands for companies, use of American-style employee stock options, which were just not a thing in China until American Silicon Valley lawyers showed up in China and explained to people how stock options worked.
COWEN: What has made Peter Thiel such a successful venture capitalist and angel investor?
MALLABY: Peter Thiel is fascinating because he articulated more fully the idea of the power law than anybody else before in venture capital. The early VCs I studied had the idea. They didn’t call it the power law, but they had the idea that one or two bets in a portfolio of ten would make all their money. Peter Thiel not only articulated it and took it further, but he then actually designed his investing and his company, to even greater extent, around that concept.
The logic of the power law is that, if all of your money will come from a couple of outlier bets, you better bet on outliers. It’s no good betting on something that looks normal because then everybody else will be doing a similar thing. You won’t be differentiated. You won’t have a moat around your company, and you won’t make supernormal returns.
Thiel’s logic was, if you are looking for those really crazy 20x, 30x, 40x wins, you want to bet on people who are themselves a bit out of the box. He makes a joke and, in fact, he boasts about the fact that the majority of his co-founders at PayPal had made bombs in high school, that Elon Musk one day — when he was driving him along Sand Hill Road on the way to a meeting at Sequoia — trashed his supercar. I can’t remember if it was a Ferrari or some other fantastically expensive car — spun it around, ruined it, and was laughing his head off because he didn’t have insurance. This is risk —
COWEN: That strategy seems entirely replicable. Anyone can take a lot of chances on smart eccentrics. What does Peter have that is not so easily replicable?
MALLABY: The key point is, even when you decide you’re going to bet on out-of-the-box people who look as if they’re in the tail, there’s still a difference between smart bets on the tail and bad bets on the tail. To make the smart bets, you do have to have a view and an understanding of where technology is going. You’ve got to skate to where the puck will be, which means you have to think forward.
Just think about Facebook, where Peter Thiel did this famous angel bet that is probably one of the best bets in US venture capital ever. How did he do that? He, first of all, was not put off by the fact that this was an eccentric 19-year-old Harvard dropout who wouldn’t look you in the eye, and that the business partner of this guy was Sean Parker, who had been fired by VCs from his past two companies.
So, he had to look through that stuff, but he also had to understand that, with the ubiquity of the internet, new kinds of communication would happen, and that this idea of social media — which had been tried and failed in other examples, like Friendster — just because it had failed a couple of times in early iterations, social media could still be made to work if you did it right, and that’s what he bet on. It was still a long-shot bet, but it was a very high-outcome bet if it went right.
COWEN: Have you ever been tempted to try VC yourself? Do you think you’d be good at it? You’re smart. You know the history of venture capital quite well.
MALLABY: No, I enjoy what I’m doing. It’s true that whenever I spend five years on a project, which is how long these books take me, my objective is to get into the cockpit with the people I’m writing about and fly around the landscape and really understand how the world looks through their eyes, to explain their thought process to people. I wind up trying to think like them.
My critics would say I write as if I was one of them, and I’m not critical enough of the subjects I’m trying to write. But my feeling is there’s enough anger and mistrust in the world. I don’t particularly want to add to that, but I would like to add to understanding. So I’m happy to plead guilty to trying to get into the skin of the people I’m trying to write about, but it doesn’t mean I want to be them. Ultimately, I’m happy being a writer.
COWEN: Well, you’re happy. They might be happy doing something else. Mike Moritz was happy writing about soccer. He has a book about Alex Ferguson. But what’s the nonreplicable feature that they have, and you think you don’t have?
MALLABY: I think it would be helpful to be more technical than I am. Most VCs have an engineering degree or something. Or if they don’t have that, they know —
COWEN: But Peter Thiel is not very technical in that sense, and he’s one of the very best.
MALLABY: That’s true. Michael Moritz also fits that model. There are clearly exceptions. Peter Thiel had started PayPal before he became a venture capitalist, and I think that was important. He’s also somebody who was deeply in that network. He just so happened to come from Stanford, Silicon Valley. That was his roots, so he was embedded in the network with people, and that’s a very valuable thing. The PayPal Mafia tells you a lot. Some of his returns come from the experience of having been deep in the trenches with people who were technical and backing them repeatedly.
