Capitalisn’t: How Washington Privatized the Capital Market

Episode Transcript

Renée Jones: You're able to grow in secrecy for extended periods of time-- The time from founding to an IPO has expanded from about four to seven years. SpaceX was more than 20 years old when it went public. That gives you a very long runway to amass market power while engaging in either anti-competitive, sometimes unethical, sometimes illegal practices to extract a lot of value through wasteful spending, self-aggrandizing behavior, self-dealing, and none of that has to be disclosed. Nobody can step in and say, "Hey, this is wrong."

Bethany McLean: Theranos, WeWork, FTX, the story of these companies is almost the story of a person, the charisma, the delusion, the lying.

Luigi Zingales: The founder as a character. It makes a very good book.

Bethany: Our guest today also thinks it makes for a bad explanation. She argues those companies had something in common that had nothing to do with personality. Every one of them got enormous without ever having to show the public their books.

Luigi: In other words, they stay private.

Bethany: It's not just the blowups. The same is true of the success stories. SpaceX went public last month, a whopping 24 years after it was founded.

Luigi: Compare that to Amazon, which went public three after it was founded.

Bethany: The real question is, why is this normal now and wasn't in 1997? What changed in between? Here's the part I really didn't expect. What changed wasn't actually in Silicon Valley. It was in Washington.

Luigi: That's the argument Renée Jones makes in a new book, Untamed Unicorns. She's a law professor and former SEC official. She claims the decisive change was deregulation. Each change looked technical, modest, pro-entrepreneur.

Bethany: Put them together and you get a very different financial system than the one that used to exist. Since 2009, more money has been raised every year in unregistered deals than in public offerings. If Washington built this, who asked for it? The Jobs Act passed under the banner of entrepreneurship and job creation. Venture capitalists helped write its IPO provisions. What about the rest of it? Rarely does Washington do things in a vacuum. Washington does things because somebody is lobbying for it. In this case, who was that somebody? Okay, so let's start with a somewhat provocative question. Why should anybody care about this?

Renée: I think it's really important to understand that a private securities offering, where there's not mandatory disclosure, used to be the exception. Now, more money is being raised in private markets than in public markets. If we're relying on an SEC oversight of securities offerings to protect investors' interests and to ensure accountability, aren't really going to function anymore. A philosophy underlying our securities law and our regulatory system is that of disclosure. The basic idea is that the government doesn't pick and choose who can sell securities to investors, but it seeks to ensure that investors have adequate information to make that decision.

If the entire regulatory system for the securities markets in the US is based on disclosure, and then we decide, "Most of the money raised doesn't have to comply with those disclosure rules," then the system really starts to fall apart. No matter how sophisticated you are, no matter how rich you are, no matter how much you know, no matter how much experience you have, if you're making investment decisions without adequate, reliable information, we're not going to have the efficient formation of capital, and we're not going to have effective securities markets. Of course, the biggest concern is there's going to be sort of creating an atmosphere for fraud and misconduct to thrive.

Bethany: You tell the story of the deregulation that has happened, and in some cases, you tell the story of why it happened, meaning the lobbying that was behind it, but it's not always clear who did it. Was it Congress? Was it actually the SEC? Was this all lobbying from private market aficionados, for lack of a better word to call them?

Renée: That's a very good question. The answer to that question is it was both. It was Congress and the SEC, but almost all of the time when the SEC is taking those steps, it's at the behest of industry interests, either lawyers for Silicon Valley, lawyers for banks, lawyers for brokers and dealers saying, "Hey, can we just have this tweak? Can we just have one more tweak? What about one more tweak?" Pretty much the exceptions begin to swallow the role of disclosure when selling securities to investors, whether in public markets or in private markets.

Luigi: Can we go a little bit in detail on those two steps that were small from the apparent point of view, but were very substantial from a practical point of view, the 1996 Affirmative Jobs Act? Both these were approved by a democratic president, so this idea that deregulation take place only under Republicans, et cetera, is a myth, and to some extent, Trump is only the last step in a long stairs that has been walked down by both sides of the aisle.

Second, I don't know if you've ever seen, but I was shocked once I saw there is a video on YouTube by this venture capitalist, very smart venture capitalist, Ravi Navalkant, who explains how the Jobs Act was passed. He basically said that it's all his creation, that he lobbied, explained how he lobbied, what he did, and how he got it done. When Bethany was asking the question, who did it, I said, "Oh, actually, in this particular case, there is the smoking gun." There is somebody who said, "I did it. I'm proud of doing it." Please explain to our listeners why those two steps were so important.

