Tuesday, December 23, 2008

The latest plan is a 'white elephant'

The latest Government plan for crises-ridden Irish economy is, letter for letter, a rehashing of past clichés and a pandering to the minority interest groups in politics and business.

When the cornerstone crumbles

Perhaps the most frustrating in the entire document is its centre piece – the so-called €500mln venture capital fund which, according to the reports represents:
“…the key element in Building Ireland's Smart Economy... is the establishment of venture capital funds worth €500 million designed to lure innovative industries and boost research and development.” The Irish Times, December 19, 2008.

The fund will allow three US-based VC companies to invest in start-up Irish and foreign-owned IT and environmental "green tech" companies setting up here. The Government will provide up €25 million a year for 10 years and take a 49 per cent share in the investment companies. Investors will avail of a 15% tax rate on profits.

As quoted in the aforementioned article Taoiseach Brian Cowen said that:
"The aim is that Ireland becomes the world's leading location for business innovation, a country where there will be a critical mass of companies - both Irish and international - at the forefront of innovation, creating the products and services of tomorrow and well-paid quality employment."

It will do nothing of the sorts.

Poor record

This plan represents a clear lack of learning from the past mistakes. Our State’s record in acting as a venture capital investor is thin in experience and disastrous in quality.

Media Lab Europe
(MLE) is one example that springs to mind. Some 8 years ago, the State decided to ride the IT bubble hysteria by dumping in excess of €35 million into an early-stage investment in a belief that government-paid provider of services to the various government agencies is the way to enhancing Ireland’s knowledge economy. Five years later it became apparent that the organization was incapable of delivering either commercial or academic value. MLE produced just 15 refereed papers (only 3 were published in the first-tier journals) between 2000 and 2005, signed up virtually no non-governmental business and clocked a mind-boggling loss on public investment.

Other high-tech state-run ‘investments’, inclusive of the public sector own IT programmes, fared equally poorly.

... and poor thinking

But last week’s plan is a true ‘white elephant’ of our economic development even if the record of this State in picking economic ‘winners’ is omitted. The plan fails on the basis of the Venture Capital sector own data across the following parameters:
(1) Timing – 10 year horizon;
(2) Sectors targeted for investment – IT and ‘green’ technologies;
(3) Type of investment – seed and early stage capital; and
(4) Size – €500 mln spread over 3 funds.

According to the European Commission DG for Enterprise and Industry (DGEI) analysis of seed capital funding, for the period of 1994-2003, 5-10 year seed and early-stage development capital funds average internal rates of return were -1.8% and 1.3% respectively. Almost exactly the same returns were recorded for the period of 1983-2003. This included better-performing US-based funds and covered the era of the IT bubble, when tech valuations reached stratospheric proportions.

European Private Equity and Venture Capital Association (EVCA) confirms the above results for more current data. As shown in Table 1, 10-year returns averaged -1.1% for the early stage investments – the same type of investment envisioned in our State plan. In contrast, development finance might have been a safer bet for taxpayers money, but considering the dire shortage of high-quality early-stage domestic firms, this would require us to “pay” established foreign firms to locate here – something that is not kosher under the EU regulations.

Table 1: Funds Formed since 1980, top quarter returns as of 31 December 2006

Figure 1 illustrates two major EU-wide market trends in VC investments:
(1) Fewer and fewer private funds invest in high-tech start ups (due to higher risk, lower returns to these investments); and
(2) Both the seed and start-up capital shares of total VC allocations have been falling precipitously over time.
The Irish Government plan runs precisely against these two trends.

Figure 1: Allocation of funds raised 2002-2006, €bn
Sources: EVCA and PEREP Analytics for 2002-2007 figures

Another report compiled in March 2006 by DG for Economic and Financial Affairs (DG EFA) concluded, among other things:
“As a whole, the returns produced by European venture capital funds specialising in early stage (seed capital and start-up) investment have been disappointing. …taking into account the relatively high risk of this type of investing, the IRRs recorded do not appear competitive when compared to the more predictable buyout investing. …The difference in performance between venture capital and private equity may well be the main explanation for the recent trend for European investment activity to focus on less risky buyout investment rather than venture capital.” As Table 2 shows, even accounting for distributions to investors, early stage financing simply does not pay off when compared to development stage investments.

Table 2: Cumulative investment multiples for EU funds formed in 1980-2003
Source: DG EFA 2007

What about the risks associated with the plan? Again, using the DG EFA data, as Table 3 states, European VC investments underperformed the equity indices in all instances, with exception for the period of post-bubble recession in the US.

Table 3: Public markets returns vs. VC investment
Source: DG EFA 2007

Suppose that the Irish Government fund performance matches the peak past returns for EU VC funds. This implies that at the end of 10 years period we attain a cumulative total value per €1 invested multiple (inclusive of disbursements, etc) of ca x2.9 (as consistent with vintage 1995 funds). This delivers an annualized rate of return of 6.6% or risk-adjusted annualized return of only 3.7-4.8%. This is worse than putting the taxpayers money into a termed deposit with the Anglo Irish Bank. Now, considering the business cycle dynamics, the current investment, assuming 2009 will be the last year of economic contraction in Ireland, implies a historical valuation coincident with the VC funds of vintage 2000-2001. In this vintage, the EU funds yielded a cumulative total value multiples of ca x0.8 and x0.65 respectively, giving a compounded rate of return on the planned state fund of -35% to -20%. Risk-adjusted, this implies a range of -58.3-87%.

Destroying the market

In 2006, a DGEI workshop on seed finance has concluded that “Public intervention needs to take place in a way that avoids the risk of crowding out the private sector.”

To date, Irish VC markets have been characterized by monopolistic competition with Enterprise Ireland (EI) capturing a lions’ share of total investment and private VC firms acting as a competitive minority fringe. Thus, even at the times of plenty the Irish market can hardly be described as that with sufficient demand/supply clearance. In other words, during the time of the robust entrepreneurial activity, Irish start-ups have shown only minor ability to attract private VC capital. Of course, the presence of a state lender with soft budget constraints (EI) helped to undermine domestic VC services.

This structure of the market has hardly changed to warrant a new intervention by the Irish Government. Indeed, if capitalized as planned, the new plan will deliver a re-enforcement of the already unhealthy degree of state monopoly power over the VC market in this country. In the end, there is very little difference between the Irish Department of Finance boffins picking the ‘winning’ start-ups or appointing three US VC funds to do this for them. After all, the rules of the game are fixed (remember those IT and green-tech ideals?) and the losers are known in advance (Ireland’s taxpayers and entrepreneurs).

It would have been simply better for the Government to drop the CGT to match the 12.5% corporate tax. At least this would have assured that private gains yield returns to the Exchequer, without socializing private losses.
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