Bob Ackerman, founder and managing director of Allegis Capital, says America's innovation engine may be stalling at the hands of lawmakers. For some venture firms, that's led to the pursuit of greener pastures in India and China. But that's taking a toll on the United States' once-robust job creation machine fueled by startups and fronted by entrepreneurs. Some international investors have gone even so far as to say, ‘The best is over for the U.S.,’ Mr. Ackerman says. “If that’s the perception, we have our work cut out for us.”

Mr. Ackerman recently shared his views with Red Herring on these matters and others. Excerpts from that conversation follow.

What's the worst bit of news to hit your industry right now?

Clearly, we are heading toward a period of consolidation within the venture industry; there is no doubt about that. I think that coincident with that consolidation we may see a shift in leadership. There’s a series of established brands perceived to be by some LPs to be "The” brands, and interestingly enough, those brands are based on reputations built in the '80s and '90s. It will be interesting to see how firms continue moving forward as the business is forced back to the fundamentals, fund sizes shrink and the people who built these reputations are retiring or are about to retire. We are likely to see different funds with different names putting up the numbers.

Are we talking about a Renaissance for venture?

In a lot of ways, I see it as venture rediscovering itself and going back to its roots. If you look at the history of VC primarily in the seed and early stages, it was the providence of ex-operating executives who didn't want to retire and who wanted to bring their expertise and capital to work for the next generation of entrepreneurs. That model created some very significant successes. Those successes attracted a significant influx of additional capital. With the capital came the need to grow firms, and one of the byproducts of the industry growing as significantly as it did is that the bar was lowered in terms of the operating experience that was assumed to have been there when the industry began. If you go back to 1999-2000, when you saw well over one hundred billion dollars coming in, there was just way too much capital and nowhere near enough experience in management to intelligently oversee how that capital was deployed. And so you had too much capital, too little experience coming together in a bubble environment that all fed on itself. So I think today we are, hopefully, heading back toward a renaissance. I hope we have learned that VC really is a cottage industry. It doesn't scale infinitely, and there needs to be a reasonable match between available capital and quality opportunity. That balance is important to be able to generate the types of returns that recognize the risks that exist in early-stage investing. And we'll maybe go back to a point where we have more experienced managers in the ecosystem to manage the capital in a sensible fashion. After the dot-com bubble burst, the level of experience in the venture industry was probably at an all time low. The previous generation of managers was retiring and many firms were left with substantially less experienced management who had to deal with the bubble. That's not a very constructive formula for working your way out of a bubble environment. Today, people have more experience, capital is coming down precipitously—and hopefully, managers have learned from the 2000 experience.

I hope we see out of this a rediscovery of venture, a return to the basics, the early stages, in particular, with reasonable funds sizes managed by experienced partners who can write small checks and generate returns with smaller exits. If the IPO market comes back and we get bigger exits, that's great, but when you make an investment you have no visibility and even less control of what the exit environment will be six years down the road from now. Making an investment assuming that an IPO market will be available in six years seems like a fool's errand to me. As a CEO, I need to make business decisions based on things that can be controlled to have a higher probability of success.

Is there going to be a cleanup of the industry, with funds going away?

I think we are going to see a number of funds go away and partners recycled. So there may be partners teaming up with other partners and new funds constituted. The challenge for firms with very large pools of capital is how to transition to substantially smaller funds. How do you right-size that? That's not easy, and the question is this: Will the LPs play their part. There is a lot of discussion about the correlation between fund size and returns – the data is pretty conclusive. LPs are talking actively about focusing on smaller funds because that’s where a lot of the returns have to come from. But the LPs have to also have to have the courage of their conviction and be willing to write smaller checks into smaller funds and eschew the mega funds.

How could some of the proposed tax changes being discussed in Washington affect venture capital?

