- 1. Public Policy for VC and PE
- Cumming & Johan (2009, Chapter 9)
2. Two Main Forms of Public Policy
- Government expenditure programs
3. Countries Considered
- European / North American Comparisons
4. Why Government VC Programs?
- Small private innovative firms contribute disproportionately to
R&D
- Social rate of return to innovation is greater than the private
rate of return
- Financing innovation is too risky for private firms (or their
employees are not appropriately incentivized to take on the
risk)
- Private investors do not skill set to be good venture
capitalists need programs to create good VCs
- Government awards to private parties certify the quality of the
company and help it to become established (and secure other sources
of funds, as well as suppliers and customers, etc.)
5. Distinctive Features of Government VC Programs
- Partnerships with private industry and awards of contracts to
best people
- Competition with private industry and unlimited ability to tap
public monies
6.
- European / North American Comparisons
- US Government VC Programs
7. US Small Business Innovation Research (SBIR) Program
- European / North American Comparisons
- Small Business Investment Company (SBIC) program started in
1958
- Awardees 51% owned by US citizens
- Multi-government selection process
- Ranked according to research potential and not commercial
viability
8. US SBIR Program is Large
- European / North American Comparisons
-
- $3.9 billion private venture capital funds
9. US SBIR Program is Successful
- European / North American Comparisons
- Firms that received an SBIR award were much more likely to
subsequently receive VC funding in later years, relative to a
matched set of firms that did not receive an SBIR award
- SBIR awardees also have higher sales and asset growth
- Whether or not an award is granted is more important than the
size of the award, consistent with the certification rationale for
government programs
10. US Small Business Investment Companies (SBICs)
- European / North American Comparisons
- SBICs are operated like private venture capital funds and are
operated by private investment managers.
- The difference between a private venture capital fund and an
SBIC is that the SBIC is subject to statutory terms and conditions
in respect of the types of investments and the manner in which the
investments are carried out. [1]
-
- For example, there is a minimum period of investment for one
year, and a maximum period of seven years for which the SBIC can
indirectly or directly control the investee company.
-
- Investee companies are required to be small (as defined by the
SBA) which generally speaking is smaller than those firms that
would be considered for private venture capital financing.
-
- SBICs also face restrictions as to the types of investment in
which they may invest.
-
- Capital is provided by the SBA to an SBIC at a lower required
rate of return than typical institutional investors in private
venture capital funds.Excess returns to the SBIC flows to the
private investors and fund managers, thereby increasing or
leveraging their returns.
- [1] These terms and conditions are summarized
athttp://www.sba.gov/INV/overview.html
11.
- European / North American Comparisons
- Australian Government VC Programs
12. Australia Government VC Programshttp
://www.avcal.com.au/
- European / North American Comparisons
- The Commercial Ready Programme
-
- $1 billion direct govt VC fund
-
- Max investment in any company: $1 million
13. Australia Government VC Programs (Continued)
- European / North American Comparisons
- Commercializing Emerging Technologies (COMET) Programme
-
- Provides scientists with advice to commercialize their
technologies
-
- 175% (reduce taxable income by more than the amount expended on
R&D)
14. Australian Innovation Investment Funds (IIFs)
- European / North American Comparisons
- Perhaps the most important
- The Australian government held two competitive selection rounds
in 1997 and 2000
-
- Five IIFs established in late 1997 (and early 1998) $Aus130
million
-
- Four IIFs established in 2001 $Aus 91 million
- Matched by private sector capital on the basis of a Government
to private ratio of up to 2:1.
15. Key elements of the IIF program:
- European / North American Comparisons
- the ratio of Government to privately sourced capital must not
exceed 2:1;
- investments will generally be in the form of equity and must
only be in small, new-technology companies;
- at least 60% of each funds committed capital must be invested
within 5 years;
- unless specifically approved by the Industry Research and
Development (IR&D) Board, an investee company must not receive
funds in excess of $4million or 10% of the funds committed capital,
whichever is the smaller;
- distribution arrangements provide for:
-
- both the Government and the private investors to receive an
amount equivalent to their subscribed capital and interest on that
capital;
-
- any further amounts to be then shared on a 10:90 basis between
the Government and private investors;
-
- the private investors component to be shared with the fund
manager as aperformance incentive;
- the funds established under the IIF program will have a term of
ten years, after which they will be closed in a commercially
prudent manner.
16. To be eligible for support under the IIF program, investee
companies must:
- European / North American Comparisons
- be commercialising the outcomes of R&D activities (as
defined by theIR&D Act );
- be at the seed, start-up, early, or expansion stage of
development.
