Firms’ responses to private- and government-sponsored Venture Capital
This report analyses actual outcomes of government and private venture capital investments (venture capital, VC) and effects on employment, turnover and investments in real capital in portfolio companies in Sweden. It also examines whether the effects differ between government and private VC.
The Swedish government has been an active player on the venture capital (VC) market since the early 1970s and its influence has been steadily increasing. Given the increased participation of governmental VC (GVC) funds in the VC market, one might presume that they have an excellent record of accomplishment and that there is a well-identified market failure for these actors to fill. Is that really the case? In this report, we discuss the function of the VC market along with the arguments both for and against GVC interventions. We also highlight the Swedish GVC experience and the Swedish GVC policy discussion.
Two conclusions can be drawn from the current Swedish debate. First, we do not really know to what extent there is a private market funding gap that motivates GVC interventions. Second, despite the long existence of GVC interventions, little is known about their real effects and performance. The focus of this report is to shed light on the performance and the effects of Swedish private and public venture capital (PVC and GVC).
One important motive for state intervention in the VC market is that the market solution is likely to generate an undersupply of financial capital. This funding gap is expected to be most severe for young innovative ventures with little (if any) cash flow and/or no collateral to pledge for credit (Lerner, 2002). The funding gap is partly a consequence of an entrepreneur’s unwillingness to fully disclose her strategy, innovation technology, and business operations. From the investors’ point of view, the difficulty in gathering information constitutes a significant hurdle in the form of a transaction cost. This causes market mechanisms to malfunction, leading to problems of adverse selection and moral hazard (Lerner, 2002; Akerlof, 1970).
Although VC firms are especially well equipped to resolve the principal-agent problem, there are reasons to believe that the market solution falls short in supplying capital. In addition to the problem of asymmetric information, private VC firms prefer relatively large investments and view investments in the earliest stages as too risky, essentially ignoring struggling new ventures. This leaves room for GVC interventions targeting firms in the early start-up phase. It has also been argued that GVC can catalyze the development of a VC market and start-up ecosystem. Despite the potential benefits of GVC interventions, a series of arguments can be raised against GVC involvement. One major allegation is that GVC can crowd out PVC investments; another is that because of GVC investors’ political nature, they lack the incentives or ability to operate businesses efficiently.
In tandem with an increased presence of GVC in many countries, our knowledge of GVC’s relative performance as compared to PVC has increased and resulted in a number of stylized facts that help to navigate in the difficult and sometimes contradictory theoretical landscape.
One lesson learned from previous empirical literature is that on average, GVC-funded firms tend to develop less strongly compared to firms funded by either PVC or mixed financing (both GVC and PVC). Because GVC should theoretically make investments that are less profitable than PVC investments, this is to be expected and may not be sufficient to conclude that GVC is not doing its job.
Turning to Sweden, after a slow start in the 1970s, the Swedish GVC market expanded considerably in the 1980s because of the creation of six regional GVC funds. These funds were scrutinized by the Parliamentary Audit Office (Riksdagens revisorer, 1996), which considered most of the early GVC investments to be failures and argued that the GVC funds lacked both knowledge and the appropriate skills either to counsel boards or to guide managers. The GVC funds are further criticized for being an instrument for employment policy.
More recently, the Swedish discussion has addressed how GVCs funds should invest, not what they have achieved. This discussion was triggered by Svensson (2011), who surveyed the Swedish GVC market. His primary recommendations were that GVC funds should focus on early-stage financing and fund-of-funds solutions in which they cooperate with private investors and take advantage of their competence. Since Svensson (2011), follow-up studies performed by the National Audit Office (Riksrevisionen, 2014) and a government-commissioned inquiry (SOU 2015:64) have made similar recommendations. However, as noted by the public small business loans program, Almi Företagspartner (2015), there can be a conflict between GVC’s focus on high-risk seed financing (which lacks private actors) and co-investments between PVC and GVC investors. Following parliament’s approval of the government’s formal proposal (Prop. 2015/16:110) in June 2016, a major reorganization of Swedish GVC is underway. These reforms have taken some of the previous studies’ recommendations to heart, including the creation of a fund-of-funds structure.
Instead of adding to the discussion of what GVC funds should do, this report looks in the rear-view mirror to determine what GVC funds have achieved so that any future policy initiative to restructure the GVC market will be well informed of the merits and limitations of GVC as a policy instrument.
The results from this study can be summarized in four points:
- The results from this study suggest that both private and public VC investments boost sales two to three years after the investment. These increased sales are largely driven by increased efficiency and investments in physical capital, while there is no evidence of any employment effects.
- The real impact of governmental and private VC on firm growth is similar, though private VC tends to have larger growth effects.
- We find evidence suggesting that Swedish GVC funds are more likely than private investors both to hold on to and continue to invest in stagnating, non-growing firms.
- There are no signs that GVC investors are more focused on seed financing and start-up financing than private investors.
¹In addition, GVC injections can be motivated by the fact that innovation’s social returns are larger than its private returns.