1. Presentation Nordic European Public
Investor Workshop
November 23, 2011
23
The case for Public VC
Investment and its problems
Per Strömberg,
g,
SIFR,
Stockholm School of Economics
www.sifr.org

2. Why is it so difficult to get enough early-
early
stage financing?
• Financing frictions / agency problems
– Because of agency and informational asymmetries,
p
difficult for an external financier to be compensated
• Externalities of entrepreneurship and innovation
p p
– Benefits from entrepreneurial firms to the economy
are larger than the monetary returns to investors
g y
– E.g. R&D, spillovers
2

3. The
Th savior: th VC market?
i the k t?
• VCs overcome agency problems by providing expertise
together with capital
– Sophisticated screening monitoring and contracting
screening, monitoring,
• Kaplan & Strömberg (2001, 2003, 2004)
– Operational and strategic value-added
value added
• Hellmann & Puri (2002)
• Does it work?
– Good for companies?
– Good for investors?
3

4. Ample evidence that VC
investment creates value f
i t t t l for
companies
p
• VC-backed companies add value to companies through strategy
development, professionalization, HR
– Hellmann & Puri (2002), Kaplan & Strömberg (2004)
• VC-backed companies grow faster and take products faster to
market compared to similar non-VC-backed startups
non VC backed
– Hellmann & Puri (2000)
• VC-backed firms innovate more
– Kortum & Lerner (2000), Mollica & Zingales (2007)
• VC value-added increases likelihood of firms going public
– Sorensen (2007)
– Majority of “real” IPOs are VC-backed (Kaplan, Sensoy,
Strömberg, 2009)
4

5. What about investor returns?
• The market for early-stage venture capital is by and
early stage
large considered to be in a crisis
• Returns disappointing post-bubble
• Fundraising down
• Especially in Europe, but similar discussion in the
U.S.
• In 2000, close to 100 private independent VC funds
, p p
active in Sweden
• In 2011, two are left…
5

6. VC fundraising (U.S.) as % of
market
Source: Private Equity Analyst

7. IRR, Venture, Preqin
, , q
70,0%
70 0%
60,0%
50,0%
50 0%
40,0%
30,0%
30 0% Median
4th quartile
20,0% 1st quartile
10,0%
10 0%
0,0%
198
198
198
198
198
198
198
198
198
198
199
199
199
199
199
199
199
199
199
199
200
200
200
200
200
200
200
200
200
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
06
07
08
-10,0%
10 0%
-20,0%
Vintage Year
• Source: Preqin, author calculations. 1055 funds.

8. From Jenkinson (2009)
8

9. Why is not early-stage VC
y s o ea y s age C
delivering returns?
• Suffered from huge inflow of inexperienced capital during
internet boom
– Kaplan, Martel, & Strömberg (2007)
• Longer-term structural problems:
– Mismatch between fund horizon and firm gestation
period
– Mismatch between economically viable fund sizes and
efficient i
ffi i t investment amounts i start-ups
t t t in t t
9

10. Pre VC
Pre-VC financing crucial for VC
model
• VC investment horizon to short to build company from start-up to
IPO
– VC outperformance concentrated in periods with hot IPO
markets – can take companies public quickly
– Especially in investment-intensive industries like life-science,
cleantech
• Hard to put enough money at work in seed investment
– Bad effort-return trade-off for both GPs and LPs
effort return trade off
– Exacerbated by increasing economies of scale in asset
management industry
• VC investment requires reasonably developed idea
– Bhid (2000)
Bhide
– Kaplan, Sensoy, & Strömberg (2009)
10

11. A case for government intervention
to solve pre-VC financing gap
1. Indirectly through subsidies and tax policy
– Best way to finance a new venture is with founder’s own money
• Encourage private savings and investment e g lower capital gains tax
investment, e.g.
• Incentive compatible subsidies!
– Also important for angels and FFF
2. Indirectly through government Fund-of-Fund initiatives
– Improving the economics of independent early stage funds
early-stage
– New source of capital as large pension funds leave VC market
• Again, importance of incentive compatible subsidies
g p p
• Brander, Du, Hellmann (2010): these methods seem to work
– Government involvement correlated with venture success
11

12. A case for government intervention
to solve pre-VC financing gap
3. Direct-investing
3 Direct investing government VC funds
– Arguably an important part of the mix
– But hard to get right
• Lerner (2010) “Boulevard of broken dreams”
• Brander, Du, and Hellmann (2010)
– Led to a lot of skepticism towards government VC
initiatives
• Problem:
– Many Government VC models try to replicate private
VC without sufficiently accounting for institutional
constraints (and advantages)
12

13. How can we get the G C
o ca e ge e GVC-
model to work better?
• The importance of investment focus
– For private VC-funds, industry and geography-focus
seems correlated with success
l t d ith
• Specialized industry knowledge necessary for value-add
• Limited geography needed to be close to companies
– For GVCs, it seems to be the opposite
• Performance of International GVCs > National GVCs >
Regional / Local GVCs (Brander et al 2010)
• Similarly, governments ability to pick winning industries
notoriously b d (L
t i l bad (Lerner, 2010)
– Why?
• Too much money chasing too few deals
• Value-added expertise harder to build and retain
13

14. How can we get the G C
o ca e ge e GVC-
model to work better?
• Be realistic regarding ability to build value-added
expertise
p
– GVCs will never be able to compete with private
market in incentives and compensation levels
– Building in-house expertise is possible, but will have
to use it in a more efficient / less labor-intensive way
private VC
i t VCs
• Focus on in pre-investment screening rather than
extensive post-investment support
–I t d t
Instead: team up with t value-added private
ith top l dd d i t
investors
14

15. How can we get the GVC-
model to work better?
• How to impose investment discipline in a GVC structure
p p
– Deep pockets and long-term horizon can be a curse
• Especially hard for re-investment decisions
– Throwing good money after bad
– Or: excessive risk-aversion
• H i li it d f d and substantial personal fi
Having limited funds d b t ti l l financial stake is
i l t k i
key for investment discipline in private VCs
– How can we recreate investment discipline without
financial incentives?
• Investment mandates that avoid reinvestment decisions
– Limitations on participation in future rounds or syndication
requirements
• Culture that encourages collective responsibility for investment
decisions
15

16. How can we get the G C
o ca e ge e GVC-
model to work better?
• Manage political risks
– Crucial for maintaining long-term horizon in a short-
long term short
term political environment
– Can politicians accept:
p p
• Entrepreneurs and co-investors getting rich?
• GVC not investing when they do not see opportunities?
• Decent compensation to successful investment
professionals?
• Below-market returns?
Below market
16

17. Do we need that the government
makes money on early-stage
k l t
initiatives?
• Conflict of goals in government-sponsored VC
initiatives:
– ”Sh ld i
”Should invest t promote l
t to t local start-up activity”
l t t ti it ”
– ”Should get at least a risk-adjusted market return”
• If these investments would make a sufficient risk-
adjusted return, we would not need th government t
dj t d t ld t d the t to
promote it!
– I e if the government needs to intervene we should
I.e. intervene,
not expect a market return on investment
• But: strong need measure social benefits and
17
externalities of early-stage financing!

18. Thank
Th k you!
!
• Homepage: www.sifr.org
• E mail: per stromberg@sifr org
E-mail: per.stromberg@sifr.org