Dialogue: Fat cats will feed at the state teat

By ASHLEY BALLS*

The announcement of a $100 million venture capital initiative in the Budget is welcome, but the reaction from the business community and media commentators shows how little is understood about the topic.

The response from chambers of commerce, industry organisations, trade unions and the media was one of measured approval, whereas the Government could have achieved the same result for no cost.

If usual pre-Budget procedure has been followed, the Finance Minister presumably instructed his officials to develop a mechanism for injecting $100 million of venture capital into the market. The result is a farce and a strong indicator that there was little research or that officials were only obeying orders.

It is a safe bet that we are going to end up with private-sector financial institutions feeding at the state teat for fat commissions and fees when they have been hitherto unwilling to enter the risk capital market. If first principles had been applied, a study of the dynamics of venture capital markets would have been undertaken. This would have revealed that, at a best guess, the domestic venture capital market generates about $100 million each year, much of it from business "angels."

At the other extreme, a study of the United States market would have revealed that, despite the dotcom boom and bust, the venture capital market is larger than ever and at present injecting more than $US24 billion ($56.57 billion) into the economy each quarter. The US Government's contribution is zero and always has been.

Finland, Ireland, Israel and Britain are frequently touted as having produced good results. Israel is the odd one out, as much of its new, high-tech business has grown as a result of its defence industry's seeking cheaper armaments.

The others share one dominant feature with the US, in that the creation of venture capital has been driven by the tax system.

Venture capital investing is high-risk, and a good proportion of ventures go to the wall. If private citizens are to be encouraged to invest in this arena through managed funds or some other hybrid entity they will be seeking adequate returns.

Herein lies a conundrum - venture capital investors get no security, so what can the investment offer them?

In other countries, tax incentives provide the answer.

Unless and until the mandarins in Wellington accept that tax incentives and subsidies are not the same thing, Michael Cullen's initiative may be stillborn. If you want investors to put their money at risk - and a 30 per cent failure rate is high risk - they will want something in return.

So far, New Zealand fund managers have had a hard enough battle persuading investors to opt for comparatively safe investments, and it is widely acknowledged that the savings rate is an international embarrassment.

So what is going to change? Are fund managers suddenly going to produce products that have a high return and low risk, and if so, why haven't they done it before? If taxpayers' money is simply going to be a prop for an investment industry that has performed poorly for years, the result is a foregone conclusion.

So what have other countries done? In the more successful ones (US and Britain), venture capital investing has remained high-risk, but making some classes of investment tax-free mitigates this.

In Britain, venture capital trusts work well at seeking investor funds and placing them in a specified range of businesses.

The investor can place taxable capital gains into these funds tax-free, and the funds themselves do not attract corporation tax. The result has been billions of pounds entering the investment market and thousands of new jobs created.

Venture capital investments still fail but the returns on venture capital trust investing remain high and usually outperform the main stock exchange index.

Ireland and Finland operate their own systems, also offering tax "protection" for investors, with positive results for all concerned.

The argument that the result is a loss of tax revenue is wrong. The reverse is true, as new revenue streams from sales, income and corporation taxes outweigh "lost" revenue by a large margin.

The Budget proposal is fraught with problems. The typical venture capital investor organisation takes a shareholding in the client company of anything from 30 per cent to more than 50 per cent, as well as charging a fee on the sum invested. After three to five years these investments are realised by way of management buy-out, trade sale, IPO (initial public offering) or similar mechanism.

If the Government is to be in partnership with venture capital firms, there is a recipe for disaster in the form of political interference, joint ownership and worse. Let's hope Dr Cullen gets better advice than he has had so far and stops trying to reinvent the wheel. Tax incentives can keep out the cowboys and deliver new jobs and more revenue.

* Ashley Balls is an international management consultant and writer on business and economic affairs.