Elon Musk was his business partner at PayPal — also, his business rival at PayPal. They would fight each other. There was a famous coup when Elon went on honeymoon, and he was fired from being CEO, and Thiel was put in his stead. It wasn’t all love and roses. Nonetheless, Peter Thiel backed SpaceX when Elon Musk needed capital.
That embeddedness in the network, I don’t have, although I spent five years embedding myself enough to write this book. I don’t have the engineering. I think there are plenty of smart people who can go and be venture capitalists. I like the idea that I spent five years getting to know one kind of business or financial specialty after another, and I’m a perpetual outside writer-cum-tourist.
COWEN: What are the cultural factors that limit the success of venture capital in South England? It has not developed a comparable network. It’s fantastic for science. It has London, financial center, at least two incredible universities, other academic contributors, yet it hasn’t really taken off. Why not?
MALLABY: My theory about this is that the lacking thing has been, historically, venture capital because you’re right, Oxford and Cambridge both have world-class science faculties in addition to strength in human sciences. Europe as a whole, actually — that’s true as well. ETH in Zurich is very strong, and there are more trained computer coders in Europe than there are in the United States. And Europe is a big, rich consumer market. So, there are a lot of strengths in Europe.
What it’s lacked traditionally . . . Traditional lines are always cultural. People don’t take risk in Europe. They’re too keen on working for a big, safe institution.
My view is that, when you get venture investors added to the mix that are willing to underwrite the risk of small start-ups, all of a sudden people are willing to start them because the risk is paid for. You can take the risk as an entrepreneur with somebody else’s money. And if it fails, you’ll have burnt up your energy and time, and that’s not to be sniffed at, but it will be somebody else’s capital that underwrote it.
Furthermore, you will be helped to hire good people to help you because a venture capitalist will be on your cap table and will use its brand to bring in good people. I’m always struck by the story that Eric Schmidt told me about why he joined Google as chief executive, which was a very risky move.
Schmidt had been chief executive of another company, Intuit, and he was joining Google that was controlled by these two grad students who were notoriously ordering him, controlling him, might fire him, and didn’t particularly like people who were over the age of 30. Eric Schmidt knew that, going into Google, he might get fired, but he did it because the venture capitalist involved — John Doerr — said to him, “Look, if they bounce you out, I’ll find you another great job somewhere else.”
That cultural thing about, why is there this risk appetite in Silicon Valley — it’s not something you drink in the water. It’s not something in the air that you breathe. It’s venture capital that is de-risking entrepreneurship and the business of joining tech start-ups.
COWEN: Venture capital is mobile. You would think it could all spread to South England, which is not a backwater by any stretch of the imagination. Very rarely —
MALLABY: Correct, and it’s happening. You’re asking the right question, and the answer is, it should happen and, by the way, it is happening. Sequoia has recently opened an office in London. General Catalyst and Lightspeed, two rather well-known American VC firms, have also recently set up offices. You’ve got Index Ventures, which is big in San Francisco, also big in London. You’ve got Accel, ditto — big in London as well as big in California.
This is happening. The ecosystem is growing. The number of unicorns in Europe is growing exponentially, and I predict that in the next 10 years, Europe will grow a lot faster than the US tech ecosystem.
COWEN: Geographically, what’s the most underrated venture scene? Where would you place it?
MALLABY: Well, it might be Europe, as I just said.
COWEN: Would you say it’s South England? Or is it Berlin, or where exactly?
MALLABY: Do you think people underrate . . . What do they think about Sweden? Because that’s surprisingly hot, right? You’ve got Spotify based in Stockholm, and all the spinoffs from Spotify, which are bound to come in.
Once you’ve got a unicorn which is worth $50, 60 billion — like Spotify is — what that’s telling you is that there’s a whole cadre of people who have experienced dramatic, intoxicating growth from the inside. They are now wealthy. They can start their own new companies. They can become venture capitalists, or they can just become angel advisers to new start-ups.
I would say Sweden is going to set up just like Seattle has, based off of Microsoft and Amazon. I think the Spotify halo effect in Stockholm will be pretty big.
