I have finally come to the realization; after 30 years on Wall Street and Silicon Valley, that our capital markets are simply obsolete and that it’s high time for a new technology that allocates money and other resources far more efficiently than both our actual technology and government. The current VC/entrepreneurship worlds are in a mess, and to their credit, the players are doing some serious introspection. But mostly, it is still business as usual.

I have nothing against VCs and angels. Most are extremely smart people. But the world of problems and opportunities is now so complex and fragmented that any system that relies on “bottleneck star-spotting talent” is doomed to hit its limits in short order. Peer investing, crowd funding, the transparent processes of Angel List, and bootstrapping are the beginnings of alternate models, but they simply don’t move enough money around yet. This is the reason Silicon Valley seems like such a messed up place to outsiders: the world’s highest concentration of extraordinary talent is being funneled towards some of its most unimportant problems (and in fact, towards work that exacerbates rather than improves things).

People in the Valley, I find, believe in the myth that theirs is an efficient free market economy of investment and that attempting to “direct” the entrepreneurial energy will kill it. This is laughable. The system is explicitly set up to direct entrepreneurial attention in extremely non-free ways. The entire region is wired to the capricious opinions of a few key people, who drive not only their own investments, but via imitation, the money of  lazier thinkers. Even if these people were 1000x geniuses with wonderful intentions for the world and preternatural ability to direct money in the right ways, there would still be a huge shortfall in the diversity of intelligence needed to make the money they control truly “smart” money. The money may be smarter than average investor Wall Street money, but it is nowhere near as smart as it could be.

A very simple measure of this is simply the high degree of localization of investment. Ghemawat in World 3.0 tracks liquidity and global flow of venture capital and estimates that the lion’s share of investment happens within 20 miles or so of the investor. This happens because the investors mitigate the risks of their own limited knowledge by only investing in companies that set up shop locally, down the street. To get the money, entrepreneurs flood to the location of the money rather than the location of the markets/problems to be solved. Some justify this by pointing to the advantages of high concentrations of talent. While this is certainly valuable, there is a very high cost paid in not being close to the problems and market opportunities. People who have the market intelligence to solve water management problems are not going to emerge out of water-rich Northern California. They are going to emerge in Southern California, Nevada and Arizona. If you try to put out a call for “water management ideas” in Silicon Valley because all the 10x engineers and serial entrepreneurs are located there, you will get brilliant ideas for social networks where water-technologists can interrupt each others’ attention, rather than ideas that actually help manage water better.  So simply creating a technology that lowers the geographic distance risks of investment would be a huge plus. If a Valley VC firm could invest in an Africa-based entrepreneur with only 10x the risk of investing in a University Ave. firm, instead of 1000x, money flows would change DRASTICALLY.

The misutilization of talent is in fact so extreme I would rather invest in an average hustler and a non 10-x engineer team who are near an actual important market/problem than in a 10x super-star team in Palo Alto. Sure the latter would execute far more brilliantly and with all the latest technical tricks. But they are at a far higher risk of solving the wrong problem and then struggling to find a market. We are reaching diminishing returns from investing in the right team in the wrong place. Investing in even mediocre teams in the right place should provide good returns by comparison, on problems that actually matter and map to interesting markets.

There is a just-so excuse I’ve heard in the Valley lately, that you can’t figure out a market before hand, and that a startup is an organization designed to “search for a business model.” True, but in a way, we’ve had to invent this whole Lean Startup process to efficiently “hunt” for markets primarily because startups are in the wrong place.

In a way the Lean Startup is a Californian solution to a problem created by trying to do everything in California in the first place. I believe that at some point you should get out of the building to be an entrepreneur. I think that’s WAY too weak. You have to get out of California. If you’ve ever tried literally “walking out of a building” in SoMA or University Ave., you know that you’ve basically not left the building at all.

Much less efficient models may end up working well if you simply made the “hunt” part easier by NOT trying to solve every damn problem while sitting in some coffee place at University Ave. It seems idiotic that I actually have to explicitly argue that a startup focusing on making money by delivering mobile banking services in Africa should…. be located in Africa. No amount of screaming that “all the 10x engineers are here!” will convince me that Silicon Valley is the right place to solve that particular problem. By extrapolation, I refuse to believe that most of the important business opportunities are somehow magically accessible to people sitting in California. 90% of the opportunities require you to leave the building…. California I mean.

