129. Samuele Murtinu on How and Why Governments Fail in Venture Capital

Governments would like to take credit for the level of entrepreneurship in their countries. Entrepreneurship leads to value creation (happier voters) and economic growth (more to tax). But, as Per Bylund points out in the Seen, The Unseen And The Unrealized, governments’ actions restrain entrepreneurship.

Dr. Samuele Murtinu joins the Economics For Business podcast to explain both how and why governments fail in their best efforts to help entrepreneurial businesses succeed.

Key Takeaways And Actionable Insights

Europe has an entrepreneurship problem.

European economies exhibit lower growth rates than the US. At the firm level, there are fewer unicorns, and fewer new technology-based firms or innovative startups and innovative ventures in general. Venture capital markets are very thin, and most venture financing is debt, which is (as Sergio Alberich described in Episode #123: Mises.org/E4B_123), a poorer choice for startups and young firms than equity.

Consequently, European countries see a lower level of innovative startup behavior. Existing firms have low levels of R&D spending. And, generally, there is an inability to turn the innovative inputs that are available into innovative outputs — new markets and industries tend not to emerge in Europe first.

And the European mindset tends to favor the idea of the entrepreneurial state — the state is thought to be where good ideas and good initiatives come from.

Governments see launching their own venture capital funds as a new means.

The key idea of the entrepreneurial state is deep involvement in economic affairs, including funding basic research, financing, shaping and directing R&D investments, and thereby creating new markets. The centrally coordinated state is seen as the driving force for the development of innovation and technological progress. For this mindset, government venture capital seems to be an available means. So governments start and implement venture capital funds — the terminology is Public Venture Capital.

These are companies and funds that are fully owned, fully funded (no limited partner structure) and fully managed by government bureaucrats, with the purpose of investing in innovative startups.

Firstly, Governments get the concept wrong at a fundamental level: they have the wrong goals.

Private venture capital funds and even hybrids like sovereign wealth funds have clear goals: rapid, high-level capital appreciation by investing in startups at an early stage and exiting as quickly as possible in a liquidity event such as a commercial sale or an IPO.

Government venture capital may have “social” goals such as encouraging industry sectors, favoring regional technological development, boosting economic growth, and providing jobs. These are vague and unclear, and may contradict individual company business plans (such as automation and minimization of labor costs). With the wrong goals, it’s impossible to succeed.

For example, the selection process for private VCs choosing firms for fund portfolios is rigorously goal-directed and VC firms have honed their candidate identification and due diligence processes in order to maximize their chances of winning from the very first steps in the investment process. Government funds lack this clarity and therefore can’t develop the requisite expertise.

Governments have difficulty letting go of control.

Private VC’s have also honed the role of the contract between them and the firms in which they invest, and with the limited partners who provide the investment capital. The contract with the startup firms is as “hands-off” as possible (see, for example, the SAFE contract — Simple Agreement For Future Equity — available for free download and free use from the Y-Combinator website: YCombinator.com/Documents) and the contract with Limited Partners gives them no role in the management of the fund. Private VC’s understand that high levels of control are not appropriate to the adaptive management of immature firms in rapidly changing environments.

Government bureaucrats directing investments in startups are averse to this kind of hands-off management.

Governments can’t get incentives right, and consequently can’t hire the best executives.

Private VC managers are highly incentivized. In the largest and most successful funds, they receive high salaries and a 20% participation in fund appreciation. The best individuals from the most prestigious business schools are hired to compete with their peers for promotions and partnerships. The most successful funds attract the most capital from the deepest pocketed sources, and the cycle of success rolls on.

Public VCs can’t attract the same quality of human capital. Typically, managers are paid a fixed salary, which can’t be seen as out-of-bounds from the perspective of bureaucratic rules and standards. If there are bonuses, they are calculated in what Professor Murtinu called a “gloomy” way. No-one is going to break any income-equity norms.

Professor Murtinu’s rigorous data-rich analysis proves beyond any doubt the failure of Public Venture Capital.

In order to analyze Public Venture Capital performance, Professor Murtinu utilized the VICO database, a comprehensive data set about venture capital backed companies in high tech industries in seven European countries. He reinforced it with additional data sources, and was able to run a comparison of the performance of firms that received public venture capital backing and those that received no venture capital. The data sets covered 25 years.

The result: no statistical difference between the performance of the two sets of firms. Public Venture Capital had no effect. It was a waste. This was true across all possible variables: productivity, whether total factor productivity or partial factor productivity like labor or capital, sales growth, employment growth, innovation outcomes, exits.

The opposite is the case for private venture capital backed firms. In the same kind of analysis, private venture backed firms are statistically superior on every dimension. The overall impact of private venture capital is very clear and highly positive.

There is one possible step in the right direction: government becomes a limited investor.

Public venture capital can syndicate with private venture capital, and so long as the investment is less than 50% of the fund total, and has no say on selection of investments, on due diligence, on governance, on monitoring, and on timing or type of exits, it is possible that the investment outcome can be positive. The European Commission is currently considering this role for Public Venture Capital.

Additional Resource

“Public vs. Private Venture Capital” (PDF): Download PDF