01/17/2013 05:08 EST | Updated 03/19/2013 05:12 EDT

What Problem Is Harper's Venture Capital Plan Trying to Solve?

Venture Capital Action Plan: Is it a Solution and if so to What Problem?

Lindsay Tedds and Peter Hunnisett

Lindsay Tedds is an Assistant Professor of economics in the School of Public Administration at the University of Victoria. You can follow her on twitter @LindsayTedds. Peter Hunnisett holds a Master of Business Administration in Entrepreneurship and is a business broker. You can follow him on twitter @ViBizBroker.

On January 14, 2012 the Government of Canada finally made some details available about its venture capital measures first announced in the 2012 Budget Plan. These measures form a package of both indirect and direct investment in the venture capital industry. The proposal, called the Venture Capital Action Plan, commits to investing $350 million to two "fund of funds" (one partnered with the private sector and one partnered with willing provinces) and $50 million in three to five existing Canadian venture capital funds over the next seven to 10 years.

It is not clear what the overall intent of these measures is. Is the intent to help build Canada's lack luster venture capital market in an effort to encourage economic growth through innovation over the long term? Or is it to simply spur Canadian economic growth through innovation in the short-term by investing in venture funds that invest in high potential companies? Either way, how these proposals will do either has certainly come under a great deal of criticism. To understand the criticisms, we need to understand the proposal and the venture capital market.

A venture capital fund invests directly in high potential growth companies, a situation that involves a great deal of financial risk. A "fund of funds" invests indirectly in companies by investing instead in venture capital funds. Funds of funds exist because there are investors that either do not have the expertise to directly invest in venture capital or do not want to.

In addition, fund of fund investors benefit from diversification by investing across multiple venture capital funds that invest in multiple industries, have different investment strategies, have different managers, and invest in regions thereby minimizing investment risk and overexposure. The fund of funds approach can be appealing to governments for these very reasons and to avoid accusations of pork barreling that often occur when governments pursue direct investment.

Why do venture capital funds and funds of funds need an injection of investment funds from the Government (or more correctly, taxpayers)? The venture capital industry, not only in Canada but also in the US, has been struggling a great deal of late. As clearly noted by the Kauffman Foundation (a well-known and respected "fund of funds"), venture capital firms have struggled to recapture much of their original cash investments and venture capital returns have been very poor since the tech collapse. The consequence is that venture capital funds of all types have struggled to raise new capital for new investment, as investors have found higher returns with much lower risk elsewhere, including the public market.

The measures under the VCAP do not address the problems with low returns. Without addressing the problems associated with low returns (driven by poor management, poor decisions, lack of opportunity, and lack of well-designed, well-timed, and well-executed exit strategies), there is no reason to expect the measures under the VCAP to serve a "flypaper" effect, attracting private sector investors to the funds or fund of funds, which could possible help grow the venture capital industry.

In fact, returns in funds of funds are lower than those obtained directly by the venture capital funds themselves since you now have costs associated with two layers of overhead (one at the fund of funds and one at the fund being invested in) that have to be paid before seeing any returns. To be blunt, in the best case, 10 years from now we have invested in a bunch of hopefully successful Canadian businesses and got some economic growth for our buck, but the venture capital industry has been offered no incentives to address their underlying problems, problems fully acknowledged by the Government of Canada's Venture Capital Action Plan, leaving us in the same state we are right now.

Of course, assuming we can obtain some new economic growth opportunities out of the VCAP, is also just that, an assumption. As indicated above, one reason for the lack of returns is the lack of opportunity. That is, there is a lack of Canadian companies that meet venture capital investment criteria and a lack of Canadian venture capital funds seeking government directed investment funds. If we lack credible opportunities, throwing more money at the industry will make no difference. In fact, the industry and the Government of Canada have not proven that there are Canadian companies out there that are both worth investing in and who, without the VCAP, would not otherwise obtain venture capital and venture capital funds seeking the type of tied investment the Government of Canada is outlining. Looking at the profile of the B.C. Renaissance Capital Fund, a fund of funds capitalized by the B.C. Government, suggests these may be real issues, with less than $24 million of the available $82 million placed with fund managers. And if there are these opportunities, how does the VCAP improve the matching mechanism?

The Government of Canada's Venture Capital Action Plan does nothing to overcome the multifaceted problems that exist in the Canadian venture capital market and which the government itself fully acknowledges exist. VCAP does nothing more than put our tax dollars at risk, a risk that the private sector investors are unwilling to take as they continue to flee the market, with no guarantee that the benefits outweigh the costs. Our efforts would be better served to directly address these well-known problems in the venture capital market to ensure long-term investment potential in high potential Canadian companies in an effort to encourage Canadian economic growth.