The government as venture capitalist:

An investigation into the public venture capital schemes in China

Dr Jun Li

University of Essex

In 2008 the Chinese government launched a new policy with respect to public venture capital that spurred the establishment of many public venture capital schemes by local governments.

Internationally, similar efforts have proliferated over the last two decades. However, tangible consensus on how to structure these programmes remains elusive.

In his new book on the topic, Lerner (2009) refers to many international efforts as the boulevard of broken dreams.

What is the prospect of success for the Chinese effort?

The central question of this study is whether public efforts to boost entrepreneurship and innovation can succeed in China. There are three sub-questions in this study.

Firstly, what are the background conditions that explain the need for public venture capital?

Secondly, what are the distinct features of programme design?

Thirdly, what is the structure of public sector governance that would prevent from ‘government failure’?

The literature has identified two policy objectives of the public sector in the involvement in the venture capital industry.

to fill an equity gap in the provision of finance to growing or growth-potential smaller businesses (Harrison and Mason, 2000)

to redress the spatial variations in venture capital investment activity that may lead to uneven spatial economic development within a country (Hood, 2000).

So far, empirical evidence in respect of the performance of public venture capital funds shows mixed results.

Author Year Scheme findingsLerner 1999 SBIR, USA 1) while the awardees and matching firms did not differ

significantly in the likelihood of receiving VC in the years prior to the awards, in subsequent years the awardees were significantly more likely to receive such financing.

2) Awardees also enjoyed substantially greater employment and sales growth.

3) The study suggests that the Federal SBIR programme has played an important catalytic role in high-technology sectors, reducing some of the information gaps faced by investors and helping the certified firms to obtain venture funding, as well as directing over $2 billion per year of public venture funds.

4) the superior performance was confined to awardees in areas that already had private venture activity, suggesting that the programme failed to redress the spatial unevenness in venture capital supply to achieve economic and development goals

5) the programme funded firms with inferior prospects.

Baygan 2003 SBIC, USA 1) SBIC investments are not addressing gaps in the private funding process, such as industrial segments or firms neglected by financiers

2) it may be contributing to over-funding of particular sectors and crowding out purely private funds.

Empirical evidence

Author Year Scheme findings

SBA 2004 SBIC, USA the composite IRRs were -12.3% for the SBA against 20.4% for the private investors and that the estimated total value to capital was 0.78 as of September 2004, compared to 1.3 for the private partners, indicating a positive return for the private partners.

Cumming and MacIntosh

2006 labour fund initiative in Canada

no evidence that the programme boosted the aggregate amount of venture spending in each province.

Da Rin, Nicodano and Sembenelli

2006 venture capital funding across 14 European countries

for every dollar being handed out by a government-sponsored programme or fund, private investors put a dollar less into the sector.

Lerner 2009 Yozma, Israel the high returns to funds that served as precursors to larger, follow-on funds, a good number of spin-off of local Yozma funds partners, increased capitalisation of the ten original Yozma groups, and a higher ratio of venture investment to GDP

Empirical evidence

Author Year Scheme findingsNESTA 2009 six UK government-

backed venture capital schemes

1) these schemes have had a positive, yet modest impact on firm performance which was measured by indicators of general capacity building, profitability and labour productivity.

2) while the schemes overall produce a positive effect on employment and are likely to produce a positive high quality jobs, the size of the effect is relatively small

3) there is a ‘U shaped’ relationship in gross profit margins over time since investment, i.e. gross profit margins collapse substantially and immediately in the three years after receiving the initial investment, level out by the fourth year and increase dramatically by year six, and that recipient firms do have higher average labour productivity.

4) these schemes are a relatively expensive means of short-term job creation5) government funding does have a positive effect on intended firm

behaviour in which firms make a trade off between short-run growth and longer-run profit as they reconfigure and invest in new products, technologies and processes for future growth

6) these schemes do play a role in the allocation of financial and managerial resources to help grow firms that have an impact on productivity in the economy.

NAO 2009 28 funds established by the BIS since 2000, UK

1) 84% of businesses surveyed for three of the funds reported that the initial funding had made it easier for them to obtain additional finance from other sources, that 32% of businesses reported they would have been unable to obtain any finance without support from the funds,

2) the financial performance of the funds is likely to be poor, although not untypical when compared to private venture capital returns over the same period

HCCPA 2010 28 funds established by the BIS since 2000, UK

1) the early funds were structured in a way that meant the taxpayer bore a disproportionate share of the risk and hence greater losses

2) there is a risk that the current pattern of investment, concentrated in London and the South East, reinforces inequalities between regional economies.

Empirical evidence

Harrison and Mason (2000) sum up the criticisms of the public sector provision of venture capital. replicate and reinforce existing spatial biases in the

venture capital industry. create market distortions which over the longer term could

drive out or displace private sector venture capital funds. Address only the partial conditions under which

entrepreneurship can flourish. doubts about the long-term financial viability and

sustainability of these funds. invest in non-competitive businesses and lower return fund

portfolio, making more difficult the attraction of additional venture capital into the region from either public or private sources.

Lerner (1999, 2004, 2009) suggests that public venture capital initiatives could fail as a result of design imperfections and implementation failure. Design imperfections.

ignorant of the realities of the entrepreneurial process. ignorant of the market’s dictates: a) pressure to “spread the

wealth”.

Implementation failures failure to building in incentive failure to design appropriate evaluative mechanisms ignorant of the international nature of the entrepreneurial

process.

