Do the Times Warrant A Rethink of State VC Policies?

Earlier this month, Kansas passed legislation to encourage $40 million in private equity investment. Alabama passed a $100 million bill for CAPCOs. Similar legislation aimed to increase the amount of venture capital available locally has passed at least one chamber in the South Carolina and Ohio state legislatures. Pennsylvania pension funds, after taking a bath in the dot.com crash and current recession are increasing the percentage of their portfolios placed in venture capital.

States and localities across the country, seeing the quarterly surveys report the continuing decline in venture capital deals (such as the Moneytree survey reported in last week's Digest), are moving to encourage more VC investment. The theory is by increasing the supply of venture capital available, more deals will be made and economic growth will follow.

But is it good public policy?

Not in the current market, suggests Harvard Professor Joshua Lerner in his recent working paper, Short Term America Revisited? Boom and Bust in the Venture Capital Industry and the Impact on Innovation. Lerner contends that increased public capital investments in times of excess venture capital availability — that which the market has demonstrated over the past two years — may actually add "fuel to the fire," particularly in hot sectors.

After presenting a very accessible economics primer on the cyclical nature of VC, Lerner explains possible reasons for the market's current behavior. Plenty of venture capital exists, Lerner argues, but it is not being invested because the anticipated or projected return is lower than investors desire (due to the recession, dot.com crash, hostile IPO market, etc.). As a result, VC firms can afford to be more selective in their placements.

Increasing capital availability, through CAPCO legislation, relaxed restrictions on public pension fund placement, investment tax credits and other programs, actually permits VC companies to be even more selective, the model suggests. The problem is exacerbated by targeting public policies toward "hot industrial sectors," such as biotech and information and communications technologies.

Given the current VC market, Lerner suggests more appropriate — and productive — public policies are to focus on the

following:

• investments on "out-of-favor" sectors and niches, possibly using SBIR and the CIA's In-Q-Tel as models;
• on boosting the quality of the demand for VC funds (entrepreneurship activities, programs and policies);
• on easing access to and transfer of early-stage federally funded research within universities and laboratories; and
• making entrepreneurship more attractive through tax policies (lower tax rates on capital gains relative to those on
  
  ordinary income).

"[T]he most effective programs and policies seem to be those which lay the foundations for effective private investment...Given the extraordinary rate of growth (and now retrenchment) experienced by venture capital over the past decade, the most effective policies are likely those that focus on increasing the efficiency of private markets over the long term, rather than providing a short-term funding boost during the current period of transition."

Short Term America Revisited? was presented at the "Innovation Policy and the Economy" conference of the National Bureau of Economic Research. Lerner's presentation and a PDF version of the working paper is available at:

http://www.nber.org/~confer/2002/ipes02/ipeprg.html