Innovation Canada: A Call to Action

7. Filling the Gaps (continued)

Recommendation 5

Help high-growth innovative firms access the risk capital they need through the establishment of new funds where gaps exist.

The Vision of the Panel

Innovative, growing firms require risk capital, yet too many innovative Canadian firms that have the potential for high growth are unable to access the funding needed to realize their potential. The Government of Canada can play an important role by facilitating access by such firms to an increased supply of risk capital.

Getting There

To realize this vision, the Panel recommends the following.

5.1 Start-up stage – Direct the Business Development Bank of Canada (BDC) to allocate a larger proportion of its portfolio to start-up stage financing, preferably in the form of a "sidecar" fund with angel investor groups.

5.2 Late stage – Provide the BDC with new capital to support the development of larger-scale, later-stage venture capital funds and growth equity funds in support of the private venture capital and equity industry. These funds would specialize in deal sizes of $10 million and above that are managed by the private sector and subject to appropriate governance practices.

The foregoing recommendations, depicted in Figure 7.3, reflect the Panel's views on where the weaknesses in the financing chain are found. However, as pointed out by Josh Lerner, a respected US analyst of the venture capital market, government intervention has to be carefully structured in order to be effective (Lerner 2009). ¹¹ The recommendations are therefore developed with the following considerations in mind.

• Government intervention should be structured to address market failures and to create a net benefit for society. The purpose of intervening in the venture capital market is to improve rates of return on financial capital through a reallocation among sectors. The purpose is not to subsidize the production of R&D – that is the role of R&D support programs. As a result, if market forces are appropriately harnessed to allocate funding, successful intervention will not require a large subsidy. In most circumstances, the government will be able to make a positive return on its investment. Setting up appropriate governance structures for the funds is an important determinant of their effectiveness and will help ensure that the intervention generates a net economic benefit. Governance structures have to be carefully developed to ensure that private incentives are appropriately aligned with the public interest and that the scope for self-serving behaviour is constrained.
• The market should determine the allocation of financing. Governments should co-invest with private venture capitalists and allow the private investors to determine the investment strategy. For this to work, a substantial amount of funds should come from non-public sources, and the government cannot micromanage the funds in terms of investment location and types of investment. It is important to allow fund managers to develop strong linkages to global experts, markets and businesses.
• Additional support for the industry has to be paced in recognition of limits on the supply of talented and experienced managers as well as on the supply of high-quality firms needing financing. While there is a minimum scale of intervention required for effectiveness, care should be exercised not to exceed the capacity of the industry to successfully manage the additional funds. As for other programs, the capacity to evaluate outcomes should be built in and the government should be prepared to make adjustments to improve performance, while at the same time avoiding rules that cause fund managers to focus excessively on short-term results.

Bearing this in mind, the Panel recommends that the BDC set up a national angel investment "sidecar" fund – that is, a pool of committed capital that "rides along with" or invests following the lead of an investment group. Working with groups (instead of individuals) results in economies of scale and promotes higher-quality investments through access to a broader range of expertise. BDC's contribution to the fund would come from its existing resources, with each dollar of BDC funding matched by at least 50 cents in funding from angel groups, although the appropriate funding ratio is likely to vary by sector. In order to encourage adequate participation, it may be necessary to provide an attractive financial structure to secure private/institutional partners and to induce private sector fund managers to invest in high-growth, innovative Canadian firms. One option is for the government to offer its partners a leveraged return in exchange for taking on more risk. This approach has been adopted by a number of countries.

• The New Zealand Venture Investment Fund, the Russian Venture Company and the new Israeli Heznek Fund (all of which were inspired by Israel's The Yozma Group fund) give private sector partners an option (but not the requirement) to purchase the government's position after a certain length of time at a price that would generate a predetermined rate of return to the government. With this structure, the government is exposed to the same downside risk as in a standard co-investment model, but has less upside potential, which reduces the expected return on its investment. Nevertheless, if market forces are appropriately harnessed to allocate funding, the government should be able to obtain a positive return on its investment. This approach raises the expected return to private investors without affecting the risk of loss. It therefore helps align private incentives with the public interest by giving the fund managers an incentive to invest in firms that have substantial upside potential rather than using government funds to offset losses on poor investments. Fund managers also have an incentive to work closely with funded companies because, once the minimum return has been achieved, fund managers are able to keep all of the additional return from their extra effort.
• In the US, the Small Business Investment Company (SBIC) program lends money to venture capitalists. The interest on the government loan is paid semi-annually and the principal must be repaid before capital is returned to private investors. These arrangements increase both the expected return and the risk for private investors. The government faces some risk: if the fund performs poorly enough, the loan principal will not be repaid.
• Enterprise Capital Funds in the UK have adopted a variant on the SBIC approach, with the government absorbing more of the risk of loss and gain by accepting repayment of capital on an equal footing with its partners and negotiating a share of the profits.

To improve access to later-stage venture capital, the Panel recommends having the government invest in private sector funds on terms that encourage larger fund sizes. The current state of the risk capital market suggests that the government may have to adopt a financial structure that encourages private/institutional co-investment by improving the risk–reward trade-off these investors face, as discussed above. The government should establish funds with the intention of leveraging private funds on at least a dollar-for-dollar basis.

The intention is not to create one large fund; rather, it is to encourage more and larger private funds supporting late-stage venture capital. Interviews with fund managers indicate that, while the optimal fund size varies by sector, larger fund sizes are more efficient because firms can be financed through early and late stages while a diversified portfolio is still being built. But these economies of scale and scope appear to be exhausted relatively quickly: the best returns in the US are obtained on funds in the $200–300 million range (BDC 2011, p. 13). The Panel's interviews with pension fund managers further indicated that it is more efficient to focus funds on particular sectors. The government should deploy the additional funding in stages in order to assess periodically the effectiveness of support.

---

¹¹ The title of Lerner's recent book on venture capital is highly revealing – Boulevard of Broken Dreams – and the subtitle even more so – Why Public Efforts to Boost Entrepreneurship and Venture Capital Have Failed and What to Do about It. (Return to reference 11)