COWEN: It’s not just that it’s properly rated; you think it’s underrated? Isn’t Sweden, Stockholm too small to be such a big venture scene if network effects are so important, if clustering is so important? Doesn’t it then have to be London, South England? Or maybe Berlin? I think I would say South England, actually, is the most underrated. Precisely because Spotify is visible, Sweden is doing just fine, but it seems to me properly rated.
MALLABY: Going on what you say about Sweden already being pretty highly rated — if that’s right, I’m happy to agree with you. Maybe South England is the most underrated.
Graphcore is a great story. This is a semiconductor design company. There was a moment, I think about 2017, five years ago, when Sequoia decided that AI semiconductor chips were going to need to take a leap to a next-generation product. All the AI companies that Sequoia dealt with were saying the hardware that they were buying was just not up to scratch. Nvidia was good, but it wasn’t good enough.
So Sequoia told one of its partners to do a worldwide search for the best emerging semiconductor company that was going to knock it out of the park on AI semiconductor design. The partner, who lived in Los Altos, California, in Silicon Valley, began by looking at a company that, guess what, was based in Los Altos, California. But he ended up recommending an investment in a company in Bristol, South England, called Graphcore. That company is now doing terrifically well. That experience is one reason why Sequoia decided to open an office in London in 2020.
COWEN: I have some questions about other topics. You have some highly regarded books about hedge funds and about the Fed. In the late ’90s, the bailout of Long-Term Capital Management — was that a kind of original sin that just set us on a path of bailing more things out at higher and higher price tags? Should we have just let LTCM fall?
MALLABY: No, I think the original sin was Continental Illinois, much earlier in 1986, I believe, when the Fed bailed out this bank which it thought was too big to fail. I’m not sure it really was too big to fail, but it was a moment when the Latin American debt crisis was still casting a shadow, when the banking system was perceived to be fragile, and the Fed just wasn’t willing to let it go. That was the original sin because taxpayer money was used to bail it out.
The interesting thing about Long-Term Capital Management, which people forget, is that the Fed convened the creditors of Long-Term Capital Management at the Fed offices in New York, but it refused to provide any taxpayer money whatsoever to backstop Long-Term Capital Management. That was salutary.
I think, if you look at what happened in the 2008 crisis, actually, hedge funds were not driving the crisis because the prime brokers who extend leverage to hedge funds learned the lessons from LTCM, and they didn’t extend loans without taking good collateral. In actual fact, hedge funds turned out to be the relatively more stable part of the system in 2008, which was a time when insurance companies and investment banks and money market funds and commercial banks and all of these other players cost the taxpayers billions, and hedge funds didn’t.
COWEN: What is it you understand about Alan Greenspan — having written a whole book about him — that other intelligent, educated people do not?
MALLABY: Behind the title I chose for the book, The Man Who Knew, the key thing was that Alan Greenspan had written a PhD thesis mostly comprised of papers he read in the 1950s. Nobody had found that thesis until I found it. When I read it, what it told me is that in the ’50s — in other words, right at the beginning of his professional career — Greenspan’s obsession was with stock market bubbles. He was really preoccupied with the way that bubbles could drive recessions in the real economy. Balance-sheet effects were at the core of his PhD work.
Now, once you understand that, it tells you that Greenspan failed in his own tenure at the Fed to prevent the mortgage bubble from inflating. He failed not because he didn’t understand about balance-sheet effects. He knew about balance-sheet effects. He was the man who knew. He knew more about them than most of the critics who suddenly discovered in ’08, “Oh, balance-sheet effects. Gee, we better go read Hyman Minsky. This is a big deal.” Greenspan knew about them, and yet he let the bubble go wrong.
What does that tell us? It tells us that the institution of the Fed was sort of trapped into a position where inflation targeting had become irresistible, and they just targeted inflation and paid no attention to asset bubbles. I think that was a big mistake.
COWEN: How is Jerome Powell doing?
MALLABY: I think Jerome Powell is about to face a huge test as he tightens rates, starting next month. History will, of course, tell us whether he manages to stabilize inflation without causing a major recession. That’ll determine how he’s going to go down. Here’s how I would frame it, having acknowledged that it’s a risky thing to stick my neck out here, but here’s how I would frame it.
