GO
Loading...

Why Governments Make 'Capital' Mistakes

Monday, 11 Mar 2013 | 3:43 PM ET
Scott Eells | Bloomberg | Getty Images

According to Crain's Chicago Business, my beleaguered home state of Illinois is about to re-enter the venture capital game.Not only has Illinois failed in epic proportions to manage its own financial house — with the worst credit rating in the nation and a nation's worst $96 billion unfunded pension liability — it has failed at its venture capital endeavors previously.

The proposed new Illinois Finance Authority venture fund would come less than 12 months after the failure of a recent Illinois Finance Authority venture fund, which took over a $2 million loss when it closed. In the real world, no venture capitalist would be able to raise a new fund with that track record.

However, when a state or government agency comes into play, the real world rarely applies. The state government doesn't need to raise new money for a fund because the'stakeholders', the taxpayers, have no day-to-day say in where their money goes.Politicians can just allocate taxpayers' money as they see fit.

This venture capital move reminds me of an episode of CNBC's American Greed.Illinois is swinging for the fences in venture capital as some cure-all to the financial mess that it is in. However, this 'show' always has the same ending (hello, Solyndra).

The bottom line is the government and its affiliated entities, whether at the local, state or federal level,should not be investing in venture capital. Here's why:

Venture Capital is Risk Capital. Venture capital involves the greatest risk among all investments.Venture funds invest in early stage, unproven businesses that fail more often than they succeed. The investments are typically structured as equity (or as an instrument convertible into equity) in order to get the highest returns for taking the risks, but it also means that based on where equity stands in the capital structure, in a liquidation, an investor is probably getting back nothing.

These types of risky investments are not appropriate for taxpayer money. In the real world, to invest in a venture capital deal you are supposed to be an accredited investor and attest that you can afford the complete and total loss of your investment.

The people of the state of Illinois- and of the United States- by and large are not accredited investors and given the financial status of our national and state governments,cannot afford to take any loss, let alone a complete loss of the money invested. Even if the fund were to get lucky, the risk/reward trade off is not appropriate. (Read more: Venture Capital is Taking Off in Mexico)

Also, a catalyst for states getting into venture capital right now is supposedly that there's less interest from private investors. There's a reason for that too. New businesses fail at rates that are estimated at anywhere between 60 percent and 90 percent within the first five years.Most businesses also don't earn a profit over their lifetime. The fact that sophisticated investors are finding more appropriate risk adjusted returns elsewhere should be a red flag for governments to not want to play there, not a signal of an opportunity.

These risky investments shouldn't be made by governments, at least not directly. They can leave alternative investment allocations up to their treasurers, who can decide if any alternative investments should be made as part of a diversified portfolio and then invest indirectly in a group of alternative investment funds. But to think that making specific direct investments into startup companies is a good financial strategy is incredibly misguided.

Government Venture Funds Can't Attract the Best Talent. One of the reasons that certain sectors of financial services succeed and make substantial returns is that they are able to attract the best and the most capable talent. Individuals that go into alternative asset management, like venture capital, private equity and hedge funds do so on with strong track records and the prospect of being rewarded handsomely should their investments do well.

A government venture fund is never going to be able to attract the top-tier talent that could start or join another private fund with "carry" participation in the fund. This means that the government is left with individuals who don't give the fund the best chance for success. (Read More: Venture Capital Firms More Picky About Clean Tech)

In the Crain's piece, it notes that the new Illinois venture fund is creating guidelines on when to exit investments, quoting the Chairman William Brand Jr. as saying, "The previous fund stuck with some holdings too long, hurting performance." This statement alone should disqualify Mr. Brandt from being involved with the fund. Venture capital investments are illiquid investments.

That's part of the risk that's incurred for the possibility of a higher rate of return. Investors don't get to decide when to exit the investment as there is no active market for the securities. Investors typically gain liquidity upon a sale, a recapitalization or an IPO (in the latter cases, potentially only partial liquidity at first). Trying to blame "sticking with a venture capital investment too long" on the failure of a venture fund is preposterous.

There's a reason why the Illinois Finance Authority's last start-up fund failed.

If You Can't Manage Your Own Finances, What Value are You Adding? The start-ups seeking out venture capital are typically looking for more than just money. They're also looking for expertise and guidance that investors can bring to the table. With a federal government that can't balance a budget and has racked up more debt that the yearly GDP of the country, or a state like Illinois that has the worst credit rating in the nation, what business expertise are they bringing to the table?

Businesses don't have the luxury of unlimited debt or consistently spending more than their revenues because eventually that behavior will put them out of business. It doesn't seem that if you can't manage your own finances that you should be weighing in on someone else's business.

Conflicts of Interest:A final reason why government entities shouldn't be investing in start-ups is inherent conflicts of interest. I know, it's shocking to think that there might be a conflict of interest where politics and government are concerned. From investing in businesses because of political affiliations- ranging from campaign contributions or associations with those involved in the business- the government often makes decisions based on non-market, non-rate-of-return factors that could severely impact an investment.

Additionally, it isn't fair to other businesses for the government to be invested in a competitor. That creates a potential unbalanced advantage in the marketplace if the government has the incentive for one business to succeed over another.

If the state and federal governments want to help businesses, they can do so with much less risk and within the scope of what they should be doing, by creating an environment that's friendly to businesses. Make it easier to start-up with less regulations and red tape, and make it easier to prosper with less regulation and lower taxes to incentivize the best and most successful businesses to want to stay in the state or the country instead of heading elsewhere.

If these governments want to help the taxpayers, then they can do so by fixing their own dire financial situations instead of focusing on those of a start-up. (Read More: Women's Start-Ups Lack Access to Venture Capital)

As has been said by many before me,it's not a government's role to directly pick winners and losers in business.

Featured