1985

The Government firstly introduced the VC concept in the ‘CCCC Decisions on Reforms of S&T System’ in March and approved the 1st VC firm (China New Technology Venture Capital Corporation, CNTVC) in September

1991

The State Council in ‘Provisions of Policies for National High-Tech Development Zones’ in March specifies that high-tech development zones can establish VC funds and that more established zones can set up VC corporations. This prompts local government involvement in VC

1999

The CCCC and State Council in ‘Decisions on Enhancing Technological Innovation, Developing High-Tech and its Industrialisation’ in August encouraged the development of the VC market, VC firms and VC funds. Subsequently, policies were issued by the central and local governments

2001

The State Council’s ‘Provisions of Setting up Foreign VC Firms’ took effect in September. It removed foreign VCs entry barrier to China

2004

The Small and Medium Enterprise Board in Shenzhen Stock Exchange was launched in May. It offers VC an exit route.

‘Securities Law’, ‘Company Law’ and ‘Partnership Law’ were issued. 10 Ministries jointly issued ‘Provisions on Management of VC Firms’ in November. The VC’s legal and regulatory environment improved.

2005 2006 2007 2009

The State Council in ‘Notice on Implementing the National Outline of Medium and Long-Term S&T Development (2006-2020)’ in August encouraged local governments and departments to establish VC Guiding Funds (VCGF).

The Development and Reform Commission, Ministry of Finance and Ministry of Commerce jointly issued in ‘Directives on Establishment and Management of VCGFs’ in October

Evolution of the VC Industry and Public VC Schemes in China

The Growth Enterprise Market (GEM) in Shenzhen Stock Exchange was launched. It offers an additional exit route for VC investments.

2008

The Ministry of Finance & State Administration of Taxation issued Notice on Taxation Policy in Support of VC Firms. The first national VCGF was launched.

In a sense the development of public venture capital schemes in China was evolutionary.

The establishment of Innovation Fund for Small Technology-based Firms (InnoFund) in 1999 can be seen as an early serious effort to address the problems of financing confronted by high-tech SMEs.

Innofund has three distinct features. It is policy-oriented, manifesting the macro policy guiding function of the

government to support the development of new and high-tech SMEs. It serves as a “pump-priming”, expenditures to stimulate more

investment in technology-based SMEs from local governments, corporations and financial institutions.

It is not aiming at profit-making but rather at social return in respect of growth and job creations.

The form of financing consisted of grant, loan interest subsidy and equity investment.

Forms of financing When the NDRC, MoF and MoC jointly issued ‘Directives on the

Establishment and Management of VCGFs’ in October 2008. It proposed four forms of public venture capital schemes.

Fund-of-fund. VCGF plays a role of fund-of-funds, contributing initial capital to a VC fund with other private founder-members and selling its founder’s shares in pre-agreed terms.

Co-investment. Both the VCGF and the VC firm co-invest in early-stage SMEs. This is designated to support VC firms in order to reduce its investment risk.

VC investment subsidy. VCGF subsidizes certain VCs so as to help them withstand risks.

VC investment subsidy. VCGF subsidizes certain VCs so as to help them withstand risks.

Evolution of schemes

Retention of existing tools

Grant - VC investment subsidy & VC investment subsidy

Modification of an existing tool

equity investment – direct co-investment

Introduction of a new tool

Indirect co-investment (Fund-of-fund)

Chinese approach to public venture capital shows an apparent influence of the Israeli Yozma model which emphasises leveraging private venture capital through indirect co-investment rather than direct public equity investment.

Thus the focus of the new Chinese approach is on risk sharing through seed corn investment in the commercialization of science and technology and similar co-investment approaches to early stage high growth and often technology-based companies.

It also concerns taking the lead in high potential, but difficult projects, where other equity players are reluctant to become involved until later stages

Risk management VCGFs invest in private venture capital funds and managers and

fund managers make and manage investments independently.

VCGFs invest until other initiators of the new fund contribute their shares of registered capital.

VCGFs entrust commercial banks with overseeing cash flows of the new fund.

VCGFs specify provisions for operating the new fund in order to ensure that the fund can stick to its strategic goal.

VCGFs hold a one vote veto right in the new fund if misconduct is found.

Challenges By the end of 2009, 43 VC firms applied for fund-of-fund and VCGF

invested in 14 with RMB309 million. The 14 newly-founded VC funds have a total financing of RMB2.382 billion.

There is evidence that local government policymakers made decisions based on “buzz”.

Local governments follow the Central government to establish VC guiding funds. By June 2009, 23 provinces had set up 50 local VC guiding funds, 19 of which operated at provincial level and 31 at city level. All the local funds possess total capital of RMB25.2 billion.

According to the Hong Kong-based China Venture Capital Research Centre report (Chen, 2008), there were only three VCGFs in 2006 with a capital of 2.5 billion and 16 VCGFs with a capital of 8.85 billion in 2008 in China.

Challenges Some schemes shared one considerably problematic feature: financial

“ground rules” that were inconsistent with their basic missions.

the schemes operated under the rule that its investments be undertaken profitably. This requirement has been interpreted as meaning that its returns each year were expected to be above the inflation rate.

These requirements seem quite out of line with the funds’ ultimate objectives of addressing failures in early-stage venture capital markets. The Finnish experience showed that this requirement led to the Finnish Industry Investment Ltd (FII) to emphasise later-stage investing, in the hope that a more steady profit flow would allow the fund to remain in compliance with its ground rule (Lerner, 2009).

Challenges Mismatch between local investment demand and availability of

locally investable deals. Some schemes demand that 80% of the VC fund be invested in local firms.

Unclear and inconsistent objectives of a public venture capital organisation

Lack of clarified measure of accountability in respect of objectives and performance of public venture funds