Renée: The first statute you referred to was the 1996 statute, which is the National Securities Markets Improvement Act. What the statute did is it lifted the cap on the size of private investment funds and said you can be as big as you want and still avoid registering with the SEC as a mutual fund. The capital, the assets under management in private markets started to soar from just about, well below $1 trillion in 1996 when NSMIA was adopted to, in 2025, more than $17 trillion.

Startups that used to have to turn to public markets to raise the money that they needed could now find that money in private markets because there were so many private funds and they were so big and there was no cap on their size. Then startups started to grow larger in the private markets. I think Facebook is a very good example of that where it grew very large. It had a billion-dollar IPO. It was one of the first billion-dollar private companies or private startups, I should say.

Even Facebook had to face the reality of becoming a public-reporting company because there was a rule in place at the time that said if you have 500 shareholders or more and you have $10 million in assets, then you have to register with the SEC and become a public-reporting company. Google and Facebook reportedly went public because of that rule because they had reached that 500 shareholder threshold. They decided, "We might as well just do an IPO because we're going to have to provide those reports to the SEC anyway."

You mentioned the Jobs Act of 2012, which was really a product of lobbying by Silicon Valley. What the Jobs Act did is it took away that 500 shareholder threshold, changed it to a 2,000 shareholder threshold, but they excluded employee shares from that count. Since startups compensate their employees with equity compensation, it was the employee shareholders that were typically the ones that were pushing those startups over that 500 shareholder limit. If we eliminate the counting of employee-held shares, companies could basically stay private indefinitely, and that's what startups started to do.

Bethany: I guess I always thought that the reason that more companies were staying private for longer and the reason this was happening is that insiders could extract more of the gains when companies were privately held. You point out in your book, it's all our money at the end of the day. In other words, most of the money going into venture capital funds, the underlying money, is from individual investors. If gains are being extracted, then we're getting the gains.

What's the point of this? Is it that there is more fee extraction along the way? Because if you think about the fees, for example, that a typical venture capital fund charges, it's far higher than the fees that an index fund would charge. Is that the reason for this, that there can be more fee extraction? Why would the industry push so hard for something that seems to be not so obviously in their favor?

Renée: If you're going to be a financial manager or an investor, you would rather be in unregulated markets where you can charge higher fees and take bigger risks than be in a regulated mutual fund, for example. That's one reason. Then in terms of who benefits, do we actually end up benefiting? It's our money, public money. Let's say it's Massachusetts pension fund money.

If I were investing directly in a public company, I would keep most of the gains, whereas if the money is being funneled through public pension fund, a lot of the fees, as you mentioned, are going to the managers and a lot of the profits, a lot of the benefits of the company, a lot of the value that's being built is going to be extracted by the founders and the earliest investors.

Luigi: I would like to discuss with you a bit the rationale for many of these rules. I don't feel so compelled to have the government protecting Rupert Murdoch from making mistakes. We know that Rupert Murdoch invested, what, 100 million, 150 million in Theranos without even requiring a audited financial statement. I am in a state of shock and disbelief that this is the case. At the end of the day, Rupert Murdoch's money is Rupert Murdoch's money. Do you really want to have the government enforcing disclosure and procedure in relation between Rupert Murdoch and Elizabeth Holmes?

Renée: The short answer is yes, because Rupert Murdoch's money was enabling Elizabeth Holmes to engage in fraud, and if Elizabeth Holmes had to make disclosure to Murdoch and the other investors and she made truthful disclosures, they could have stepped in and prevented that fraud. A lot of the problems that are occurring in these private startups is because of failure of investor due diligence.

We assume they're getting information. We assume they're reviewing that information. Later, investors sometimes say, "Oh, well, this well-known venture capital fund invested in the company, so it must be a good company. I don't have to do due diligence." If nobody's done that due diligence, then everybody's just financing a complete fraud. Maybe I don't care if Rupert Murdoch loses a lot of money, but I do care that all that money is being wasted and that a lot of less sophisticated investors are being lulled along by just the fact that Rupert Murdoch is an investor.

Bethany: Disclosure requirements are also a form of societal control over corporate America, that then we get to see what's going on, and that when you lessen that disclosure, there's also this broader issue of a lack of control or awareness of what the biggest companies are actually doing. Just talk about that a little and how you came to that realization and why it's important for society to be able to have a lens into what our biggest companies are doing.

