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Policy towards private equity and venture capital

In both the US and the UK, the development of the venture capital industry has been accelerated by top-down initiatives from national governments. Within the European Union, the Commission has also made strenuous efforts to enable local private equity markets to grow. In Poland, however, the government's efforts on behalf of venture capital have been at best limited, argues Piotr Tamowicz of the Polish Private Equity Association. Tamowicz gives an overview of the most effective policies and argues that such strategies would have a great impact on Poland's already burgeoning private equity industry.

In most of the countries where dynamic private equity markets have developed, this development has been assisted and stimulated by governments. Such activities took place both in countries with strong liberal traditions, for example the US and Great Britain, and in the states of interventionist character, like France and Germany. The governmental assistance had a clear rationale. Beyond discussion is the fact that the venture capital sector contributes to revitalizing business and increases business birth rates. Reliable research published by the European Private Equity and Venture Capital Association (EVCA) shows that venture-backed businesses grow faster than others, are more profitable and dynamically increase employment.

The involvement of private equity and venture capital in technology-oriented ventures has a tremendous impact on innovation and general modernisation. Recent research in the US indicates that patents resulting from venture capital investments have much higher quality and usefulness than others. The research further estimates that one dollar invested in new technologies through venture capital generates three times more innovation than traditional research and development activities.

Apart from such effects as business development or increased innovations, the development of financial markets is yet another advantage resulting from the activities of the PE market. A strong PE/VC industry means greater possibilities of converting domestic savings into investments and diversification of risk. Without private equity, the prospects of many privatization programs, retirement reforms or consolidation processes would be more daunting.

The range of activities undertaken by Western governments in the PE market is broad: from direct involvement of government agencies as sources of capital, to providing loans, guarantees and subsidies for private funds, to tax relief programs and regula-tory activities such as creating viable investment vehicles.

The oldest examples of governmental support for the private equity market come from Great Britain and the US. Even before World War II, the British were worried by major difficulties small businesses had to face when trying to get external financing. Among recommendations of a parliamentary committee called to deal with the issue was the idea to create a special institution that would provide businesses with small amounts of equity capital. In this way - based on the capital of five private banks and the Bank of England - the Industrial and Commercial Finance Corporation was established in 1945. Known worldwide, the corporation still exists and functions today under the name of 3i (for Investors in Industry).

The British made another attempt to invigorate the venture capital market on the regional and local levels. Between the years 1979 and 1984, a number of bodies to promote economic growth (so-called Enterprise Boards) emerged, largely in municipalities dominated by the Labor Party. They dealt with investments of the venture capital type, among others. This way the Greater London Enterprise Board, West Midlands Enterprise Board, West Yorkshire Enterprise Board, and Greater Manchester Development Fund started their activities. In 1982-1985 Enterprise Boards invested approximately £35m pounds in 200 businesses. Despite frequent criticism of the effectiveness of their activities, and the blocking of economic activity of the municipalities in the Thatcher years, some of the boards continue to exist, mostly in a privatized form, and they constitute an element of local financial systems. In turn, the Scottish Development Agency established in 1975 serves as an example of a regional initiative. The Agency, operating under a new name and as a network organization, is still very active in the area of equity investments.

On the other side of the Atlantic, the governmental factor was also not passive. Free-market Americans approached the issue with more finesse than the British. Instead of creating public competition to private institutions, the federal authorities decided to back private funds. In this way, the Small Business Investment Companies (SBIC) program came to be, with its aim to support the market of private equity with federal capital loan funds. According to US government data, by the year 2000 the program helped finance about 87,000 small businesses and create 600,000 new jobs.

Over the years, the growing experience of governments showed that direct involvement of public funds is not the optimal way to support development of the private equity industry and rather tends to generate market distortions. Other means, directed to support private sector activity in PE/VC have proved more effective. Both in the US and Britain the removal of legal barriers standing in the way of private investment played a major role. For example, the US government made a move highly regarded by experts to liberalize investment regulations on pension funds (the Employment Retirement Income Security Act), which allowed for the channeling of long-term pension savings to the PE/VC industry. The British, in turn, backed the private market with a system of tax relief (Business Expansion Scheme, Enterprise Investment Scheme, Venture Capital Trust).

