A passport for VCs

Richard L.Hudson

A venture capital fund was formed in Austria. Its aim was to invest primarily in Austrian companies, but attract capital from all over. So it incorporated as an Austrian company “limited by shares” (MFAG), a standard legal form. Under the Austrian tax code, that meant its Austrian investors would get a tax break provided that, among other things, at least 75 per cent of the fund’s capital was invested in Austrian companies. Sounds straightforward – but wait: it quickly got complicated.

Problem 1: The fund’s general partner, under Austrian law, couldn’t itself participate in the fund (an arrangement that some investors prefer, to align the general partner’s financial interests with their own.) So a quick fix was adopted: A parallel fund was formed, as an Austrian limited partnership (KG), as a vehicle for the general partner to risk its own money.

Problem 2: The fund’s Swiss and German investors had tax problems. Two more fixes followed. First, another parallel fund was formed in Guernsey, as a limited partnership, as a tax-efficient investment vehicle for the Swiss. Then, because the Germans needed a different solution, yet another parallel fund was incorporated in Germany, as a limited partnership.

The bottom line: The lawyers and accountants made off like bandits. The set-up costs were step, and the cross-jurisdictional operating costs – four funds, in three countries – ate up 0.4 per cent of the fund’s total, lifetime committed capital.

Fragmented markets

Alas, though the fund can’t be named, it’s a true story buried deep in a new report on the venture capital industry released by the European Commission, “Removing Obstacles to Cross-border Investments by Venture Capital Funds”. The problem highlighted by the report: a crazy-quilt of tax codes and financial regulation in Europe is hobbling the local VC industry, and the European economy. This fragmentation keeps VC funds smaller and poorer than most of their American counterparts. As a result, the report concludes, the VC industry “has worked below its potential in Europe”.

It helps to look at the ills of Europe’s VC market. It’s small: in 2005, according to the report, VC investments comprised 0.11 per cent of European gross domestic product, compared to 0.18 per cent in the US. It’s less profitable: by the end of 2003, the average internal rate of return over the prior five years was 2.3 per cent among European VCs, compared to 22.8 percent in the US. Over the prior ten years, the IRR was 8.3 per cent in Europe and 25.4 per cent in the US. (For early-stage funds, the Americans did even better, with an average 54.9 per cent five-year return, and 37 per cent 10-year return.)

Vulture capitalists

With such an anaemic set of averages from the VC industry, is it any wonder that the smart money for the past five years has been pouring into private equity funds – the “vulture capitalists” decried by German socialists, who have reaped mega-returns by buying and breaking up sick companies, or dabbling in maths-PhD computer trading?

By contrast, conventional VCs – however much entrepreneurs may loathe them as rapacious in their own right – at least take the time to think about their companies’ strategies, vet their management, and go to the board meetings. And they like emerging technologies: VC-backed companies spend an average 45 per cent of expenses on R&D – an order of magnitude greater than the typical “old economy” private-equity investees, according to the EC report.

The result is striking. Not only do European VCs raise less capital than Americans, they spread what little they have more thinly.

European VCs actually invest in more companies (7,207 vs. 5,406 in the US), but give each tech company an average of only €900,000 (compared with €6.1 million in the US). That makes the under-capitalised companies more likely to fail, and skews the return curve for European VCs towards failure rather than success. “The result is that the US markets create a small number of rapidly growing, successful companies, as opposed to the European approach of targeting more modest returns from firms across the whole investment portfolio,” the report says.

The solution? Well, in the short-term, forget any thoughts of a common tax or regulatory policy across the EU; there’s no way that Poland, which bans pension funds from investing in “risky” VCs, will adopt the comparatively “light hand” UK regulatory approach to funds and fund management. But there are a few obvious suggestions, starting with the paperwork. One blindingly obvious step, for instance, is creating the idea of a “passport” for VC funds, so that they can register only once – in their home country – and then be automatically allowed to manage investments in other EU nations.

Another idea, to avoid cases like the Austrian fund: let fund returns be taxed only once, in the investor’s country of origin, rather than take a second tax bite in the fund’s home base.

There’s nothing particularly new in all this, but the report is part of a Commission campaign to prod the fiercely independent financial regulators and finance ministries of Europe into considering the consequences of their unwillingness to work together: they are dividing the market, to nobody’s benefit.

The odds aren’t high that there will be much change; tax policy is firmly outside the legal powers of the Commission. But there’s a small ray of hope that somehow, some day, the rules will change.