- have a majority of its employees (by number) and assets (by
value) inside Australia at the time a licensed fund first invests
in the company; and
- have an annual average revenue over the previous two years of
income that does not exceed $4 million per year and revenue in
either of those years that does not exceed $5 million.
17. 18. 19. 20. 21. 22. 23. IIFs Relative to Private VCs in
Australia
- European / North American Comparisons
- More likely to finance start-ups
- More frequently stage and syndicate their investments
- More likely to have smaller portfolio sizes per manager
- No difference in propensity to obtain IPOs and no difference in
share price performance of IPOs
24.
- European / North American Comparisons
- Government VC Programs in Canada
25. Labour Sponsored Venture Capital Corporations (LSVCCs)
- European / North American Comparisons
- Mutual funds that invest in private equity
- Established by and run by private VCs
- Affiliated with a labour union (nominally)
- Dual goal of employment growth and profit maximization
- Established in Quebec in 1983 and other Canadian provinces from
1988-1993
- LSVCCs compete for new deals with private VCs
- Investors are individuals, and receive massive tax breaks for
investment (up to $5000 contributions)
- LSVCCs are listed on Stock Markets, operate like a mutual
fund
- Covenants are very poorly structured
26. LSVCC Tax
- European / North American Comparisons
-
- Are individuals (contrast to limited partnerships and corporate
VC in the US)
-
- Receive 20% provincial + 20% federal tax credit for investments
up to $5,000
-
- Other tax savings make the after tax cost of a $5,000
investment as little as $1500
-
- Anyone that invests in a LSVCC need only care about the tax
incentive
27. LSVCC Tax
- European / North American Comparisons
28. LSVCC Covenants
- European / North American Comparisons
- 60% (under the federal legislation) of new funds received must
be invested within a certain amount of time after receipt otherwise
a penalty is imposed:
-
- Tax on funds received but not reinvested (20%)
-
- Revocation of the funds registration
- The remaining 40% of new funds received must be invested in
liquid securities
- LSVCCs cannot invest more than the lesser of $10 million or 10%
of the equity capital on the LSVCF in any one business
29. LSVCC Covenants
- European / North American Comparisons
- Constraints on time to reinvest are not trivial.E.g. 1996-1997:
Working Ventures (Canadas largest LSVCC) had to refuse new capital
contributions for over 1 year!
- There are other covenants
-
- Cannot have more than $50 million in assets or 500
employees
-
- 50% or more employees must be full-time and 50% or more of
wages must be paid to residents in the jurisdiction governing the
LSVCC
-
- Cannot carry on business or reinvest funds outside Canada
30. Are LSVCCs a Superior Organizational Form?
- European / North American Comparisons
- LSVCC LegislationLSVCC funds will have higher agency costs and
generate lower returns than private VC funds (evidence on
subsequent slides)
- Therefore, if LSVCCs crowd out other investors, this is a bad
thing
31. 32. 33. New Funds for Investment
- European / North American Comparisons
- Overhang of uninvested capital
- Capital commitments versus drawdowns from capital
commitments
34. 35. 36. Why Might Crowding Out Exist?
- European / North American Comparisons
- LSVCCs: Required rate of return on investments is significantly
lower than that of private VC funds
- LSVCC investors obtain a significant return from their tax
savings it doesnt matter if the investment makes an economic
return
- Crowding out is a natural consequence of the tax advantage of
the LSVCCs.This advantage lowers the LSVCCs required rate of
return.This in turn allows the LSVCCs to outbid other types of
funds for entrepreneurial investments, lowering rates of return and
discouraging the establishment of non-LSVCC funds
37. Crowding Out Mechanism
- European / North American Comparisons
-
- Lowers LSVCCs required rate of return
-
- LSVCCs outbid other VC funds for entrepreneur investments
- Institutional investors are risk averse, and commit funds prior
to VCs selecting entrepreneurial investments
- Risk of increasing LSVCC investment
- Discourages the establishment of non-LSVCC funds
38. Cost of Funds Amount of Funds S 0 Demand S 1 S 2 More LSVCC
(Ignoring effect on Other Funds) Reduction in Private VC (100%
Crowding Out) Reduction in Private VC (WORSE!) (>100%) 39.