I would say that COVID was this humongous shock to both supply and demand. Unprecedented. The Fed responded in an unprecedented way with a stimulus, which, as you know, was multiples of what was delivered in 2008. That did get us through the COVID downturn with remarkably little economic privations for Americans. That is an amazing achievement. COVID was tough in many ways in health terms, in mental health terms, but actually, balance sheets of households did very well.
Now, that is a huge achievement. You couldn’t achieve that without accepting some risks that you would overshoot. How do you target the right amount of stimulus when you are in that completely uncharted water, and you don’t even understand the trajectory of the pandemic, let alone the pandemic’s effect on the real economy? They took a risk. They may have overshot and overstimulated it. We’ll see if they exit without causing a big recession.
I think they will. I think that history will judge Jerome Powell to have been a very brave risk-taker and actually a success, but I have to admit that I could be wrong.
COWEN: Do you think the Fed was excessively intimidated by the fiscal authority? There’s a joint effort going on, and the monetary authority, fiscal authority — they often want different things. Do you think it’s the case the Fed exactly understood the calculus, or was shocked that inflation came in at almost 7 percent? Or even an alternative is, they secretly welcomed it being that high, or they would’ve preferred it only had been at 4 percent, but the fiscal authority had more power?
What’s your mental model of what went on in the government as a whole? There was overshooting, but how does the Fed fit into your exact story?
MALLABY: My strong feeling is that the story of Fed captured by the fiscal authority, or in other words, the president, is wrong. That ever since Paul Volcker — the mental model of the Fed — everybody who works there, including and especially the chairman, is that Paul Volcker was a hero. He got inflation under control.
Antihero is Arthur Burns in the 1970s. He let inflation get out of control. You don’t want to go down in history like Arthur Burns. You want to go down in history like Paul Volcker. At threshold level, that is still a dominant instinct. Yes, we’ve been, since around the early 2000s, through this kind of zero-lower-bound, oh, inflation-is-too-low worry, and so that encouraged some risk-taking with the amount of stimulus, and now we’ve overshot.
I still think the dominant mental model is, don’t be Arthur Burns, be Paul Volcker, and no amount of pressure from the executive branch would wipe that out, especially when you look at the executive branch and you ask, “Okay, so who is the chief economist in this fiscal authority that we’re talking about?” Is it Janet Yellen, the former Fed chair herself? Do I think she was trying to subjugate Fed independence? Of course I don’t. I think it’s a preposterous slander.
I really think that the Fed allowed overshooting not because they were being bullied by the president or by the Treasury, but simply because inflation surprised them on the outside.
COWEN: Here’s a very easy question. Adjusting for risk, do hedge funds even yield supernormal positive returns on net?
MALLABY: It depends on the period you look at. The best way to think about supernormal positive returns is, I think, simply to say uncorrelated returns. An uncorrelated return which isn’t driven by just the market going up is pretty hard to come by. A normal return, I think, is zero, if you’re trying to do that.
Any positive return which isn’t correlated with the stock market benchmark, or whatever other benchmark you’re choosing, is good and, in terms of a big, diversified pension fund or endowment portfolio, will help your Sharpe ratio because it’s giving you some extra juice to your return without adding to risk because it’s not a correlated position. So, when you net out the volatility of your hedge fund exposure with all your other exposures, it’s actually volatility dampening. That’s the idea.
Do they produce offer, is the question. When I published my book in 2010 about hedge funds, the best research at the time said that, net of fees, there was positive offer and it was 3 percent a year between 1995 and the late 2000s. That was a pretty strong positive number. I think since 2010, the positive number has declined to be much, much smaller and maybe even to disappear in some time periods. I think that happened because of quantitative easing.
If you think about hedge funds, what is it that they do? They get paid to assess risk and price it. If risk spreads are being squeezed and compressed and reduced to almost nothing by the central bank through quantitative easing, then hedge funds are going to be paid less for doing their work. I think that’s why supernormal positive returns — to use your language, Tyler — have diminished. I think they may now come back because of the end of quantitative easing and the raising of interest rates in the face of inflation.