Renée: I think there's two aspects of that. First, the disclosure requirements and the governance rules provide a level of discipline on investors and the managers of these startups. If you know you have to disclose something and you know it's going to be subject to the glare of the sunlight, the sunlight being the greatest of disinfectants, as Brandeis would say, it's really going to have a moderating impact on your behavior.

As a startup starts to grow and understood it was going to reach that 500 shareholder threshold and have to do a public offering, they started to start behaving more and more like a public company. Starting to think about bringing in executives who have experience. Facebook is a good example. It brought in Sheryl Sandberg. Google brought in Eric Schmidt. Those are the so-called grown-ups in the room that the market trusted to run those companies.

When we eliminated that mandatory public disclosure rule, all that discipline, nobody really had the power to say, "Hey, you need to put in place good structures that are appropriate for an enterprise of that size." I think more importantly, types of things you have to disclose. Legal risks, operational risks, who your competitors are, what are your competitive advantages, all of those things. If a lot of those things are based in illegal behavior or anti-competitive behavior and you're going to have to disclose it, well, your competitors will have that information and they can step in. Regulators will have that information and they can step in.

If you're able to grow in secrecy for extended periods of time-- The time from founding to an IPO has expanded from about four to seven years. SpaceX was more than 20 years old when it went public. That gives you a very long runway to amass market power while engaging in either anti-competitive, sometimes unethical, sometimes illegal practices to extract a lot of value through wasteful spending, self-aggrandizing behavior, self-dealing, and none of that has to be disclosed. Nobody can step in and say, "Hey, this is wrong." We've really relied, to the extent of the frauds that I write about in my book, FTX, Theranos, Uber, WeWork. Most of what we learned comes from journalists like you, Bethany. That's how we know exactly what was happening at those firms.

Luigi: I'm sympathetic to the argument, but it seems to suggest that we should have more disclosure in larger companies, period, regardless of the way they finance themselves. In a sense, the SEC is the wrong instrument because the SEC was designed for securities trading. You're saying that even if I have a private company, like, say, Bechtel, I don't raise any public financing because I'm so large. I become systemic. Because I become systemic, I need to reveal more information. That should be a standard disclosure for everybody, not just based on the financing. Is that what you have in mind?

Renée: It's not exactly what I have in mind, but there are certainly strong arguments for that. That's the way that the system operates in Europe, where it's based on your size, revenues, number of employees, and not whether you're raising money in public and private markets. I think a particular problem arises in our markets when we have very large companies, again, with massive impact on the economy, with dispersed shareholder bases and weak shareholders. If you're talking about a company like Bechtel or the Koch Industries, they have more or less centralized control where the owners are in control.

We might be concerned about some of their conduct that needs to be regulated, but we're not as concerned about people who control the company, the managers, the executives, exploiting their position at the expense of the owners. I think there's similar concerns, but a little bit different concerns there. Another way of saying it is that with respect to startups that stay private indefinitely, there are corporate governance concerns that don't really arise at family-owned companies, even though there might be other reasons that the public wants insight into those other large firms.

Bethany: I was thinking, as you talk about the scandals that have happened, why it is, in the face of that, that the venture capital industry is still pushing so hard for less and less requirements? You'd think they'd look at this and say, "Oh, we want a system, too, where these companies are mandated to have to disclose so that we don't get caught up in these failures." Yet the push seems to be going in the other direction.

The answer, as simple as when they lose, they lose other people's money. When they win, they get to keep the majority of the gains, given the fee structure, when the companies are private for longer. Is it as simple as that, or is it that they're not as smart as we all think they are, and they're not looking at all the ways in which this is going wrong and saying, "Huh, maybe we should reverse course here"?

Renée: I think it's a little bit of a mixed bag. I think there are the more traditional venture capitalists who really believed in the old traditional venture capital model where the venture capitalists are the mentors and the tutors, and they really have control, and they're really guiding the company towards profitability. When the law changed, venture capitalists really lost a lot of that control and that power.

Still, if you're a venture capitalist and you get in early at a company at a ground level and it grows really quickly, even if it does so through illegal behavior or fraud, or even if it never really develops a sustainable business model, those early investors are probably going to benefit, because as the company gets older, bigger, more well-established, they'll bring in other non-traditional investors. They'll bring in corporate venture capital like maybe Meta or maybe Google, or they'll bring in mutual fund investors like maybe Vanguard or T. Rowe Price or maybe SoftBank.

