Published for Private Capital Magazine – Spring 2012
Why only a bold government move can boost the country’s short supply of VC financing
Canada is among the most generous countries in the world in its financial support of research and development for its emerging technology companies. Its support for business R&D as a percentage of GDP is the second highest of any OECD country and ahead of that of the U.S. It is not surprising that Canada’s emerging technology companies are a fertile source of some of the world’s richest R&D.
In stark contrast, the VC financing that is essential for commercializing that R&D remains in severely short supply. While fundraising by Canadian VC firms picked up ever so slightly in 2011, companies still invested significantly more than they raised. This continuing gap is unsustainable and highly predictive of inadequate future VC investing. As a result, much of that R&D (not to mention the billions in government money that fund it) is going to waste and will never produce Canadian products, jobs and exports.
In the absence of VC financing to convert that R&D into economic value, the Canadian government’s generous support for R&D is akin to a vast program for creating advanced aircraft when there is no fuel to fly them. These government R&D expenditures have effectively become a subsidy to U.S. businesses that acquire the most promising of these capital-starved but R&D-rich Canadian companies cheaply, then reap the financial rewards by commercializing that R&D and bringing those companies to industry leadership.
The Canadian government must act as a catalyst to intervene on a one-time basis in a bold and fiscally-responsible way to jump-start a self-sustaining, market-driven, independent private VC industry by creating a fund of funds program that possesses the financial strength, top-tier investment management and global connectedness to successfully commercialize the R&D of its emerging technology companies.
This newly created fund of funds, in turn, would proactively organize 10 new VC firms and select the most highly qualified Canadian GP managers for each through a rigorous national RFP process. Each of these 10 new VC firms would be capitalized with a total of $200 million. Of this $200 million, the Canadian government as an LP would contribute $80 million (40 per cent), conditioned on each VC firm’s raising an additional $120 million (60 per cent) from foreign and Canadian LPs. These VC firms would also be required to recruit top tier (top-quartile/-decile) performing U.S. or other foreign GPs to partner with their Canadian GPs. The result would be 10 new VC firms with a total of $2 billon under management in an innovative partnership of the public and private sectors.
Foreign LPs would be motivated to invest in these 10 new VC firms due to those foreign LPs’ successful experience in investing in prior VC firms managed by these same participating top-tier foreign GPs. In short, these top-tier foreign GPs would bring their loyal LPs with them to Canada. As an added incentive to ensure that result, these LPs would be given the right to buy out the Canadian government’s 40 per cent LP interest in each VC firm within six years, at cost plus interest. Because this buyout right can greatly enhance the LPs’ ROI, it would be a significant additional draw for attracting them to invest in the 10 new VC firms.
This new fund of funds program would position Canada to successfully commercialize the R&D of its most promising emerging technology companies while avoiding the Canadian VC industry’s past mistakes:
1. The top-tier foreign GPs for the 10 new VC firms would be chosen in a rigorous international RFP process to ensure they possess top-quartile (hopefully, decile) prior performance. Studies demonstrate that top-performing GPs show a significant “persistence” in achieving recurring strong performance in future funds and account for virtually all of a VC industry’s positive performance.
2. The top-tier foreign GPs selected would bring with them their “connectedness” to major global customer markets, strategic clusters, pools of international capital and serial entrepreneurs. This connectedness would address a vulnerability of some Canadian VCs and entrepreneurs arising from their lack of immersion in, and experience with, global markets and clusters and the strategic customers and competitors therein. Think of these foreign GPs as “aligners” and “bridges.” They will have the global knowledge and experience to work with their Canadian GP partners to help portfolio companies better align their products with what is needed by the market. They will also be bridges to global markets, strategic clusters and international capital pools, and to the myriad of customer, capital, distribution, marketing, technology and employee opportunities therein.
3. Two hundred million dollars is the right amount of funding for each of the 10 new VC firms. The roughly $100 million, on average, currently under management by Canadian VC firms is a serious handicap for taking emerging technology companies through their growth cycles into industry leadership and an IPO or M&A. In addition to having “deep pockets” to invest large amounts in potential big winners, VC firms in the $200-million range also possess enough funds to attract and retain sufficient staff with a high level of experience and specialized expertise. This financial heft can also relieve the pressure on VCs to sell portfolio companies too early at too low a price. It is not surprising that studies have shown that VC funds with about $200 million under management have the strongest investment performance over time.
4. The new fund of funds program would also avoid the structural flaws of some of the labour-sponsored and government funds in the past. The compensation of the GP investment managers in the 10 new VC firms would be at VC private-industry competitive rates, ensuring these firms’ ability to attract and retain top-performing investment managers. This compensation system heavily rewards achieving IPO and M&A liquidity events that generate ROI, thereby aligning interests of VC investment managers with those of their portfolio companies’ senior management and stockholders. There would be none of the kinds of tax incentives and restrictive investment rules that have distorted investment behaviour of certain labour-sponsored and government VC funds in the past in ways that diminished investment performance.
5. The 10 new VC firms would have some flexibility to co-invest outside of Canada with leading foreign investors to maximize investment opportunities and global connections. This recognition of the imperatives of globalization and interdependence in our contemporary world of borderless capital and customer markets will enhance ROI and lead to these foreign investors co-investing in Canadian companies with the 10 new VC firms.
6. Each of the 10 new VC firms would possess highly specialized domain expertise in a single sector: IT, healthcare or cleantech. This focus on companies in high growth industries will help maximize the new VC firms’ ROI while facilitating creation of clusters.
What distinguishes this proposed fund of funds from others is that it will proactively organize and staff the 10 VC firms in which it invests under a well-planned blueprint. If these 10 new VC firms are implemented as outlined, the result will be significant ROI for participants and large numbers of sustainable Canadian jobs and exports. In addition, it is likely the Canadian government would receive back most, if not all, of the money it invests plus interest. The goal is not for Canada to make money on its LP interest, but to provide strong incentives for investing in and growing Canadian companies.
A further likely result is that Canadian institutional investors would be attracted back to the VC asset class. Without the return of institutional investors, there is no sustainable solution for the Canadian VC industry. Finally, the program’s success would result in a long-term self-sustaining private VC industry in Canada – with huge consequent economic benefits for many years. This is the definition of a fiscally responsible government investment, both on its merits and when weighed against the unacceptably high cost of failing to take action.
While this $800 million in federal money may sound like a lot, in reality the government will be investing annually in relatively more modest amounts – approximately $100 million each year for five years ($500 million total) with the balance of $300 million invested over years six through ten for follow-on rounds. Much of this last $300 million would not be needed if a significant number of the VC firms’ investors exercise the buyout rights, with most of the money already paid out coming back to the government instead.
This program would be a quintuple win: for participating LPs and GPs, Canada’s technology companies, the Canadian government and the future of the Canadian VC industry.
Stephen Hurwitz is a partner at Choate, Hall & Stewart LLP, Boston. His full paper on this subject can be accessed at www.choate.com/media/pnc/0/media.3040.pdf.