COWEN: To ask the same question we discussed with venture capital, what is the non-replicable asset held by the very good hedge funds? Otherwise, more capital comes in and competes that excess return away, right?
MALLABY: Yes. Again, I think the answer to your question is partly that capital does come in and compete excess returns away as strategies are discovered. As you look at the history of hedge funds, there keep on being new strategies that get invented, or maybe new areas of finance where old strategies can be applied.
Now we’re in a world of big data, which means that new datasets become available to investors. You can crunch new sets of numbers, using new AI algorithms, and develop new insights about patterns that appear to repeat themselves in defiance of efficient market logic, and you can invest on those. The first people to do that will get supernormal returns.
Then, after a bit, that technique may become understood by enough people that more capital comes in, and the returns get competed away. But this is a dynamic Darwinian evolutionary industry, and new methods and techniques will be invented as the old ones cease to be profitable.
COWEN: Let’s say there are some hedge funds that are quite special, but it seems a lot, the large numbers are not. Yet they’re still doing some version of 2 and 20 fee structure. How is that sustainable if a large class of hedge funds don’t really offer the promise of beating the market?
MALLABY: Well, look, the famous case here is mutual funds, where actively managed mutual funds, last time I looked at the data, had a negative return. Because the skill that’s being purportedly provided is less than the fee, even though the fee is just a 1 percent of assets under management. There you’ve got negative alpha.
Why do people continue to buy exposure in these money-losing, actively managed mutual funds is because hope springs eternal, and people always think that they are investing in the top quintile of clever managers who are going to defy what the average does.
People go to Las Vegas and gamble, even though they know that the house has better odds than they do as the punters. I think at a basic level, it’s not so surprising that people continue to invest in actively managed hedge funds because they’re a better option than actively managed mutual funds. The same would be true of actively managed venture capital, by the way.
That’s part of the answer. The other odd part is that, as I was saying, over a long stretch of time, hedge funds have produced positive uncorrelated returns, which are good for a portfolio. The common way that this gets reported in newspapers, which is to say, “Look, the S&P went up 15 percent last year, and hedge funds only returned 4 percent, so hedge funds are a bunch of losers” — that is financially illiterate because you’re not comparing apples with apples.
You need to compare what the alpha was in the two sets of strategy. By definition, the alpha in the S&P 500, the S&P 500 is the benchmark, so it’s a correlated return when the alpha was zero. What’s interesting is to get some uncorrelated return that then dampens your volatility in the rest of your portfolio because much of your portfolio will be correlated with the benchmark. If you can get this uncorrelated return, that will dampen the rest of your volatility, improve your risk-adjusted return in your total portfolio, and make your portfolio better.
COWEN: How did Ray Dalio become so rich?
MALLABY: Between us… I know this is a podcast, but I’ll answer your question anyway. Between us, Ray Dalio the man — in my estimation, you can’t answer that question. I feel sometimes when I listen to him that half of what he says is obvious, and the other half is nonsense to the point where it becomes a parlor game to look at Ray Dalio’s principles and say, “Gee, if you see an open door, walk through it.” Was that the way you built the company? I don’t think so.
I think if you want to understand why Bridgewater did well for a long time, although it’s done less well recently, it’s not about him. It’s not about the man. It’s about the machine he built. The machine. Just patiently built a research organization that carefully built its own model of how markets work by scraping data, producing very precise, clear studies of relationships — one variable does this, the other one will do that.
When you aggregate that knowledge base over time, you build an investment black box that really did work for quite a stretch. Based on my conversations with people who work for Ray Dalio, I come away a lot more impressed, frankly, than I do by the public relations shtick I’ve heard from him in the last 5 or 10 years.
COWEN: As a writer, which topics in finance and investing do you think are under-covered?
MALLABY: I think, actually, that investing — if you go at it from the perspective of, how does this really make money? What is the source of alpha? I think that in general is a bit under-covered. The starting point amongst a lot of academics — as your questions, in a way, have been telling us — is there shouldn’t be any returns. Alpha should be impossible to generate.