When those non-traditional investors come in the late stage financing round, they usually purchase a significant amount of shares from the early investors. Even though the company may end up failing, those early investors, if they got in at a very early stage, are still going to benefit tremendously from the company's inflated valuation, even if, at the end of the day, it doesn't succeed. Venture capitalists are basically set up with a model where most of the companies that they invest in fail, hopefully not the multi-billion dollar ones, so they can afford to write off the losses. I think a good example of that is when FTX failed and Sequoia was like, "Eh, accounting error or whatever," you know?

Luigi: It seems to me, then, in your analysis, you underplay the dimension of cost. Disclosure is great, but ain't cheap. It ain't cheap for a number of reasons. One is that we still have pretty arcane rules with a lot of lawyers involved that still bill thousands of dollars an hour. Also, at least investors claim, legal liability, that if you make a mistake, you can be sued and so on and so forth. Part of the resistance against disclosure is the fear that this might be too expensive. As economists, we always say that if you never miss a plane, you waited too long at the airport. If you never have a fraud, you probably invested too much in disclosure and prevention. There must be some optimal level. [laughter] What should limit how much you should disclose?

Renée: I think that's my favorite analogy you've ever used, Luigi. I'm not sure I agree with it, but I like it. Anyway, sorry. [laughs]

Luigi: Also because I miss a lot of flights, so I think I have to justify that, especially to my wife who wants to arrive at the airport three hours in advance. [laughs]

Renée: When I talk about the need for disclosure, the need for disclosure for the largest companies, the largest startups, we're talking about multi-billion dollar companies and the cost of disclosure compared to their revenues or the amount of money that they're raising. Multi-billion dollar financing is minuscule. Second of all, for many of these firms, for most of these firms, they do have to produce that disclosure and they're providing it to some of their investors, but not all of them. Not all of the investors are well-informed. Finally, if they're not producing the disclosure, then the investors and the directors can't provide oversight. That leads to the governance failures that are the focus of my book.

I don't see how you can run a multi-billion dollar enterprise and not produce annual reports, annual and quarterly financial reports, not provide the type of information that public disclosure would require from the SEC to your investors on a regular basis. I'm not arguing that the private company disclosure doesn't have to be to the letter and as extensive as the public company disclosure, but investors do need information when they initially make investment decisions, and the investors who typically serve as directors also need the information on an ongoing basis to provide appropriate oversight of the operations of the business and actually to make the valuation decisions as the startup goes through the various stages of growth.

Bethany: Stepping back a little, the narrative is very much what, I guess, I believed before this conversation or before reading your book, which is that the fault is all in public market deregulation. No one ever talks about-- Some work Luigi has done aside, very few people ever talk about private market deregulation. Why did this become the narrative? Who promulgated this?

Renée: People have noticed, for example, that the number of public companies has fallen dramatically from, let's say, its height in 1996, which was about 8,000 public companies to only about 4,000 today. When people try to explain why, and this may be a cynical argument or it may be an innocent argument, but they always point to over-regulation. They'll say, "Oh, it's because of Sarbanes-Oxley, it's because of Dodd-Frank, it's because of the SEC, they have too many rules, they're too complicated. It's because of plaintiff lawyers, they sue too frequently."

That's the source of all of these problems, and that's why companies are going private, and that's why startups are staying private. If you really look at the changes in the law and when the number of public companies started to decline and when startups started to stay private for not 5 to 7 years, but for as long as 20 years, it really points to the statutes we talked about earlier.

A lot of finance and law professors have said this. It's actually these deregulatory statutes that seem to have had the more significant impact. If you are against regulation, you're not going to make that argument. If you want to deregulate public companies and you're going to blame the shortage of public companies on over-regulation, then obviously deregulation seems to be the answer. If you identify the problem as deregulation, well, then you would have to re-regulate it, and that's not what the current SEC wants to do.

Luigi: I think you're right, but I will add an additional element. I think economic theory is not there yet to explain fully, or we don't have a good theory explaining regulation of private markets. We understand protecting widows and orphans, that's the 1934 regulation. [laughter] We understand some form of externality. However, it's a little bit hard to explain why we need to protect, again, Rupert Murdoch. Also, why we need to protect endowments and sophisticated players.

You would expect, this is when I started in this profession, I was naive and I thought that, "Oh, certainly venture capitalists will demand the information they need. There is no need to mandate any disclosure because they're smart enough that they will do it." Either you conclude, like Greenspan did in 2008, these are not strong enough. Or you need to find another compelling reason why we need to regulate.

The article that Bethany was mentioning, I was saying that we need to have more information to allocate the capital properly as an economy, because at the end of the day, a lot of our pension money is allocated in the private market. That's one story. You push another story that intrigues me, which is the governance issue. Elaborate more on this. Why do we need more disclosure to help companies govern themselves?

