Arbitrage has long been a relatively simple way to make money but as the world continues to globalise and limits on capital flows are reduced it has become more evident how much reliance modern venture investors are placing on this form of competitive advantage.
Arbitrage opportunities can crop up in a number of ways, investors of similar companies in different regions can value their prospects differently, for example.
Investors taking differing views on economic prospects and the importance of innovation and change underpins the heart of the capitalist system, which has helped drive unprecedented prosperity for the majority of the world’s population over the past 20 years.
But differences can occur due to tax and regulatory barriers. Private partnerships and funds are treated differently from private companies in regulation and in areas such as consolidation of accounts onto the parent’s books, while debt often has tax deductability of interest whereas equity does not, which helped drive the recent leveraged buyout and property booms.
The general rule of thumb that the tax and regulatory code should be progressive – ie tax the wealthier more – and fair so some forms of organisation and capital structure have no special merit over others has long since been lost in a deluge of special pleading by lobbyists.
A number of countries have tried going back to basics – Canada in the 1990s – with commensurate examination of what the tax and regulations are trying to achieve in terms of services provided by government, ie looking at the wood not just the trees. Two hundred years ago about a third of UK government was spent on the Admiralty, with much of the remainder on collecting the taxes to pay for it.
Other countries are starting to take a lead, with the US examination of tax breaks for the oil and gas industry and UK’s Mirrlees Review, although for every step forward there is a step back.
Late last month, the International Accounting Standards Board opened consultation on plans for funds to be exempt from consolidation of accounts, which law firm SJ Berwin "warmly welcomed".
With private equity and venture capital firms the modern day conglomerates, albeit ones cloaked in private partnerships domiciled in favourable jurisdictions, corporations as the often more public face of business organisation is treated with more rigour.
Governments should instead concentrate more on the ways to achieve its goals, such as economic prosperity and national security, through encouraging innovation. Corporates often have large cash balances, extensive distribution and manufacturing skills and an understanding of customer needs and penalising them (relative to uncorporations) and their attempts to fund and support entrepreneurs is counterproductive.
Just as debt and equity can broadly be split into public and private (on the amount of information available) its uses can also be divided into money to fund innovation or to make an existing asset or idea more efficient.
The legacy of the credit crunch should not be further opportunities for regulatory and tax arbitrage but a re-examination of the systemic factors that underpinned it – starting with reliance on debt and roadblocks in the way of innovation, including limits on corporate venturing.
The countries that have grasped this the earliest, such as China, are building fundamental competitive advantages over other regions mired in special pleading.