State-Sponsored Venture Capital: Are CAPCOs a Solution or a Problem?
Daniel Sandler, Faculty at Law
University of Western Ontario
This article critiques a particular VCF program that has gained some notoriety: certified capital company (CAPCO) programs, which target venture capital investment from insurance companies with a 100 percent premium tax credit for the money they invest in CAPCOs. However, CAPCO programs are, in my view, a waste of limited state resources and, in fact, may do more harm than good in developing a regional venture capital industry.
The US formal venture capital industry is large by any standard. However, it is a mistake to generalize about a "US" venture capital industry because relatively little of the country, in terms of geographic area, benefits from that industry. As a consequence of the limited geographic scope of venture investing and its important impact on building an entrepreneurial culture, particularly in the high tech sector, many US states have adopted programs to increase venture capital investment as a means of creating quality jobs, new wealth, and fostering economic development in the state. The primary programs through which state governments can facilitate formal venture capital investment are:
- government funded and managed venture capital funds (VCFs);
- government investment in private VCFs;
- tax credits for private investment in VCFs.
This article critiques a particular VCF program of the third variety that has gained some notoriety: certified capital company (CAPCO) programs, which target venture capital investment from insurance companies with a 100 percent premium tax credit for the money they invest in CAPCOs. However,
CAPCO programs are, in my view, a waste of limited state resources and, in fact, may do more harm than good in developing a regional venture capital industry.
Louisiana was the first state to adopt a CAPCO program, in 1983. Other states were slow to follow suit, although since 1997 eight other states have introduced similar legislation and many other states (as well as Washington, DC) have been heavily lobbied by a relatively concentrated CAPCO industry. Four major CAPCO groups-Advantage Capital, Enhanced Capital, Stonehenge Capital and Newtek-accounted for approximately 80 percent of the $1.65 billion of the total state tax credits granted between 1986 and 2001 across all US states. These CAPCO groups spend a significant amount of time and money lobbying to maintain existing CAPCO programs and to establish new ones.
All CAPCO programs follow a similar pattern, illustrated in the following example. A CAPCO's promoters invest $500,000 to establish the CAPCO (although, in Louisiana, only $200,000 is required); the CAPCO issues $25 million in secured notes to insurance companies. These notes generate $25 million in premium tax credits to the insurance companies over a 10-year period. These premium tax credits, together with a certain amount of the capital raised by the CAPCO-approximately $10 million in this example-cover the principal and interest obligations of the CAPCO to the insurance companies under the secured notes. A further $1 million covers financing and related costs, leaving approximately $14 million to be invested in qualified small businesses by the CAPCO owners.
All CAPCO programs have "pacing requirements" that the CAPCO must meet. The pacing requirements refer to the time periods in which a specified percentage of the CAPCO's certified capital (the capital benefiting from premium tax credits) must be invested in qualified small business investments in the state; these pacing requirements vary from state to state, although in no case do they require more than 50 percent of the certified capital to be invested in qualified businesses. However, all states require a CAPCO to invest 100 percent of its certified capital (i.e., $25 million in this example) in qualified small businesses in order to voluntarily decertify and make distributions to the CAPCO promoters. Assuming that the CAPCO invests the entire $14 million available in qualified investments, the CAPCO must liquidate some of these investments and reinvest at least $11 million in other qualified investments in order to reach the investment threshold necessary for liquidating distributions. The CAPCO can lose a substantial amount of the $14 million and still be highly lucrative to the promoters in two respects. First, the management fees permitted by legislation-generally 2½ percent of total certified capital-are based on both actively managed venture capital and the capital set aside in US Treasury bonds or other low-risk investments to cover the payments to the insurance company investors. So, in the above example, management fees can be $625,000 per annum (i.e., 2½ percent of $25 million) even though only $14 million is actively invested in qualified venture capital-type investments. Second, the entire venture portfolio of the CAPCO essentially belongs to the equity owners. Even if the CAPCO manager is successful only in maintaining the $14 million originally invested-in fact, even if it loses a significant portion of this investment-the entire amount belongs to the CAPCO promoters.
