EU targets equity shortfall

Governments in Europe are pumping more money into venture capital but some believe their intervention could cause as many problems as they solve.

This year, the Russian government said it would commit about $555m (£427m) to venture capital. This month the French government announced a £2bn ($2.6bn) commitment to the industry over the next six years, while the first enterprise capital funds, in which the government invests in venture alongside private investors, closed in the UK.

These initiatives have been launched with great fanfare, but they are not the first public sector schemes designed to stimulate the venture industry. In Europe, particularly since the Lisbon agreement in 2001 when member states agreed to make Europe the world’s most dynamic and competitive economy by 2010, almost every country has created a program to improve access to risk capital. In a paper published last year, the European Union identified 42 schemes providing equity finance. There were further initiatives aimed at guaranteeing venture funds, as well as tax breaks intended make the sector more attractive to investors.

Governments argue this intervention is necessary to plug the equity gap the stage of growth where small businesses find it hard to attract finance. The EU said: There is a long-standing market failure in early-stage equity finance warranting public sector action.This failure occurs because the returns on these early-stage or seed investments make them unattractive to private investors, while a lack of security and reliable cash flow makes bank loans hard to find.

Patrick Sheehan, head of the European Venture Capital Associations venture committee, said: What’s new is the role of the EU in pulling these strands together. There will be regional differences but there’s a broad trend of convergence. The EUs paper argued that better cross-border co-operation was essential to generate greater scale and diversity for venture funds.

Sheehan said member states were working hard to share best practice. Most of the latest initiatives involve some kind of public-private sector partnership. French president Jacques Chirac said his governments $2bn commitment, which will be invested through the quasi-treasury organisation Caisse des Depots et Consignations over the next six years, would be supplemented by a further $1bn from private sector investors. For the UKs enterprise capital funds, venture firms and business angel groups were invited to apply for up to £25m ($37m) of funding, which would be granted on the basis that the manager would be able to raise at least this much again from private investors. Indeed, enterprise capital funds exemplify many of the features identified by the EU as best practice unsurprising since the UK venture capital industry is the most developed in Europe.

A controversial feature is the preferential terms on offer to attract private investors. Once fees have been paidand the capital returned to investors, there will be a limit to the potential share of the profits the government receives. As a result, private investors will receive a disproportionately high profit share from their investment, relative to other funds. Duncan Woollard, a partner at SJ Berwin, a law firm that advised the government, said: The accepted wisdom is that there are good opportunities, but its hard to attract investors to smaller deals. So, its no good using standard fund terms you need to make them more attractive to investors by enhancing upside potential.

However, this has led to disquiet among private investors particularly the ones that will miss out. Some argue that this kind of state intervention distorts the market, because investors will receive a higher return on their money from an enterprise capital fund than from any other seed capital fund, given the same performance. This will inevitably make it harder for non-enterprise seed capital funds to attract money.

Michael Elias, managing director of Kennet Venture Partners and a former head of the European Venture Capital Associations technical committee, believes the government should be focusing its attention elsewhere. The government shouldnt be setting up venture funds or creating parallel investment vehicles that are effectively competing against the private sector. Their efforts would be better spent on creating tax incentives that will accelerate and enhance fund performance. A free market is best.

One possible compromise can be found in Ireland. Following pressure from the Irish Venture Capital Association, the government has committed $175m to invest in privately-managed venture funds. However, the government will be treated in just the same way as any other limited partner and will receive the same returns and rights as any other investor thus ensuring these funds do not receive a competitive advantage. Niall Carroll, chairman of the Irish trade body, said the government had made a decision not to interfere with market focus.

But not everyone thinks this approach is necessary. Simon Acland, managing director at UK venture capital firm Quester, said: I dont think enterprise capital funds will distort the market. Managers won’t start doing deals on radically softer terms. But he is reserving judgement on whether the scheme will improve on previous incarnations. Governments tend to hop from one initiative to another, he said.

It is too early to say whether these schemes will succeed, or require fine tuning. Sheehan agreed states had to be wary of distorting the market. He said: If governments are pumping money into funds with sub-market returns, that’s no good for the market, either. But he emphasised that Europe is at the start of the process. Nobody’s sure of the perfect solution yet, so greater communication between countries is the most effective approach. But at least members are on a common journey.