Feds focus on venture capital

In mid-January, the government announced its plan. Although there still are many details to be hammered out, that plan is centered on the philosophy that by committing enough public money – while also leaning heavily on the private sector for the investment expertise – the feds can attract other investors to join in. That might give the Canadian VC sector the momentum to sustain itself eventually.

To get there, the feds are seeking to establish a couple of new, large national funds-of-funds that will, in turn, invest in several VC funds. From there, the underlying funds will invest in startups (of which one-third must be based in Canada) – although the funds-of-funds also would be able to put as much as 20% of their capital directly into companies, too.

The government has earmarked $250 million for this effort, which represents its biggest bet. But Ottawa also wants to attract co-investors to these funds-of-funds, including institutional investors, such as pension funds and sovereign wealth funds; banks and insurance companies; strategic corporate investors; and the provinces. These other investors would be expected to put up at least $10 million per fund-of-funds. And the new funding vehicles will be managed by general partners chosen from the private sector.

In addition to setting up the new funds, the government plans to contribute up to $100 million to recapitalize some existing funds-of-funds in partnership with willing provinces. As well, the feds will make another $50-million investment directly in the three to five existing high-performing VC funds.

Many of the specifics of these initiatives have yet to be worked out. The government isn’t saying how many existing VC fund-of-funds it intends to invest in, how big each allocation will be or what sort of investment strategy the government intends to support. These details will depend on discussions with the provinces and prospective private-sector players in the VC sector.

Although the initial plan may still be somewhat lacking in details, that likely won’t be for long. The government has said it wants to hear from potential co-investors by Feb. 8. Ottawa also indicates that it will be consulting with the private sector in the coming weeks for advice on the existing VC funds that should receive an immediate capital infusion (the $50-million commitment) and on the process for choosing private-sector management for the planned new national VC funds-of-funds.

Such close co-operation with the VC sector is a hallmark of this initiative. The plan so far is already the product of extensive consultation with the VC sector, which took place over last summer.

Those consultations found, among other things, that VC fundraising has been declining in Canada since 2001 and that many private-sector investors have abandoned that asset class, leaving governments as the primary source of new VC money. As a result, the number of VC funds has shrunk, too.

@page_break@ Although one of the fundamental reasons for the decline in available capital is the poor returns the sector has generated in the past, there is hope that future returns may be better, given that the weaker VC managers have been weeded out and new, more experienced managers have emerged.

However, the hope of improved returns hasn’t proven strong enough to draw investors back into this area of the market, leaving startup companies desperately short of VC funding.

This is the type of market failure that justifies government intervention, the VC sector contends. And sector players hope the approach being taken by the government – with its emphasis on attracting co-investors and relying on private-sector managers to produce profit-maximizing returns – will ultimately lead to the development of sustainable sources of private VC funding. This project isn’t intended to be the sort of unaccountable “pork” that governments are often accused of funding. Rather, it’s meant to catalyze the sector so it can eventually stand on its own.

Not surprising, the VC sector is full of praise for the government’s approach the far. The sector’s trade association, the Toronto-based Canada’s Venture Capital and Private Equity Association (CVCA), is lauding the proposed plan, saying that it “recognizes, and provides active support for, the vital role of venture capital and venture capitalists.”

The government’s interest, of course, goes well beyond propping up VCs for their own sake. The ultimate goal is to support the growth of high-tech startups in Canada, hopefully transforming the economy and creating high-value jobs in the process.

A sure signal of the importance the government is attaching to this effort is the fact that the prime minister himself announced the plan and stressed its long-run objectives.

In announcing the plan, Prime Minister Stephen Harper, said: “Canada’s long-term economic competitiveness in the emerging-knowledge economy needs to be driven by globally competitive, high-growth businesses that innovate and create high-quality jobs. We will provide the resources needed to put Canada’s [VC sector] on the path to sustainability and ensure Canada’s high-potential firms have the resources they need to succeed.”

Indeed, a white paper published in October 2011 by Stephen Hurwitz, partner with Boston-based law firm Choate Hall & Stewart LLP, argues that the shortage of VC funding does undermine the economy. The paper suggests that this lack of capital means that Canadian technology startups are chronically underfunded. Thus, they either fail at a relatively early stage or are sold to better funded rivals from other countries at relatively low prices, thereby surrendering much of the benefit of extensive government funding for research and development. Thus, the economy often loses these sources of growth as a result.

Hurwitz’s paper called on Canada’s federal government to try to put an end to this with an initiative similar to the one the government now is proposing, by: financing VC funds-of-funds; bringing in private-sector general partners to manage the funds-of-funds; and inspiring co-investors to multiply the size of the funds-of-funds in order to catalyze the creation of a self-sustaining VC sector.

“The plan definitely has the right mission,” says Hurwitz, of the government’s recent announcement. “There are a lot of challenges ahead in the implementation, but I’m optimistic that [the government has] real potential to have a significant impact with what it is doing.”

The big questions now are whether the private sector buys in, and whether the government is able to create the sort of leverage that its plan envisions. Hurwitz says that, ideally, the government’s $400-million investment will be matched, if not exceeded by private-sector commitments. Hopefully, he adds, the plan will attract enough co-investment to generate a $1-billion capital infusion for the VC sector.

Just how the government’s plan persuades institutional investors to return to an asset class that has largely been abandoned in recent years remains to be seen. Hurwitz’s white paper suggests that incentives should be offered to bring in private-sector investors. For example, the paper proposes that private players be granted the right to buy out the government’s interest in the new VC funds-of-funds within six years on favourable terms (at cost plus interest) or be allowed to take a disproportionate share of the funds-of-funds’ profit.

Indeed, the government acknowledges that “reasonable incentives” will be required to attract institutional investors.

The danger is that public money simply ends up subsidizing private returns. But attracting private capital must be the short-term goal if the long-term objective of building a self-sufficient VC sector is to be achieved.

Absent that, having the government merely pump money into VC funds may provide a temporary boost, but isn’t likely to lead to anything sustainable.IE

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