Government-backed VCs funds ‘too constrained’ to deliver big returns

The report by the British Private Equity and Venture Capital Association and Nesta, the National Endowment for Science, Technology and the Arts, is sobering reading for governments that are hoping to restore their economies by pumping money into innovative start-ups.

In the UK its publication comes ahead of the creation of the £1 billion government-backed UK Innovation Investment Fund, due to be operational by the end of the year.

Entitled “From Funding Gaps to Thin Markets: UK Government Support for Early Stage Venture Capital”, the report analyses the impact of investment from six UK government-backed venture capital schemes on 782 companies over the period 1995 to 2008.

It finds that these government-backed VC schemes have had a positive effect on company performance and job creation. But this effect has been small, and significantly less than the effects that purely private venture capital would be expected to bring. Many of the problems arise from the structure and limitations of government-backed schemes established in the UK to date.

Too often they have been too small, too regionally focused, poorly managed, or unable to provide enough capital or effective follow-on funding.

The report makes the following policy suggestions:

1. Raise the minimum size of “hybrid’” venture capital funds with a mix of public and private money to £50 million. Smaller funds do not have sufficient scale to take high-performing firms in their portfolio through the several rounds of financing necessary for a successful IPO or trade sale exit.

2. Remove any geographical constraints. Requiring a fund to invest only in a limited geographic area reduces the size and calibre of the start-ups that they can invest in, limiting their ability to generate commercial returns.

3. Remove limits to maximum investment levels per portfolio company. Filling narrow funding gaps by restricting the amount of capital funds can invest per company forces growing companies to devote too much time to the disruptive and costly search for new investors, rather than running and growing their business. Policy should focus on the creation of funding escalators, which are able to provide multiple rounds of funding over time, to assist growth companies in their progression from formation to successful market exit.

It is clear that progress has been made and these initiatives have recorded commendable successes, but policy in the future must be smarter and heed the lessons of the past ten years, said Simon Walker, Chief Executive of the BVCA. “These schemes are often prisoners of regional and operational constraints which prevent them from unleashing the true potential of high-growth companies.”

The obvious tension between regional and industrial policy should be settled in favour of a forward-thinking industrial policy which focuses on flexible, bottom-up regional policies, rather than inflexible top-down ones. “The structure of the recently announced UK Innovation Investment Fund shows that lessons are being learnt and to fashion a new strategic direction for Britain policy must continue to evolve by eradicating the constraints of the past,” Walker added.

Previously, there has been little more than anecdotal evidence about the performance of government-backed venture capital schemes, noted Jonathan Kestenbaum, Nesta’s Chief Executive. “The conclusions of this report can now help to shape the structure of the government’s new Innovation Investment Fund. Multiple objectives have been the downfall of previous government-backed schemes but we now have the opportunity to put this right.”