How to make government investment a success

Source: Management Scope (04/09/2019); Auteur: Sophie Manigart

Government bodies can make a difference by investing in companies with growth potential, claim Sophie Manigart and Thomas Standaert of Vlerick Business School. They have analysed four models for government investments and advocate a proactive government with a hands-off mentality. 

The question is no longer whether governments can play a role in high-risk investments in promising companies, but above all how. The way the government uses public money to stimulate business is subject to change, namely from the old-fashioned, centralist, ‘French’ approach to the modern variants of 2019 with umbrella funds or ‘funds of funds’ that countries such as Belgium now tend to apply. By now, almost everyone acknowledges that this ‘government aid’ is genuinely effective. Businesses with high growth potential still have difficulty financing vital investments. As a result, society misses out on many things: not only jobs but also high-tech developments and innovations. To tackle this issue, governments around the world have developed policy instruments that aim to increase the risk capital on offer. There are successful examples wherever you look, from Silicon Valley to the Brainport Eindhoven Metropolitan Region. American companies like Apple and Tesla would probably never have survived without government funding. Innovative companies in Europe such as Skype and Spotify would probably have failed. In the Netherlands, innovative companies such as BioNovion have benefited from government support, in this case in the form of a ‘ROM’, or regional development corporation (for the Brabant region). After a long run-up, the Dutch investment institution Invest-NL will probably also be launched in 2019.  

Analysis of four models

The way government bodies ‘intervene’ in the risk capital market by injecting public money has changed over the past few decades. Broadly speaking, there are four models for government investments.

1. Direct and solitary

The first method, which is the one that was historically most often used, is the method where the government invests directly in businesses. All the decisions in the venture capital process – from selection to exit – are taken and implemented by government officials. This form of government investment led to the venture capital industry in the United States and inspired the government models in many regions, from Asia to Australia and Europe. The same approach is used in the Netherlands, for example, through the above-mentioned regional development corporations.

2. Directly, but in partnership

The second method is an extension of the first. Again, the government invests directly in businesses but does so in partnership with private investment funds that ideally take the lead in the investment consortium. In this model, the government still holds considerable sway. Although a private co-financier is involved, the government plays a direct role in the decision-making process.

3. A passive government role

The model above has evolved into a third model. In this method, the government invests in private investment funds that take care of all the investment work. The private investor is free to take autonomous decisions, albeit within the framework conditions of the investment contract. The government only plays a passive role and is hands-off when it comes to investment decisions. The main example of this model is the European Investment Fund (EIF), which was founded in 1997 and has often been copied internationally. Well-functioning Dutch examples are the Seed Capital scheme and the Dutch Venture Initiative.

4. The government invests but does not make decisions

The fourth method goes one step further. In this method, the government invests in private funds of funds (also called ‘umbrella funds’) that are managed entirely by equally private fund managers. They decide in which funds to invest.

It should be clear by now that the government’s involvement in the first model is very extensive, whereas, in the final model, almost all the decisions are left up to private parties. Our research shows that the less the government interferes in the substantive direction, the greater the chances of success. The models are discussed in greater detail below.

Model 1 | Less innovative

We can be short and to the point about the first model of direct, solo investment in businesses, namely that it seldom yields the best results. Businesses that raised funding through this model grew less quickly than privately financed businesses. Moreover, they grew no faster than companies that raised no funding at all. Furthermore, they are less innovative, create fewer jobs, and are less likely to raise subsequent funding.

Model 2 | Greater growth

The second model, in which the government works in partnership with private investors, yields much better results. Companies that raise funding from both public and private investors experience more growth than companies that only attract one of these investor types. Our research shows that independent risk capital providers mainly invest in teams with stronger growth ambitions – and these often have more experience in enterprise. Moreover, these positive results are partly explained by the on average higher amounts invested in the case of co-investments between public and private investors. Hence the government can stimulate growth by increasing the investment capacity of independent funders.

Model 3 | Very successful

We were also the first in Europe to make a detailed study of the third investment model, in which the government invests in private investment funds. Our research revealed that this model is very successful in stimulating and providing more resources to the private risk capital market. European risk capital providers appear to be twice as likely to raise attracting subsequent funding if a government body invests in their current fund. The government is a stable partner with investments in half of all the subsequent funds raised. In fact, the government prefers to invest in subsequent funds of funds in which it was already involved. Unfortunately, this is unrelated to the fund’s past performance. That means that less efficient fund managers are kept alive artificially by the government.

Model 4 | Even more hands-off

The fourth method – the fund of funds or umbrella fund, in which private fund managers have complete control – is very promising. The Canadian government pioneered this model with the launch of the Venture Capital Action Plan (VCAP) in 2013. In Europe, it was once again the European Commission that was the first to copy this model. Last year, ‘Brussels’ set up a new form of investment along these lines. It chose to work even more hands-off in the investment fund market. To this end, funds were allocated to six funds of funds that were given the task of complementing the funds with investments from parties such as institutional investors, for example, pension funds. Just like the successful European Investment Fund, this model is now being copied. Since this year, Belgium has a privately-run fund of fund, the Belgian Growth Fund, which is a partnership between the government, banks, and other institutional investors.

Time for a new step with Invest-NL

The above findings are, of course, also very relevant to the Dutch situation. The Netherlands has a long history of government investment in risk capital in the form of regional development corporations (ROMs). Incidentally, this has been a success story. Now, Invest-NL is a significant new step. Because even a government can only spend its money once, it is of course in the public interest that this is done most effectively. Our research has made it even more apparent what this most effective way is. A government that invests in a company directly and takes all the decisions tends to yield the poorest results. The most efficient method is to rely on private investors for both the investment decision and the follow-up after the investment as well as for both direct investments and investments through funds of funds and umbrella funds. Therefore, the government needs to apply this method even more often. It should stay as proactive as before but take a hands-off approach.

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