First, Let's Kill the Angels

I wrote about the Dodd bill and its problems last week. But a new problem has surfaced that has major implications for the US economy and our ability to grow it. For all intents and purposes, the bill will utterly devastate angel investing in the US. And as we will see, that is not hyperbole. For a Congress and administration that purports to be all about jobs, this section of the bill makes less than no sense. It is a job and innovation killer of the first order.

First, let's look at a very important part of the US economic machine, the angel investing network. An angel investor, or angel (also known as a business angel or informal investor) is an affluent individual who provides capital for a business startup, usually in exchange for convertible debt or ownership equity. A small but increasing number of angel investors organize themselves into angel groups or angel networks to share research and pool their investment capital.

Angels typically invest their own funds, unlike venture capitalists, who manage the pooled money of others in a professionally managed fund. Although it typically reflects the investment judgment of an individual, the actual entity that provides the funding may be a trust, business, limited liability company, investment fund, etc.

Angel capital fills the gap in startup financing between "friends and family" (sometimes humorously given the acronym FFF, which stands for "friends, family and fools") who provide seed funding, and venture capital. Although it is usually difficult to raise more than a few hundred thousand dollars from friends and family, most traditional venture capital funds are usually not able to consider investments under $1-2 million.

Thus, angel investment is a common second round of financing for high-growth startups, and accounts in total for almost as much money invested annually as all venture capital funds combined, but invested into more than ten times as many companies (US$26 billion vs. $30.69 billion in the US in 2007, into 57,000 companies vs. 3,918 companies). (Wikipedia)

(Incidentally, angel investing got its name from people who invested in Broadway plays, and the term began to be used for investors in similarly risky startups.)

This has become a very big deal in the US. Angel investors put as much money to work as all the mainstream venture capital funds. And the internet has greatly expanded the network of angel investors. In 1996 there were about ten organized angel networks, most quite small. Now there are many hundreds, and some of them are quite large and organized, with some serious money amongst the members.

"Angel investors committed fewer dollars but increased the number of investments during the first half of 2009," according to

Here are a few quotes from Venture Beat, a publication of the venture industry. (

"Specifically, one of the things we need to take into account is while 10 years ago it may have taken years to build a company, companies are now built in a matter of weeks. So this 120-day waiting period is frankly ridiculous. I have companies with tens of thousands and hundreds of thousands of users that are built in a matter of weeks. They're generating actual dollars of revenue, creating jobs, investing in real estate office space, capital equipment, etc. If they had to wait 120 days to actually apply for the ability to obtain financing it would absolutely just crush that market.

"I think this is a very short-sighted proposal. It seems far afield from the problems that the banking committee is actually trying to address."

Additionally, allowing states to set the rules rather than having one set of rules that governs business startups, is guaranteed chaos and adds another layer of costs. Which state will require what rules and how will they conflict? Will a startup have to register with each state where there might be an investor? Aaaggghh! Seriously?

So why is it in there? Let me offer an informed speculation. Remember when I was writing about four years ago about the SEC wanting to raise the accredited investor standards to $2.5 million? I provided a link to let readers comment on that proposal, and about 400 of my readers made 99% negative comments. It went away. And the SEC also lost the ability to regulate hedge funds, through a court decision that said the agency didn't have appropriate Congressional authority.

So, what's a regulator to do? Get the language you want inserted into a 1,300-page bill, and add a few extra dollops of authority just to see if you can get it. (And someone from some state regulatory organization had to have lobbied for removing the federal exemption. Those things just don't appear without someone pushing them.)

During the last contretemps, the SEC had a carve-out (if I remember correctly) for venture capital and private equity funds, as far as the accredited investor qualifications were concerned. They left the limits at "just" $1 million for venture and private equity, while appropriately acknowledging that they had no wish to hurt the venture capital or angel investing mechanisms in the US.

I testified before Congress that the limits should be removed altogether with regard to investments like hedge funds. My argument is philosophical in nature. Quoting from my 2007 testimony (the entirety of which is here:

Second, if you really think we need to raise the accredited investor limits, then carve out an exemption for venture capital.

And keep the clause that gives startups federal exemption.

And, if you really want to create jobs, then cut capital-gains taxes on new ventures and angel investing to 10% or less. Let's create some incentive to get America moving!