Renée: Sure. The traditional venture capital model, venture capitalists would give a startup founder money, and as the business grew, they would provide additional financing. That's a system of staged financing. The next stage of financing was conditional on meeting certain milestones. Venture capitalists also insisted on certain control rights. They had representation on the board of directors, and the more money they put in, voting control over the board would shift from the founders towards the outside investors.

It was all very small, enclosed systems. There would be a syndicate of venture capital investors, and they would basically control, nurture, and guide that startup to the IPO. All of that's fallen apart. I mentioned the non-traditional investors coming in. A corporate venture capitalist or a mutual fund, they're not interested in governance. That's not their investment model. They don't give you the money, and they want to step back. They don't have the expertise. They don't have the time. They don't have the inclination to provide that oversight.

The venture capitalists who want to continue to provide that oversight are being weakened, and founders are getting shares with super voting power. The founder has 10 votes per share. They can out-vote the venture capitalist and the corporate venture capital who brought in all that money. They can control who's on the board of directors. They're essentially choosing their bosses. This is just a dysfunctional system. When problems arise, the founder's in control. If a director is giving them trouble, they can kick them off the board.

We've seen evidence that that happened in the Theranos example where one of the early investors, one of the early directors raised questions about Elizabeth Holmes' conduct. He talked to the chair of the board. The chair of the board told Elizabeth Holmes, "This person is raising these questions," and they decided, "This person should just leave the board." That's where we're creating an environment where misconduct, self-dealing, fraud, mismanagement, all of that can go on for extended periods of time because investors have really given up a lot of their ability to reign in and discipline ineffective, if we want to use a polite term, ineffective managers.

Bethany: A small piece of this puzzle, and yet maybe the answer shed light on how this whole thing happened. Why on earth have the standards for an accredited investor not been adjusted for inflation? How has that happened? Could the SEC just do that? Everything's adjusted for inflation. Why not that?

Renée: The SEC has proposed inflation adjustments, and every time they propose it, industry has howled. The SEC has been instructed by Congress to review the definition. I think it's every four years. This is part of the Dodd-Frank Act. The SEC has considered that, I think now three times. Each time they said, "We're not going to make an adjustment." The last report from the SEC was really interesting. It was during Gary Gensler's leadership at the SEC.

It pointed to a lot of the arguments that I make in favor of making that adjustment in terms of the expansion of the pool of accredited investors, the fact that many of the wealthiest investors in the US are typically the oldest investors because they've accumulated wealth over a long period of time, that older investors may be vulnerable to more risky schemes because they are maybe on a fixed income and they want a reliable income, so they might fall for, "This is a safe thing," even if it's not safe.

The biggest concern is as we get older, unfortunately, we lose some of our cognitive functions. The elderly are especially vulnerable to fraud, but despite all of that and despite pointing out all of that, there wasn't a recommendation to increase or to adjust the accredited investor definition for inflation. It's lack of political will and also pressure from industry.

Luigi: Yes, I look forward to the moment there will be another category of accredited investor. You must be below 65 or 70. I think that that will go down very well. [laughter] It seems to me that we are in the final act of a pushback, a little bit like if you look at the banking sector, the banking sector over the '80s and '90s got deregulated and then, of course, exploded in 2008. By that time, everything was doing everything. There was no regulation. There was no Glass-Steagall. There was nothing. The regulation, the 1934 regulation that separate public and private market has been eroded over time.

Now, the combination of changes in state law because Delaware, that is the primary state for corporate law, has changed a bunch of rules basically to please Elon Musk. Then we see that the new SEC seems to have decided that proxy rules need to be changed. There's too much democracy in corporations and we need to basically shut down shareholder proposals and, I don't know, go back to probably predetermined shareholder meetings. They want to do shareholder meeting electronically with predetermined questions. It's basically a charade with no absolute power. Are we going to see an implosion like we see in 2008 of the corporate governance?

Renée: I'm very concerned about the issues you raised with respect to corporate governance in Delaware. Musk isn't in Delaware anymore. He went to Texas. His company, Tesla, went to Texas and SpaceX went public as a Texas corporation. Now Delaware is worried about other companies leaving. They're worried about Facebook leaving. They changed the law again to prevent Facebook from leaving. The corporate governance rules that we depend on to keep corporate directors and managers honest are being eroded as we speak.