Crowding Out Private Equity: Canadian Evidence
- European / North American Comparisons
- LSVCC Legislationhas not increasedthe total supply of venture
capital
- Crowding out(substitute one form of VC for another)
- Even more surprising: LSVCC Legislation has led to areductionin
venture capital (unequivocalcrowding out )
- Harm caused by LSVCCs: substitute one form of VC for anotherend
up with an interior form
- Harm caused by LSVCCs: reduction in VC investments by about 400
investments per year, or $1 billion in investment activity
- Crowding out is among the start-up and expansion stages of
entrepreneurial firm development
40. Aside On Regulation in General
- European / North American Comparisons
- Anecessarycondition for someone to be sympathetic to regulation
is that there be a clear and unequivocal argument (i.e., theory)
and evidence (i.e., data) of market failure.
- That is, in some market or industry, such as venture capital,
there is some structural impediment that reduces the proper
functioning of the market
41. This is anecessarybut NOT asufficientcondition for 3
reasons
- European / North American Comparisons
- The costs of regulation, including the direct costs and the
distortionary market effects of regulation, are frequently
prohibitive, perhaps exceeding the expected gains even if the
regulation could correct the claimed market failure.
- The regulatory process can be hijacked by private parties and
distorted to their own ends to the detriment of economic
wealth.
- Once created, the regulatory process is hard to stop even if
the underlying market failure disappears (elements of the
production of the good or service become unsustainable at
competitive prices through the market) again to the detriment of
economic wealth.
- (It is not impossible to stop wealth-destroying
regulation.)
- (Example: deregulation of the New Zealand financial services
sectors.)
42.
- European / North American Comparisons
- United Kingdom Government VC Funds
43. UK VCTs are remarkably similar to Canadian LSVCCs
- European / North American Comparisons
- Mutual fund that invests in private equity
44. UK VCTs (to 2005) Canadian LSVCCs (to 2005) Riskmetrics
Risk-Grades Rank 1-Year Return 3-Year Return 5-Year Return Pseudo
Beta 1-Year Return 3-Year Return 5-Year Return Mean 59.019 9.027
-6.175 -34.395 0.097 -3.664 -6.915 -6.968 Median 54.390 5.800
-10.000 -40.300 0.090 -4.130 -6.370 -5.010 Standard Deviation
53.879 21.613 42.791 39.038 0.081 9.880 7.701 6.738 Minimum 1.360
-43.600 -70.100 -82.900 -0.030 -34.640 -26.010 -23.840 Maximum
381.280 86.200 191.100 95.200 0.340 26.200 5.460 1.660 Number of
Funds for which data exists in column 72 78 69 38 47 111 44 23
Total Number of Funds as at March 2005 99 123 Year of legislation
allowing first fund 1995 1983 Quebec, 1988 Federal Canada,
1989-1994 Other Canadian Provinces Aggregate pool of capital in
asset class managed as at March 2005 1.6 billion 4.3 billion
Broadly described tax incentives for investors to invest 40% tax
relief on individual investments of up to 200,000 (after Finance
Act 2004); 20% tax relief on individual investments of up to
100,000 (before Finance Act 2004) The maximum tax subsidized
investment in any year is $Can 5000 (2164).The after-tax cost of a
$5,000 LSIF investment made through the vehicle of an RRSP (see
section 2) ranges from$1180 to $2390, or roughly 27 to 48 %of the
nominal dollar cost of the investment 45.
- European / North American Comparisons
- Comparisons Across Europe and North America
46. Institutional and Other Investors Venture Capital Funds
Entrepreneurial Firms Fundraising Returns Supply of Investments
Demand for Investments Part II Part I Part III 3 Parts to the
Analysis of Government VC Funds Armour and Cumming (2006 Oxford
Economic Papers) 47. Armour / Cumming Findings Across Western
Europe and North America
- European / North American Comparisons
- Favorable tax and legal environments facilitate the
establishment of venture capital and private equity funds and
increase the supply of capital.
- Temperate bankruptcy laws stimulate entrepreneurialism and
increase the demand for venture capital and give higher
returns.
- Government programs, by contrast, crowd out private equity
investment and lower industry returns.
- These effects are both statistically and economically
significant, and more pronounced that the effects from control
variables pertaining to stock market MSCI returns, real GDP growth,
patent activity, etc.
48. 49. 50. 51. 52. Summary (1/2) Law Matters
- European / North American Comparisons
- Low EVCA Index better (low taxes and stronger La Portaet al .
legal variables)
- Favorable Bankruptcy Law better (short time to discharge)
- Law is more important than many of the economic variables for
investing, fundraising and returns
- Policy Implication: governments can facilitate VC by improving
legislation
53. Summary (2/2) Government VC Funds
- European / North American Comparisons
- Can impede the development of VC markets (Canada / UK
model)
- Can help the development of VC markets (US / Australia
model)