The activities and visible successes of the British and American PE/VC industries drew the attention of continental Europe. The Dutch, like the British, started with directly investing public funds into the VC sector. After a while, however, they moved on to more sophisticated programs - such as the program of public guarantees for equity investments. In 1985, the French introduced an income tax incentive and capital gains tax relief encouraging an increase of VC investments. Also Germany, which until then had no tradition of venture capital, introduced regulatory changes and numerous programs supporting the industry's growth.

For the last several years, the private equity sector has been a subject of special interest on the part of the European Union. In 1998, the European Commission adopted the Risk Capital Action Plan aiming to create a Pan-European venture capital market. It includes regulatory changes, entrepreneurship promotion, development of a business angel network, and other initiatives. In 1998, the Seed Capital program started. It consisted of refunding up to 50 per cent of a private VC fund's operating costs, under condition of having met a specific set of criteria. This program has been continued and expanded by several programs, for example Seed Capital CREA, I-TECH, and EFT Start-up. The Seed Capital CREA focuses on refinancing part of the operating costs of funds that invest in the early phases of business development. Its aim, in addition to helping small companies get access to capital, is to create among the EU member countries a network of so called seeding funds. The I-TECH and ETF Start-up programs have as their task to encourage VC funds to invest in innovative or technologically advanced small businesses.

The EU, for a number of years, promoted private equity through support for the European Venture Capital Association. Its backing allowed for a broad promotion of the ideas around venture capital and private equity investing and spreading knowledge of the principles of such activities among European entrepreneurs and investors. Similarly, the EU supported EVCA's actions aimed at ensuring high business standards and the industry's voluntary self-regulation.

The development of private equity in Poland differs from the above. National government involvement in the emergence and expansion of PE/VC funds was very limited. Programs for developing the private equity industry were realized without conviction. The Act on Investment Funds and its further amendments were steps in the right direction, however, as it turned out in practice, insufficient to create suitable legal forms for domestic venture capital vehicles. The program of regional investment funds has remained small in size, corresponding to a pilot program. The present tempo of privatization fails to encourage inves-tors to tap this source of investment projects. Paradoxically then, the growth of venture capital in Poland - several hundred realized investment projects, billions of dollars invested, about 30 well-rooted management firms - took place with only limited government initiatives and even without adequate legal forms allowing the mobilization of domestic capital. This shows that the base for the development of the industry was the stimulus of independent, dynamic market factors. It had its price, though, in the form of insufficient development of the sector of small VC funds that focus on small enterprises and start-ups. On the other hand, this weakness is also an opportunity - a chance to develop a sector, which clearly helps economic development and job generation in particular.

The programs presented above show that with a proactive approach, public support can be made available and successful in developing the private equity market. It is also clear which types of initiatives can bring questionable results. While the pro-grams of direct public investments showed significant weaknesses, building a good regulatory environment (including investment vehicles) proved not only beneficial but necessary for the development of the private equity industry. Positive outcomes resulted from the removal of constraints and the offering of incentives to institutional investor such as pension funds to invest in private equity funds. Incentives for the emergence and development of VC management firms are also of noteworthy positive value.

Taking good advantage of the experience from other countries for supporting the development of the private equity industry in Poland would make it possible to free further the immense potential that lies within the combination of private equity and private enterprise.

Piotr Tamowicz, PhD, is an economist, fellow at the Institute for Research on Market Economy in Gdansk

Polish Private Equity Association (PPEA) gathers private equity/venture capital investors active in Poland. Associate Membership is also available for other persons, companies and institutions interested in development of the private equity/venture capital industry in Poland. For further information please visit www.ppea.org.pl.