It used to be the federal government provided a floor so Delaware wasn't necessarily competing with other states. It was more or less competing with the federal government. When Delaware went too far with its corporate governance rules and there was a scandal, the federal government would step in to protect investors. That dynamic's changed because the SEC chair is chiding Delaware and other states for protecting shareholder rights, like the shareholder rights to sue and not have to go to binding arbitration. Instead of the federal government creating a floor, it's basically now the SEC is urging states to derogate or reduce their standards even more.

Will there be an implosion? I fear that there will be in public markets or in private markets. I hope not. I hope we can get some reforms in place and get a little bit more backbone in our regulators before that happens. I'm really concerned about the inflated valuations in private markets, both in private equity and in venture capital. These companies are having trouble achieving their exits. This is an economic problem. It's not because of regulation. It's because the valuations that they're parading around are really high. They basically overstate the values of those firms, and they can't get the money that meets those valuations in either a private negotiated transaction or in a public offering.

The move that seems to be underfoot is to open up our 401(k) plans, the $12 trillion to $14 trillion, and define contribution plans and say, "That's a great place to put these assets," these assets that we can't otherwise liquidate. That means the risk is, and I think it's a very big risk, of transferring these overvalued, illiquid, opaque assets from private asset managers to ordinary Americans saving for their retirements and their 401(k) and similar plans.

Bethany: I found this really interesting, Luigi, and I have to admit, I'm really sorry I wasn't aware of your 2009 paper, but now I'm going to go back and read it. I really had swallowed whole hog pretty much the story that's out there, which is that the rise of private markets is because of too much regulation in public markets. I had actually never realized that that wasn't the story. The rise of private markets is because of deregulation of private markets. I think that's just a fascinating and much-needed way of looking at this phenomenon.

Luigi: To be fair, it could have a little bit of both. I think Sarbanes-Oxley did increase the cost of being public. At the same time, I think did reduce the number of fraud. That's the reason why I was pushing Renée on this point, because there is a cost-benefit analysis you should do at some point. I think that actually what SOX did was great. However, it may have discouraged some companies from going public.

Then the question is, you need to think globally, and maybe the solution is to increase disclosure in the privately held market and not deregulate the public market. All this is, you need to have a fundamental view of why you're doing this. The part that I wish Renée had a better answer, but it's a difficult question, is what is the fundamental theory behind regulation? During the new deal, we add a theory. We need an alternative theory, and there are pieces of it, but I don't think there is a coherent whole. At least, I couldn't see it. Did you?

Bethany: Why did you not like her answer about disclosure? I agree too much hangs on this idea of the prevalence of fraud in private markets, but I actually thought her answer was really good, which is that we don't need to prove that there's more fraud in private markets than in public markets. We just need to know that fraud in private markets has gone up. I think the idea that there's more opportunity available for fee extraction along the way in private markets is very compelling, and the idea that we, the public, are the ones that bear the cost of failure.

I also think this idea that it is important as a society to have some insight into what most big companies are doing is really important. I liked the point she makes in the book that regulation as it is captures a lot of that, if not all of that. I hear you. A really all-encompassing, what is disclosure for in a modern world? I'm not sure I heard that either.

Luigi: If you go with the fraud theory, what is the right level? I think that I'm with her that if you raise billions of dollars, you need to be disclosing, but if the billions are half a billion or 100 or million or 10 million or $1,000, you need to put a threshold to that. You need to have a sense of what are the costs and what are the benefits. Two, think about Theranos. I don't think I suffer from the impact of the blowup of Theranos. Neither did you. Now, unfortunately, some patients follow, but I think that that's a terrible consumer protection law that did not allow them to sue. If pension money is involved, it's a different story, but if Rupert Murdoch plays the roulette and loses, I'm not so sure that I want to be there restricting him.

Bethany: Maybe the argument is if you're taking money from a public pension fund, if it is money that, end of the day, belongs to the public, then the disclosure requirements need to be there. Maybe it's not by size. It's by who's giving you the money, and it doesn't matter if that's in the wrapper of a pension fund because we all know that pension funds are not necessarily sophisticated investors. They are marketed to extensively by hedge funds and private equity firms and venture capital firms and swayed by the fancy offices and the night outs and the really smart-sounding people.

Maybe that's where the disclosure changes, that if you're taking money from the public, you need to disclose. I think I agree with you that some level of fraud is going to happen regardless, and it's not just the trade-off with regulation. It's that some level of fraud is going to happen if people are trying big things. I've argued frequently that the line between a visionary and a fraudster is pretty close. In the end, if you're allowing people to be visionaries, you're going to allow some fraud, too. Maybe that's an explicit conversation that should happen, which is what level of fraud is acceptable. You could even agree and then work backwards to the rules from there.