CAPCO programs have been costly to the states that have introduced them: to date, the aggregate cost to all nine states with CAPCO programs is well over $1.5 billion. Whether this cost is justified or not depends on the benefits to the state of the program. Only Louisiana's CAPCO program is old enough to warrant a cost-benefit analysis and the only analysis of that program of which I am aware-a study commissioned by the Louisiana Department of Economic Development in 1999 -suggests a positive cost-benefit analysis only if highly favourable assumptions (in my view, unrealistic assumptions) are made about the success of CAPCO investments.
If the costs of the CAPCO program exceed the benefits, as is likely the case, then the program makes sense only as a limited-term catalyst to create a self-sustaining venture capital industry; however,
the CAPCO program is fatally flawed in this respect. The investors in the program do not put money at risk in venture capital investments. They are secured creditors making a good rate of return on their investment. In the absence of the tax credits and the ability of the CAPCO to fully guarantee their loans, the insurance companies simply would not make similar investments.
Since the CAPCO program will not prompt insurance companies to make true venture capital investments, it can create a self-sustaining venture capital industry only if the CAPCOs (or their investments) attract other venture capitalists, and sources of venture capital, to the state. That may be possible if the investments made by CAPCOs attract a concentrated pool of motivated entrepreneurs in growth businesses to the state who in turn attract private venture capitalists. However, that is unlikely to be the case. The relative ease by which CAPCOs can raise money coupled with the pacing requirements imposed on the CAPCO, has two potential consequences. First, CAPCOs may be willing to invest in portfolio firms that private VCFs have, perhaps for good reason, rejected. Second, CAPCOs may tend to overvalue potential business investments compared to their private VCF counterparts. Expressed another way, if a desirable portfolio business is seeking a particular amount of money, a CAPCO would be willing to take a smaller equity participation than a private VCF for the same cost. In other words, the cost of capital to the small business has been reduced.
The CAPCO tax credit may reduce the cost of capital to SMEs in the same way that tax-free municipal bonds reduce the borrowing costs of US cities. In the municipal bond context, reduced borrowing costs are good for the city because the city is seeking only money, not opinions from lenders on how to spend the money it raises. However, in the venture capital context, portfolio firms, unlike cities, require more than money. They require assistance in developing a strong management team to assist in product development and marketing and in general business administration. Private VCFs tend to be active participants in the development of their portfolio firms. CAPCOs, on the other hand, do not have the same motivation to add value to their portfolio firms.
CAPCOs can be beneficial if they simply increase the pool of venture capital available in the state. However, if through their investment behaviour, they displace private venture capitalists, then they may in fact be detrimental not only to the venture capital industry, but also to the economic development of growth-oriented small businesses and therefore to overall economic growth. I am not aware of any CAPCO study in which this issue has been addressed. However, a study of another type of government-sponsored venture capital investment vehicle used in Canada-labour-sponsored venture capital corporations (LSVCCs)-suggests that LSVCCs do crowd out private VCFs rather than enhance the amount of venture capital available.
CAPCOs are structured differently from LSVCCs, although they share certain key features that likely produce the same crowding out effect.
In particular, both programs require up-front investment by qualified investors in order to obtain a tax credit and then impose pacing
requirements on the CAPCO or LSVCC.
The significant up-front incentive reduces the pressure on the fund manager to invest the capital in qualified investments while the
pacing requirements with accompanying penalties may lead to last-minute, hasty investment decisions.
Under neither program is the fund manager subject to appropriate pressure from the fund's investors to undertake the degree
of due diligence or the extent of monitoring expected in private sector VCFs. In both cases, in fact, there is a distinct
possibility that CAPCOs or LSVCCs crowd out private sector VCFs. The incentives offered under both programs are too rich
and neither program is designed to promote the operation of VCFs in the same manner as in the private sector.
In my view, these programs are a recipe for disaster rather than a catalyst for growth.