Better geographical distribution of entrepreneurial talent and money near markets and problems is merely one way to make the capital markets”smarter.” There’s tons of others.

Please share your thoughts.

I believe four major actors—petrodollar investors, Asian central banks, hedge funds, and private equity—are today’s the key power brokers playing an increasingly important role in the world’s financial markets.

Excluding cross-investments between them, oil investors, Asian central banks, hedge funds, and private-equity firms together held $20 trillion in assets at the end of 2012. Their assets have tripled since 2000, making them two-thirds the size of global pension funds.

Together these four players are reshaping global capital markets in a major way. They each represent large new pools of liquidity with longer-term investment horizons than traditional investors that allow them to pursue higher returns—and risks. They have markedly diversified the investor base and expanded private markets for capital. They are spurring financial innovation, enabling the more efficient spreading of risk, and spreading liquidity.

Although the boom years ended in late 2008 as the financial crisis escalated and the global economy slumped, we believe the power brokers fared relatively well though their paths have greatly diverged: petrodollar and Asian sovereign investors are more influential than ever, while the rapid growth of hedge funds and private-equity firms has halted abruptly.

Petrodollar investors—including central banks, sovereign-wealth funds, high-net-worth individuals, and other investors from the major oil-exporting countries—remain today the largest of the four classes of power brokers over the next five years under all of our scenarios. In the base case, we project that the foreign financial assets of these investors will rise to nearly $9 trillion by year end 2013. In the quick fix, with the price of oil staying at nearly $100 a barrel, their assets grow to more than $13 trillion, nearly half as large as the assets of the world’s pension funds for that same year.

The sovereign investors of Asia—its central banks and sovereign-wealth funds—see their foreign wealth grow to $7.5 trillion by year end 2013 in our base case. China, with its foreign financial assets growing to $4 trillion, accounts for more than half of this total, though its current-account surplus declines relative to GDP. In the quick fix, with world GDP and trade recovering more quickly, the foreign assets of Asian sovereign investors grow to $8.5 trillion.

Regarding the hedge fund industry, although it is starting to slowly recover from the bloodbath of 5 years ago, we expect assets to recover slowly to $1.5 trillion by year end 2013. That’s slightly better than the total at the end of 2008 but still well below the peak in 2007. A major constraint on the growth of hedge funds is the size of their investors’ portfolios: the collective wealth of pension funds, insurance companies, endowments, sovereign-wealth funds, high-net-worth individuals, and other such investors fell from $91 trillion in 2007 to an estimated $75 trillion by the end of 2008. In our conservative base-case scenario, battered but resilient, in which the economic recovery doesn’t begin until mid-2015 – bar any extraordinary event that could delay the process – , it takes four to five years for these investors’ assets to regain their 2007 levels. Unless the appetite for investments in hedge funds increases a good deal, this delay will substantially curtail their fund-raising.

As for private-equity buyout funds, their assets under management fall in our base case, to $1 trillion by year end 2013. For starters, the collective wealth of their investors (like those of hedge funds) has declined sharply. Second, this scenario assumes that megadeals—leveraged buyouts worth more than $3 billion a piece, which dominated private equity during the boom—won’t revive anytime soon, because investors have less appetite for them, and banks working through credit losses face funding constraints. Meanwhile, private-equity managers are looking beyond buyouts, to other types of investments, such as distressed debt, infrastructure, real estate, and venture capital. We therefore project that total private-equity assets under management will grow modestly in our base case, to $3.4 trillion by year end 2013.

No one knows how the still prevailing financial and economic turmoil will play out, but our analysis shows that in virtually any scenario, the power brokers will remain a significant force in global capital markets. Oil exporters and Asian and Middle East sovereign investors will continue to be major players, controlling vast pools of wealth. Hedge funds and private-equity buyout funds are down but not out.

The evidence to date gives some reason for optimism that the risks these players pose are manageable. Nevertheless, the concerns being raised by the rise of the new power brokers are real and justify careful monitoring.

We at the Financial Policy Council suggest that the four players would be wise to note public concerns and voluntarily take steps to minimize them.

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