One of the challenges we have now if you look at venture as opposed to other assets, be it private equity or hedge, is our timeline for returns. In PE, you’re holding period will be three or four years, typically. And then you get your profit, with is taxed at long term capital gains. When you look at venture, we look at six, seven, eight years out and we get taxed at long term capital gains. If the tax treatment changes to current income, how does that affect behavior? People start saying I am not really sure I want to work that hard for eight years and see future profit gets taxed as current income. There is no incentive in being patient and building things over the long term. It's going to be an interesting question for the industry. Beware of the unintended consequences of these policies.

How about other regulatory changes?

Again this is the land of unintended consequences. I don’t think that politicians and regulators have enough knowledge and understanding of the nuances of various private asset classes to appreciate the distinctions. For example, recently we saw a treasury proposal for calling for all alternative manager and venture included to register with the federal government as potential sources of systemic risk to the U.S. economy. Venture, private equity, and hedge funds were all lumped together for this exercise yet the profile of each of these asset types is radically different – not to mention the scale. Hedge funds use an exceptional amount of leverage, PE uses a good amount of leverage, and venture capital uses no leverage. There are no systemic risks from venture, and we could all go away tomorrow and there would be articles written for a couple of months bemoaning our passing. But that's it. There would be no run on the banks, no rush of foreclosures, now wild gyrations around exotic derivates or rush to delever and decapitalize. The simple unfortunate byproduct would be that there would simply be no ready pools of risk capital to support research-oriented startups. And that would be a loss. Not to mention a loss to job creation. So what you see is a well intentioned initiative mistargeted with unintended negative consequences. Sarbanes Oxley came out of Enron. Lawmakers decided to regulate these things more closely so there can't be another Enron out there. These were well-intentioned regulations, but the unintended consequence is that it applies to young startup companies as well, and this has had a chilling effect on their desire and ability to go public. One of our companies, Ironport Systems, got acquired by Cisco for $830 million when it could have gone public. One of the primary considerations was SOX compliance. What are the incentives to go public in this environment? There was good intent: Let's make sure there are no more Enrons, but it is having a significant stifling impact on the technology industry, on young companies going public, and on job creation. When a company gets acquired, it's a nice exit for us, it's wonderful for LPs, but job creation stops. At the same time, other economies around the world have studied Silicon Valley and are trying to emulate it. Last year you had 6 billion to 8 billion dollars invested in China and India; 10 years ago this would have been invested in the United States, period. As a result, jobs are not being created here. Capital markets will form around where innovation is taking place; the supporting infrastructures will form around that activity because it is primarily transaction driven. Increasingly we see companies looking to go public on markets in Japan, Hong Kong, or Singapore. But let’s also add immigration policy to the list of challenges. We've always been an immigrant-driven economy, particularly in technology. But those immigrants are now going back to their countries because of governmental regulations, and the capital is going with them. Experienced VCs are going with them. IP is being developed there, and the jobs that result from this are being created somewhere else when we desperately need them here. When I talk to Middle Eastern and European investors I hear some of them saying the best is over with the U.S. We have benefited from our culture of innovation for so long that we may be taking it for granted. We are in denial. We look at our prosperity and at the engines our economic growth and innovation almost as a birth right. But again, talent and capital are movable and will always seek the higher reward to take the risks.

Are we experiencing a hangover from the previous under-regulated years, and now the backlash is over-regulation?

Yes, along with some striking lapses in individual responsibility along the way. If you look at the problems in the economy last fall, at the number of people that precipitated the crisis, it's a relatively small number of people, and then you have the Madoffs, of course. At AIG that was just 70 people who were creating the products that proliferated through the economy because people thought they could get a free lunch. There is no free lunch. They were so far ahead of the regulators, and by the way they will always be, innovators will always be ahead of regulators. The registration of venture funds is going to have a negative impact. You'll see funds moving offshore. You'll see people who'll say, "I don't want to do this anymore." Sometimes it feels like there is an assault on innovation in our economy and it's not intentioned. The federal government just doesn’t understand how carefully balanced this equation is, what really drives the process that allows innovation to happen here.