25 October 2016
The innovation ecosystem is beginning to gain momentum, which means efforts will bear fruit in due course. Photo: Internet
The innovation ecosystem is beginning to gain momentum, which means efforts will bear fruit in due course. Photo: Internet

How to invigorate the venture capital market

This year’s policy address outlined a series of measures regarding innovation and technology.

The HK$2 billion Innovation and Technology Venture Fund is worthy of further discussion.

Under the proposal, the Hong Kong government will partner with private venture capital funds to co-invest in the start-ups they pick, with an investment ratio of 1:2.

The authority will retain certain rights, including the right to refuse to invest in projects deemed problematic. 

The fund is reminiscent of the Applied Research Fund (ARF), publicly owned and launched in 1993.

ARF was at first administered by the government and criticized for funding too few projects.

Later, the government engaged private venture capital (VC) firms to manage ARF only to bump into another problem.

According to the agreement, private firms could exercise absolute discretion in investment decisions to the extent that one of them sold a HK$23.78 million investment for US$1 without first notifying the government.

ARF was perceived to be ineffective and eventually abolished in 2005. 

With this in mind, the government needs to position itself accurately, without intervening to such an extent as to undermine flexibility or over-relying on the private sector.

Maintaining this delicate balance, like walking a tightrope, is no easy task. 

First, to ensure prudent use of public money and select capable partners, clear and objective criteria and transparency are crucial in the selection of private VC funds.

Israel’s Yozma is a case in point.

Yozma invests in numerous VC funds in order to promote competition and create more jobs.

It also proactively makes use of foreign VC funds, whose global connections can help entrepreneurs acquire follow-on funding.

These features could be considered in the design of selection criteria.

Second, correct incentives should be in place to encourage better portfolio management.

Since VC firms need to contribute more than the government in this matching fund, fund managers should have every incentive to hold up their end.

To provide more incentives, the government might well consider the experience of Yozma, which allows private VC funds to purchase government stakes almost at cost (plus an interest rate of 5-7 percent) within five years.

Third, more control is not always better.

The government ought to take into account the diverse needs of start-ups and allow for flexibility where appropriate.

A lesson can be learned from the Advanced Technology Program (ATP), a US government scheme that funded industry-led research projects from 1990 to 2007.

One of the awardees, Torrent Systems, accomplished R&D earlier than scheduled, without using up the funds.

Yet, the US government demanded that the company extend the research to irrelevant areas in order to keep the unused funding.

Finally, the company partnered with IBM and gave up the unused funding but ATP still threatened to shut it down.

Prof. Josh Lerner cited this story as an instance of punishing a promising start-up for its success.

Hong Kong should not repeat this mistake. 

Last but not least, the technology fund should follow through on the social mission of supporting entrepreneurship and galvanizing the VC market.

If government officials or fund managers try to prove themselves by striving for short-term returns, they are barking up the wrong tree.

In fact, projects with certain prospects and low risks, while delivering a fast buck and making life easier for fund managers, should not be the targets of the fund because they can always raise capital in the market by themselves.

If the fund only focuses on these safe investments, it will effectively compete with and crowd out other private VC funds, hindering the development of the VC market.

What is even worse is that those promising projects that have yet to rise above the crowd and need a helping hand from the government the most would be left out in the cold.

The social mission of the fund should not be overridden by the pursuit of nice figures in the short run.

Agreements between the government and private VC funds should ensure that the investments are in line with the policy intent.

Besides, politicians and the public ought to be patient and avoid judging the fund by its returns in just two or three years.

It takes time for the fund to unleash its full potential.

As the development of the innovation ecosystem is beginning to gain momentum, efforts will bear fruit in due time.

Germaine Lau and Ben Lee are co-writers of this article

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