Luigi: I think that one point we didn't discuss with her, but I think she's absolutely right, is that we need better disclosure on stock option for employees in privately held companies. I had to give some advice to both of my kids when they got jobs with some vesting or stock options, and you're completely in the dark. They tell you that you have the right to buy one share of the company. They don't even tell you how many shares there are in the company. Forget disclosure of financials because you can get the internet, you get a sense of what are the sales of the company. If you don't know the number of shares, what does it mean the value of the share? It's complete dark. I think that that needs to be revised.

Bethany: I agree with that. The other part that I would really, really like more light on, because I really had-- I think I had fallen victim to a very simplistic way of thinking about this, which is that private markets allow insiders to get rich. It's really not so clear when you look at her analysis of who the holders are, which is that it is mostly our money through pension funds, et cetera. Then what's the incentive for private markets? What I would like to better understand is who's extracting value along the way. Who's getting paid what? If you take SpaceX, for example, how much money did insiders make? Meaning the people who are running the venture capital firms that invested in SpaceX.

How much money got siphoned off? How much of the value got siphoned off along the way before SpaceX was public? That's, I think, a missing piece of this equation, too, because you have to believe that whoever is pushing for it, if the venture capital industry is pushing so heavily for companies to be able to stay private for longer, there's more there than them wanting companies to be private in order to evade the strictures of public market disclosure. You have to believe they're making more money along the way. I want to understand exactly what the mechanisms are by which that's happening.

Luigi: I think that one of the beautiful thing of public markets is that we're treating everybody the same. The big advantage of insiders or private markets is they can pick and choose. It's not necessarily that you make more money with the private markets, but you make much more money if you have the right content. The proof of it is look at the performance of the funds.

First of all, there is an enormous difference in performance of a venture capital fund. At least historically, this was quite persistent. If you look at the mutual funds, it's difficult to have a dramatically different performance than everybody else. Why? Because it's a fairly equal treatment of everybody. In private markets, that's not the case. The valuable opportunities are exchanged among insiders, and the public is left holding the bag for the losses.

Bethany: That's interesting that it's an information arbitrage. Anyway, this is one of those topics where I would love any of our listeners who has insight into this to weigh in. Please, if anybody has thoughts on this, shoot me an email or a message on LinkedIn. I did think, however, though, I had not really thought about this. I've been thinking about an argument around private equity and 401(k) plans, which is around fees.

Actually, I was thinking that the smarter thing to do as I listened to her, it might be, okay, fine, private equity firms, you want access to our 401(k) money, but any private equity firm that is taking 401(k) has to disclose every single one of the companies and its portfolios, what they're worth, how they're being valued, has to file financial statements for them. This whole thing has to be public. I bet that would be enough to make them say, "Oh, no, no, no, wait, maybe we're not so sure we want your money after all."

Luigi: I also was intrigued by your argument about fraud, but I can't make it work unless you have some kind of bounded rationality. You would expect that, again, the Sequoia of this world would pay attention to the risk of fraud unless, from their point of view, the opportunities are so large that they tolerate. Then again, if they tolerate a certain level of fraud, why is it inefficient to tolerate a certain level of fraud?

Following your argument, if it's difficult to tell between the fraudster and the visionary. There are some places in which there are so many visionary that it's worth throwing the money randomly. That's what I got from reading the book about Stanford is that venture capitalists throw their money at Stanford students and they know they're a bunch of fraud, but on average, they do pretty well.

Bethany: Yes, I guess that might be the case, and that's a really interesting way to think about it. I would argue that that's not the way it works. They don't do their homework. There's this famous transcript of the Sequoia funds agreeing to invest in FTX, and they basically did it over an afternoon where Sam Bankman-Fried was playing a video game, and he checked all the boxes for what Silicon Valley venture capitalists increasingly look for in a startup. He seemed like an iconoclast. He seemed to completely disrespect authority and to not have any respect for his would-be investors, and they liked all of that, so they invested, and that was that. I think--

Luigi: Sorry, Bethany. Sorry. Do you know the story about the way Diamond, at least, used to be sold by De Beer?

Bethany: The way what?

Luigi: The way Diamonds used to be sold.

Bethany: No.

Luigi: It's related. It seems crazy, but it's related. It's very costly to determine the quality of a Diamond, and so rather than selling Diamonds one at a time so that everybody had to spend the time monitoring, they would put a bunch of Diamonds together and sell those buckets all together. Some you get lucky, some you don't get lucky, but you save a tremendous amount of transaction costs monitoring the quality of the Diamond. It could be that the same is true with VC.

