Promoting Start-up Financing: Global Context
(Published in the Financial Express in 2018)
Dr. Shah Md Ahsan Habib
Before World War II, Venture capital was more of a rich man’s whim than an industry. The US Venture capitalists pioneered the venture capital business immediately after World War II, roughly three decades before venture capital grew to a significant size in any other country. In 1957, the Federal Reserve System conducted a study that concluded that a shortage of entrepreneurial financing was a chief obstacle to the development of what it called ‘entrepreneurial businesses’. To correct this, the Small Business Investment Act in 1958 was passed to establish Small Business Investment Companies (SBICs) as vehicles for small business financing. SBICs are private corporations licensed by the Small Business Administration (SBA) to provide venture capital to new companies. The purpose of SBIC Act was to establish government-controlled venture capital funds for developing new and early stage business. Venture capital did not become a significant source of financing in Europe until the 1980s. As a consequence of the number of initiatives taken by the Commission of the Communities, in 1983, the European Venture Capital Association (EVCA) was set up to provide a professional organization to the European investor. Asia-pacific region is another key region that is pushing venture rapidly. Of the neighboring countries, venture Capital has been a new type of financing for the past three decades in India; they have been contributing to the development of economy by financing the entrepreneurial capital requirements. A comparison of various sources of venture capital investments in US, Europe and Asia reveals that the pension funds is the major source of investment in venture capital in USA whereas in Europe the banks play a major role as a source of venture capital investments. However in Asia Pacific the corporate investors are the leading sources of the venture capital investments followed by banks and insurance companies.
International financial institutions have played notable role in market development in several developing countries. Despite these constraints, the World Bank supported the venture capital project, noting that ‘the guidelines reflect a cautious approach designed to maximize the likelihood of venture capital financing for technology-innovation ventures during the initial period of experimentation and thereby demonstrate the viability of venture capital in several countries. International Finance Corporation (IFC), a member of the World Bank Group, is the largest multilateral source of equity and loan financing for private sector projects in developing countries. For the past two decades, IFC has promoted venture capital funds in developing economies in an effort to improve small and medium size firms’ access to equity finance and management expertise. IFC has undertaken activities ranging from advising governments, to structuring, investing in, underwriting, and placing funds, to identifying fund managers. IFC invested more than USD 1 billion in venture capital upto 2017. The financial results from these investments have been mixed. Initially, venture capital industry was young even in many industrial countries and entirely new concept in emerging market economies. The underdeveloped stock market in most countries made it difficult for funds to sell their investments. As the venture industry has gained acceptance and expanded, it has become increasingly clear that venture capital funds are effective way for IFC to invest in a large number of firms too small for it to invest in directly. In a relatively recent initiative, The World Bank and IFC, in partnership with the Emerging Markets Private Equity Association (EMPEA), have launched a community of practice to share knowledge and collaborate on issues around private equity and venture capital development. This partnership between EMPEA and the World Bank Group is engaged in providing a seamless space for knowledge sharing and collaboration among all stakeholders in the industry, and is contributing to World Bank’s common goal of broadening access to equity finance for SMEs in emerging markets and developing countries from start-up to growth.
Investors in venture funds are largely institutional, high net worth individuals and corporates. These investors while entrusting their funds to the fund managers seeks commitment from such fund manager by way skin in the game. Such arrangement leads to conflict as the fund manager is an investor as well as a manager. Therefore, a framework is required to address such conflicts. The G30 Report recommends that ‘Managers of private pools of capital that employ substantial borrowed funds should be required to register with an appropriate national regulator. The regulator of such managers should have authority to require periodic regulatory reports and public disclosures of appropriate information regarding the size, investment style, borrowing, and performance of the funds under management’. The G‐ 30 recommendations also deal with the―moral hazard issue identified by the Financial Stability Forum (now known as Financial Stability Board) in 2000 by stating that―Since introduction of even a modest system of registration and regulation can create a false impression of lower investment risk, disclosure, and suitability standards will have to be reevaluated. The G ‐ 30 also considers that for funds above a size judged to be potentially systemically significant; the regulator should have authority to establish appropriate standards for capital, liquidity, and risk management.
In country context, venture capitalists and their private equity firms are regulated by the US Securities and Exchange Commission (SEC). Venture capital is subject to the same basic regulations as other forms of private securities investments. In USA, as per Dodd-Frank Rules, since venture capital is a type of private equity investment, the laws and regulations that affect private equity also apply to many aspects of venture capital investment. Historically, private equity investments were lightly regulated. The Dodd-Frank Wall Street Reform and Consumer Protection Act, passed in 2010, and it introduced several new requirements for investment banks, fund managers, and others in the financial industry. One important aspect of Dodd-Frank is a provision called the Volcker Rule. The Volcker Rule prohibits banks from using their own money—as opposed to money on deposit from customers—to make certain investments, including private equity. This means that generally banks cannot serve as VC firms.After Dodd-Frank, hedge fund managers and private equity fund managers were required to register with the Securities and Exchange Commission. Following the global financial crisis, the EU came up with Alternative Investment Fund Manager Directive (AIFMD) which is an EU law on the financial regulation of hedge funds, private equity, real estate funds, and other Alternative Investment Fund Managers (AIFMs) in the European Union. The Directive requires all covered AIFMs to obtain authorization, and make various disclosures as a condition of operation. Regulatory compliance became probably the most critical challenge following the most recent global economic and financial crisis.
In regard to the market, Global venture investment reached record high. United States, Europe, Israel, Canada, China and India have the most developed markets for venture capital environment. However, there are evidences of the decline in the number of completed deals at the earlier stages: angel / seed. The reason of this decline is that as the VC investment has grown more sophisticated, the early-stage became too pricey for many. Investors globally remain focused on late-stage companies with proven technologies and markets, paying relatively high prices to reduce their risk of failure. It became more challenging for early-stage companies to get the VC community’s attention and funding.
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