I think to understand how it is generated is difficult. It requires a lot of getting close to the subject, getting close to the people who work for the subject, sorting through the nonsense, as I’ve just tried to do in my answer about Bridgewater. I don’t think that many people, frankly, have the time to spend five years on one topic and try to provide an answer. That’s how I’ve tried to differentiate, is to make five years of time to go look at a specialty. And I hope that is an under-covered thing and, therefore, that I’m adding value to the books which are on the bookshelf.
COWEN: Putting aside family connections, your wife being editor of The Economist, but what is it in media or journalism you’re especially bullish on? Is it Substack? Is it old-style MSM [mainstream media]? Is it… whatever?
MALLABY: I’m a big admirer of The Information, which is a Silicon Valley media start-up. It’s been going about 10 years. The reason I’m a fan is that I think that’s the right model for media start-ups.
I think Substack, where it’s a lone writer doing a newsletter, can be excellent when you’ve got an unbelievably talented and energetic and exceptional person. You interviewed, Tyler, Andrew Sullivan not so long ago. I would put him in that category of just an exceptional person. If he wants to do Substack, fantastic. He’s exceptional.
I think most of the time, somebody can be great at a Substack for three years, possibly five years, but it’s pretty hard to sustain that level of focus and energy. If you don’t sustain it, you’ve built a brand over three to five years, and then you throw it away because you stop, or you just go off the boil.
Therefore, it’s more sensible to create a collective journalistic effort. That’s what The Information is doing. It’s going at a particular area, which is tech. It only covers tech. It hires good people who know what they’re doing. It’s got a team, and it’s building that team, and I think that’s terrific.
COWEN: As a journalist, you covered Japan for years. What do you see as the economic future of Japan? They seem to have a shrinking population, fairly low growth. Not much appears to change. Is that just going to continue forever, and there’ll be a tiny Japan with hardly any people in it? Or what’s going to change?
MALLABY: I think Japan has areas of innovation that remain interesting. It’s been a while since I lived there. I was there in the mid-1990s. My sense is that, in areas like innovation around provision for old age — that’s an obvious area where Japan has a lot of old people, and they’re doing quite a lot of things to make that work for society. The silver economy, as it’s called, is something to look at in Japan.
It remains highly educated, sophisticated, both in terms of the visual, aesthetic side of engineering and the technical side of engineering. Although the macro in Japan often looks underwhelming because, with a declining population and restrictive immigration policies, you’re going to get a negative path in terms of macro growth, nonetheless there’re some interesting things there.
COWEN: If you think about the role of Japanese culture in possibly discouraging risk-taking — is that like South England where you think venture capital can step in and get people to take the risk? Or just there’s no way through that barrier? Because there don’t seem to be that many new truly excellent Japanese companies at a large scale. Sony mostly sells insurance at this point. What’s gone wrong with risk-taking in Japan?
MALLABY: Masayoshi Son, of course, is Japanese. Now, you’ll point out correctly that he’s Korean-Japanese, and that might make all the difference. He felt marginalized growing up because he was Korean. Because he felt marginalized, he left Japan in his teens and got a degree from UC Berkeley, so he is a different kind of Japanese person. But he did go back to Japan and built this huge software distributor called SoftBank, and then he parlayed that into this tech-investing holding company.
It shows that entrepreneurship is not entirely impossible in Japan. I think it could happen, can happen. I’m not close enough to it to understand why more of it hasn’t happened.
COWEN: Who’s the greatest living British historian?
MALLABY: [laughs] Oh, gosh, that is a great question. I would say the most entertaining is Niall Ferguson. There are historians of early modern Europe who . . . I think I’m going to say Peter Goodwin. The fact that I’m blanking on his name shows you that I’m not hugely confident about the answer, so I’ll stick with Niall Ferguson. He’s always a wonderful writer and provocative to read.
COWEN: What’s the economic future of the World Bank once China stops borrowing from it, which, of course, at some level, has to make no sense?
MALLABY: Yes. China, for a while — let’s say between 1990 and 2005 — generated just a vast amount of the World Bank’s success, both because it reduced poverty hugely, and that made the global statistics in poverty reduction look good, which made the World Bank look good, and because it just borrowed money and paid it back unfailingly, and that was great for business.