Bethany: I was getting to that point, and I like that. I had not heard that particular story before, but I was getting to that point, which is that, and I'm trying to think it through, but I'm not sure under that scenario who gets the gains and who bears the losses. In other words, if the loss is primarily taken by pension funds who have invested in Sequoia when something goes wrong, but in the meantime, the partners at Sequoia get to skim off the fees on the assets that they're managing, as well as probably a disproportionate set of the fees on the gains when something goes well, but they manage to stick the losses on the pension fund or more of the losses, then I'm not sure I like that answer.

It's fine if it's all completely proportionate. If the old-school way or the theoretical way of private equity and venture capital is actually how it works, and if they lose by making a bad investment, then they all lose too, then you know what? I have more sympathy for the Beer and the diamond way of going about things, the inability to tell the difference between a fraudster and a visionary. If the answer is that they extract enough in fees along the way, and on the winners, that it's disproportionate, and that the losses end up being borne by the pension funds that have invested with them, then I don't like that answer. Does that make sense?

Luigi: Yes, absolutely.

Bethany: I don't know enough to know, by the way. I don't know that we have enough transparency into how the fee arrangements work to be able to answer that.

Luigi: Actually, I think we do, but it varies case by case. There are two ways in which fees are paid. The carry, which is the percentage that the general managers-

Bethany: I know.

Luigi: -take out of the partnership, can be deal-by-deal or portfolio-based. If it is deal-by-deal, that's the stuff that you don't like because you don't compensate the winners with the losers. If it is at a portfolio level, then I think that is more fair. My understanding is that the more sophisticated investors are pushing for at a portfolio level, but it's not sure that every venture capitalist has it. I think that you need to go case by case.

Bethany: Except even when it's at the portfolio manager. Now, as venture capital firms and private equity firms have gotten so very, very big, the fees on the assets under management can be so enormous that the carry matters less to them. If you're investing $1 billion and getting a 2% fee on the assets under management, you care a lot less about the carry than you used to if you were running $100 million fund and getting 2% of the assets under management and getting the carry. Suddenly, the fee on the assets under management starts to become real money when venture capital firms and private equity firms have gotten as big as they have. I think that skews some of the incentives.

Luigi: That's absolutely true, but this is more true for private equity. The management fee is higher for private equity and the funds are larger in private equity than VC, where they generally take a little bit less risk.

Bethany: Are they? I thought it was 2% and 20% for most VC firms as well. Certainly, while VC firms aren't as big as the big private equity empires like Blackstone, they're a lot bigger than they used to be.

Luigi: That's for sure, but I think that in some private equity, it might have actually more than 20% on the upside if they're being less than 2% as a fee. The general rule at 2% and 20% has been slowly eroding.

Bethany: Then that would undercut my argument. If you have a venture capital firm that is taking, say, 50 basis points in assets under management and taking a carry on the performance of the portfolio, not on a deal-by-deal basis, then you know what? Then I'm more sympathetic, I think, to your Beer and diamonds, to being a Beer that picks diamonds approach if it's structured differently and less sympathetic.

Luigi: The other thing is that it seems that there is a lot of need to defend not only widows and orphans, but also a lot of people operating in the market. There are a lot of people who allocate capital, who have no business of being allocating capital. I think that this is something that we should recognize and be more aware of.

Bethany: Yes. I also think that an implicit argument in her book that maybe answers the question that you set out with, which is what are the securities laws for, is that disclosure really is-- it really does become a race to the bottom. The less disclosure that is mandated, the less that people can ask for. Even among very sophisticated investors, as the Sequoia example with FTX shows, when there's a lot of cultural pressure not to ask for disclosure, then they don't.

Or in the case of Theranos, I remember one of the famous stories is an investor who refused to invest because she wouldn't provide audited financial statements, but everybody else did because the cultural pressure was there to do it without audited financial statements. In other words, it is this slippery slope. The less disclosure is available, the less disclosure people feel like they are able to ask for.

Maybe a function of modern securities laws is just to provide a baseline for what sort of disclosure must be standard so that they're can't be this race to the bottom. By the way, if that disclosure were standard, and there are people like me, journalists, who could do their work because we could get the disclosure and dig into it in the way that you can with publicly traded companies. There would certainly be others who would be incentivized to do it. Maybe that's the argument for it at the end of the day is simply a baseline.

Luigi: Yes, I completely agree. I think it's an important baseline that we are slowly and slowly eroding.