I try not to get myself worked up these days. I exercise hard in the mornings in the gym, eat and sleep well, meditate, and conciously practice stillness of mind.
That didn't seem to stop me from getting a blood-pressure spike this morning when I read Donnelle Eller's piece in today's Des Moines Register about the Iowa Fund of Funds 'bailout' costing taxpayers $26 million dollars.
While I applaud Donnelle for her story and providing the background, she didn't get a chance to pursue the 'why' of the fund as much as the ex-post-facto 'what' of the current situation. She chose to focus the story on the current, incomplete status of the Iowa Fund of Funds, and not on the inconsistent and failed support of the program by our State government. This is a classic case of misdirection.....
The Iowa Fund of Funds, as it was stated in her story, was created in 2002, partially implemented (they had trouble raising funds from the private sector, more on that in a minute), and then revised again in 2005 to use bank financing and tax credits in lieu of private investment. What funds that were raised from the private sector, and later bank financing, were deployed in to private venture capital funds around the United States, including many in the Midwest. These are funds that contain investment capital from limited partners (LPs) from around the world, and are professionally managed by experienced professionals.
These seasoned professionals were handed very few constraints on how the Iowa capital was to be deployed, and they selectively invested it in the best opportunities that presented themselves. These deals were infrequently in Iowa, which was fine because at no time were the venture capital firms directed that they had to invest the funds in Iowa. If they had been told that they had to invest the funds from Iowa into Iowa companies exclusively as a condition of receiving the monies, I suspect many of them would have turned down the offer for funding. Not all of the best possible deals for their venture capital funds originate in this small state of three million people.
The original Iowa Fund of Funds plan specified $100M to be invested into these professional venture capital firms. Somewhere along the line, this number was adjusted downward to $60M, which created any number of problems. First, when you are investing capital in a venture firm, you sign a contract specifying a specific total investment to be paid in installments, called 'capital calls', to the fund when the dollars are needed. Venture firms invest these funds over time as companies and investment opportunities present themselves, and not all at once (in fact, it's considered a distasteful Freshman mistake to deploy all your 'dry powder' immediately after the LPs send you their checks). If you receive a capital call (or 'cap call') from the VC and do not deliver the contractually-promised $$, you are considered in default, and your existing investment may be rendered null and void. At this point, the VC will often divvy up the returns/your original capital amongst the other LPs.
The second problem the downshift created was/is that the funds didn't end up being completely raised from private organizations as originally planned, but also from additional bank financing in 2005, as the story specified. Setting aside for the moment the entire concept of borrowing from a bank to invest in startups, the monies planned in the missing $40M that were to go to debt service suddenly disappeared. Not good.
Put a pin in those two issues for now.
A venture capital firm invests any given venture fund in a number of different companies. These companies require initial funding, and often follow up funding from the same fund. As such, it often takes years before 100% of a fund is deployed into it's portfolio companies. Then, the companies put the invested capital to good use and hopefully create great returns for the investors. In reality, statistics generally lean towards a 40/40/20 rule, where 40% of all invested capital gets flushed by failures in the portfolio, 40% squeak out about the money invested, and 20% provide above-invested returns. Before the recession, Venture Firms were lauded for returning a better-than-market-average rate of return on invested capital.
This takes anywhere from 5-15 years.
The invested companies are little startups, struggling to find customers, revenue, and profitability. They aren't certificates of deposit, savings bonds, or mutual funds with preordained maturity dates. They are inherently risky, and that's why (when they succeed that 20% of the time) they return outsized returns to investors. When you have 10-15 companies in an investment portfolio, they have their 'liquidity events' (dissolution, initial public offering, acquisition/merger) at different times, so it often takes years for an entire group of invested companies to hit their respective finish lines, and for the fund to have run it's course.
Back to the issue at hand, the Fund of Funds. They secured legislation for tax credits for private investors to incent them to invest in the FoF. The FoF then invested these in venture capital funds, which in turn invested these monies in companies around the United States. The purpose of the FoF was two-fold, to return a competitive rate of return, and also to create goodwill and increased visibility for Iowa companies for these professional venture capital firms.
When the legislature kneecapped the FoF to $60M, it not only undid any goodwill that it had engendered with the private capital community, it actually set Iowa way, way back. Iowa became a liability for these venture funds. Suddenly our cap calls will go unanswered, and our debt service to the banks becomes an anchor around our necks.
When I say 'liability' above, I mean reputational liability. Financially, the VC firms will look like heroes to their other limited partners as they get to take the invested capital from Iowa and play Santa Claus to the other LPs by giving them a pro-rata share of Iowa's invested capital. They still get paid, but we don't.
It's like swimming 3/5th (60/100) of the way across the English Channel, deciding you can't make it, and turning around and swimming home.
What wasn't mentioned in the story is that there is a similar investment approach currently being implemented by the Iowa Economic Development Authority and the Iowa Innovation Corporation, the public/private hybrid approach that took the place of the Fund of Funds. Tax credits and private investment will be utilized to invest in Iowa companies via one or more professional fund managers.
The topic is a complex one at multiple levels, as startups are hard, venture capital investing is hard, and politics is hard. They all have different maturity dates (election cycles, venture fund timeframes) and external pressures that often force you to make expedient decisions over optimal long-term ones.
One simple takeaway is that if you are going to take taxpayer money, either directly from the general fund or in the form of tax credits for corporate investing, and invest it into startups, be sure you have an attention span long enough to see it to the end. Otherwise, all you are doing is repeating the same mistake over and over with each new approach. In a prior blogpost turned Des Moines Business Record editorial, I compared this process “to a child who kept digging up the ground where he had planted seeds, because he was frustrated that the flower was not yet blooming.”
I really wish that the people making these decisions about what programs to discontinue and why would take the time to understand how much of our hard private-sector work they are undoing by digging up these seeds. I also wish that when they were gleefully digging up the seeds they planted (and didn't have the patience to let sprout), that they wouldn't attempt this completely obvious and ham-handed misdirection by repeating the old foil of it being a 'bailout'.
If anything, it's a bailout of their own shortsightedness.