You’re right that, with China graduating, it creates a problem. Also, it’s a problem because China as a shareholder is problematic. Part of the reason why the World Bank and IMF worked well for a long time, relative to other multinational institutions, is that you had this lead shareholder in the form of the United States, which basically called the shots. That provided some clarity and strategic direction for both the Bank and the Fund.
I think now, with China being pretty big and influential within the World Bank, it can disagree with the United States on something, like where China should be ranked in the Doing Business report that the World Bank produces. This was a famous case where China seems to have put pressure on the World Bank president, and as a result, or indirectly or something — we don’t exactly know — China got re-ranked in that ranking of where to do business. That’s the kind of thing that undermines the World Bank credibility.
China is problematic, both because it’s graduated and because it’s a tricky shareholder, and I think that it needs to find its way. Until the US-China economic relationship goes better at a macro level, the World Bank risks becoming the UN Security Council, where the P5, the veto-wielding big powers, were at loggerheads on great-power politics and, therefore, just froze the UN and couldn’t agree on things.
COWEN: If you could pick someone now to head the World Bank unconstrained, whom would you pick and why?
MALLABY: That’s another great question. I think you need somebody who would be good at this great-power politics. I think Bob Zoellick, when he was head of the World Bank a few years back, was a good choice because he was an American, but he was also close to China and understood China. If you had to pick somebody now, I guess you would go down the list of Americans who have been ambassador in China or maybe vice versa. I think it would take somebody like that who has the stature. I don’t have a name that pops into my head, but that’s —
COWEN: A young Bob Zoellick is what you want?
MALLABY: A young Bob Zoellick, yes.
COWEN: Why does classical liberalism seem to be dwindling today? Admittedly, you may choose to challenge the premise, but many countries are going in reverse. Democracy is not more popular. There seems to be less tolerance of other people’s ideas. What’s going on? What’s your most fundamental account of that?
MALLABY: I think there are lots of strands to this debate, and I would just highlight two of them to set up my answer. I think the fact is that liberal capitalism has declined in popularity enormously since the 1990s when we thought that it had won. Fukuyama’s statement was blunter than other people’s when he said history was ending, but it wasn’t different to most people’s. It really did feel as though other countries were converging around that model.
Now, you poll young Americans, and they prefer — or they say they prefer — what they call socialism. What they quite mean by that is another debate. Anyway, liberal capitalism is clearly falling out of favor. Now, is that because capitalism wasn’t as great as we thought it was in the 1990s, and now we’re spotting the flaws? Or is it because it was great but now it’s gone wrong?
I think there’s some truth to the second, that it was great, but we’ve allowed some things to go wrong. In particular, we need more competition to prevent both monopoly and monopsony. We need to do more about state capture by lobbies.
We need to do more about inequality because it’s all very well, saying you only care about equal opportunity, but income and wealth inequality is okay. But we know that the latter, the income inequality, bleeds into the former. Once you’ve got really severe inequalities of wealth, people can transfer that advantage to their kids. Things that happened in the 2000s, like the virtual elimination of the estate tax, are a really, really bad thing, and we need to undo that.
It’s one thing to say we want strong incentives for entrepreneurship, and I’m all for that because I’ve just written this book about venture capital, and I believe in disruption in the economy, and I believe in risk-taking, and I believe people should be compensated for taking those risks. But at the same time, you need to reset to safeguard some equality of opportunity, and I think things like the estate tax ought to bite, and that’s really important.
COWEN: Last question: what’s your favorite movie and why?
MALLABY: Let’s see. I think The Grand Budapest Hotel has a kind of zany, surrealistic charm that is irresistible, so I’m going to pick that as my favorite movie.
COWEN: That is an example of venture capital also, right?
MALLABY: [laughs] Yes, that’s right.
COWEN: Sebastian Mallaby, thank you very much. Again, I’m very happy to recommend to you all Sebastian’s new book — all of his old books as well, but the new book is The Power Law: Venture Capital and the Making of the New Future.
MALLABY: Thank you, Tyler. That was a lot of fun.
Thumbnail photo credit: David Levenson