Some Quick Thoughts on Goldman

Goldman Sachs is all over the news after being charged with fraud. The way I see it, this is essentially a charge that there was not full disclosure. And it appears to me that that is true. It also is true that Goldman will argue (or I think they will) that only very sophisticated investors who signed very lengthy offering documents were involved, and they should have known better. They were also reaching for yield.

But this is just the tip of the iceberg. I was writing about these "CDOs Squared" in late 2006, and many of these were done in 2007. It was obvious to me (and others) that they were going to blow up. I often wondered who was buying the equity tranches of these synthetic CDOs.

Last week I read a very interesting report from propublic.org about a hedge fund called Magnetar, which basically did the same trade as in the Goldman deal. And they did those deals with nine banks.

I should apologize here and note that I intended last week to send you the entire, if lengthy, article as an Outside the Box, but for the first time in years just got overwhelmed in New York and did not have the time. You can read the whole article at target="_blank">prospectuses, the banks didn't disclose to CDO investors the role Magnetar played. [emphasis mine]

"Many of the bankers who worked on these deals personally benefited, earning millions in annual bonuses. The banks booked profits at the outset. But those gains were fleeting. As it turned out, the banks that assembled and marketed the Magnetar CDOs had trouble selling them. And when the crash came, they were among the biggest losers."

Look at the charts below. The financial institutions are once again soaring on new profits, with almost 30% of total corporate profits and a huge proportion of the growth in profits coming in the last 12 months.

Side bet: Goldman and at least 8 other banks are going to have serious litigation costs, if they don't actually have to eat the losses of the investors in these synthetic CDOs. Understand, these were not securitizations of actual mortgages. They were securitizations of derivatives that acted like these mortgages, and the worst tranches of them to boot. On top of their loan losses, there could be tens of billions of losses to investors in the CDOs they sold. This will play out over years.

As Pro Public noted, the hedge funds did nothing illegal. If the housing market had continued to go up another year or two, most of them would have imploded while waiting for the market to break. More than a few funds did. It can be a difficult thing to bet on the end of the world and then have to wait.

The issue is disclosure. I wonder if the ratings agencies knew. Would that have changed their views?

I hope someone writes an in-depth investigative book about this. I'll buy it.

La Jolla and Dallas

Tomorrow night I am going to a birthday party for the publisher of this letter, Mike Casson, who will be 65. Mike and I have been close friends and business associates for 40 years. We can't remember how many deals we have done together over the the decades. But there was one thing in common with all of them: we have never had a piece of paper or a contract. It has all been done by handshake. My grandfather was born in Texas in 1859, and he taught my Dad who taught me that in Texas a man's handshake is his contract. Mike is a true Texan and a true friend. Without him, you would probably not be reading this letter. A man could not ask for a better friend and partner.

This week has been a whirlwind. After a speech on Tuesday in New York, I appeared on Bloomberg and Fox Business, and then the next day did Yahoo Tech Ticker, along with meetings and an in-depth interview with Steve Forbes at his office, which will be up soon, as well as a turn on Canada's BNN, remote from the Nasdaq. (I am sure you can Google the others if you care to.)

Then a dinner with Art Cashin (of CNBC fame) with Tiffani and son-in-law Ryan. Art was in rare form, and we learned a lot. (Art, you can't waffle on me on Maine! You have to be there!)

This week I fly to La Jolla for my annual Strategic Investment Conference, co-sponsored by my partners at Altegris Investments. As usual, we are sold out and I have a few upset friends who could not get tickets. I think we will have to move it to a larger venue next year. It is quite the all-star lineup. Niall Ferguson, George Friedman, Lacy Hunt, Paul McCulley, David Rosenberg, Gary Shilling, Jon Sundt, Mike West and your humble analyst. Seriously, I think we do the best conference in the country. I will report back!

And the Mavericks start the playoffs on Sunday. I think there are half a dozen teams that could win it. We have been doing well lately. I am looking forward to being home most of the next six weeks, and I'm hoping the Mavericks go deep into the playoffs (and win?!?).

It's time to hit the send button. Have a great week. I know I am.

Your ready for the weekend analyst,

John Mauldin
John@FrontLineThoughts.com

Copyright 2010 John Mauldin. All Rights Reserved