Capitalizing Trouble

Envious of California’s high-tech economy, state officials are about to force Michigan taxpayers to effectively insure wealthy investors against losses through a state-backed venture capital “program.” The program is meant to foster economic development, but it is highly unlikely to do so and should be abandoned. It risks major failures in a glutted market that could expose taxpayers to significant losses.

“Venture capital” describes the highly specialized financing provided to new start-up companies, often technology-based. A venture capital fund is a pooled investment vehicle (often a partnership) that primarily invests the financial capital of other private investors in enterprises that are typically too risky for average equity investors or bank loans. Typically, a group of three to five general partners will manage a venture capital fund and through skill, luck or a combination of both, earn a profit for its investors.

Michigan state government entered the venture capital scene in 2003 with Public Act 296, which allowed the creation of a state-sponsored venture capital program referred to as the “Venture Michigan Fund.” This new program is commonly known as a “fund of funds,” because the VMF invests in other venture capital funds that will then make investments in individual companies. The fund’s goal is to create a $150 million pool of money for investing in (primarily) Michigan-based start-up companies that venture capital firms believe can succeed dramatically, thus creating jobs and wealth for the state.

The board that oversees the VMF is comprised of four appointees of the governor and the Legislature; two state employees; and a nominee of the Michigan Venture Capital Association, which is an industry advocacy group. The board is expected to hire a “fund manager” soon to raise money for the VMF and decide which private venture capital funds will receive VMF dollars. To entice investors, the VMF board has mulled a guarantee of profit on its risky investments by offering single business tax credits to investors for the amount the VMF falls short of a guaranteed rate of return of around 6 percent.

There are five primary reasons this venture capital program is bad policy.

1. There is currently a huge surplus of private funding available to qualified venture capital firms; no state assistance is required. In a recent New York Times article entitled “Venture Firms Say Billions Were Raised in the 3rd Quarter,” the Times states that leading venture capitalists have expressed concerns that the huge influx of monies will tempt venture capitalists “to finance start-ups with dubious business prospects simply because the money is there.”

Mark Heesen, president of the National Venture Capital Association, told the Times that the industry is in danger of taking on more money than it can successfully invest, jeopardizing returns. Steven Dow, a general partner of Sevin Rosen Funds, put it more bluntly, saying that the increase in venture capital monies raised “is horrible news. I think it’s going to be very hard for the industry as a whole to make good returns.” He added, “At the macro level it’s obvious to everyone that there’s too much money in this asset class, but at the micro level of course every firm thinks it’s different.”

The state apparently thinks it’s different, too, but it’s almost certainly in over its head. In the United States, there is more than $257 billion in venture capital under management. This pool of risk capital is the envy of the world, but it is not for the faint of heart.

Remember that from 1999 to 2001, there was a spectacular run-up in the share prices of all technology companies, followed by an equally massive correction in the financial markets. Many industry experts believe that the major vestige of this stock market bubble, aside from workers’ depressing 401(k) statements, is the massive oversupply of venture capital nationwide. It is ironic that Michigan bureaucrats now want to “invest” in this sector and backstop potential investor losses with taxpayer money.

2. America’s capital markets are the largest and most efficient in the world. To suggest that Michigan needs a government-backed fund is to somehow argue that capital markets are broken in the state or that venture capital logic does not apply here.

But does anyone seriously believe that an Illinois-based investor will forgo a great investment opportunity simply because it is in Michigan? Fundamentally, state officials just don’t like the answer that the capital markets are giving them: The state’s business climate — driven by high taxes, stifling regulations and government overspending — discourages new business growth.

The state’s problem in this area is widely recognized. For instance, the Washington, D.C.-based Tax Foundation recently released its business tax climate index of the 50 states. Michigan finished 36th. If officials really want to improve the flow of venture capital to Michigan, they should work on eliminating the single business tax (for starters). Capital will come to Michigan if it is welcome.

3. The state may try through this program to do what a private investor would not do: guarantee a substantial profit on a risky venture capital investment. Yet every economic decision made by investors would be affected by the fact that they are ensured of an acceptable rate of return. The classic “moral hazard” caused by public guarantees will increase the likelihood of failure by inducing investors to take risks that they would otherwise avoid.

Many traditional businesses make investments and bear all the costs of making poor decisions. Why should the state subsidize a small fraction of investors and compensate them for their poor investment decisions? In fact, Michigan will be on the hook for up to $150 million in revenue losses. This money would have to be recovered somewhere, risking tax hikes on all businesses to cover the losses of a few, high-risk investments.

4. The track record of state programs to assist start-up technology firms in Michigan is questionable. For instance, in 1989, State Treasurer Robert Bowman expressed disappointment in a similar state venture capital program that had lost almost 10 percent of state pension funds invested in it since the fund’s inception in 1982. The Saginaw News reported on Sept. 11, 1989 that Mr. Bowman was forced to reposition the fund to avoid “the economic development aspect[s] of its venture capital investments, even though it originally hoped to give Michigan entrepreneurs a boost.”

5. The VMF program politicizes the entrepreneurial economy. Despite the state’s best efforts to limit conflicts of interest, the program risks corruption. For example, the VMF board will include several members who could benefit from the new fund’s choices.

To its credit, the state Legislature has inserted “conflict of interest” language in the law prohibiting a director from participating in any VMF transaction in which he or a close relative has a financial interest. This does not mean, however, that the transaction won’t still take place, with a fund manager investing VMF fund monies in venture capital funds in which the board members have a pecuniary interest.

It is perilous to give such investment authority to a fund manager whose employment depends on a board that would stand to benefit from the manager’s investment choices. Such relationships can result in investments made to please superiors or to help colleagues, rather than to support economically superior venture capital firms.

The VMF is an example of central planners trying to dress up their edicts as market- and business-friendly programs. Unfortunately, this distracts state officials from the pressing need to improve Michigan’s business climate — meaning that when the huge pool of American venture capital looks at Michigan, it sees more state programs, rather than real opportunities.

Michael D. LaFaive and Laura J. Davis are, respectively, director of fiscal policy and research assistant at the Mackinac Center for Public Policy, a research and educational institute headquartered in Midland, Mich. Permission to reprint in whole or in part is hereby granted, provided that the authors and the Center are properly cited.