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When Government Steps In: Will Industries Skyrocket?

By Dong Chen and Valeria Ryabchina

Initially posted on the BSPEC blog

Oh the places fastidious VC firms won’t go! The profile of a strong portfolio candidate is subject to more than a few criteria that not all companies can fulfill. Despite high dry powder levels, many PE and VC firms remain blasé about these targets. Industries with heavy assets requirements, or companies in unappealing areas receive little attention from sponsors. For the organizations that lack the appeal to raise a PE’s heart rate, the state may step in by offering financial backing. The government does this by creating funds of funds (FoFs) as well as becoming LPs for VC and PE funds. By setting specific investment requirements for the financial sponsors it partners with, the governments are able to channel capital toward particular industries and promote entrepreneurship in certain regions. The funds set up by governments in this way are called government-sponsored funds (GSF) or government-sponsored venture capital (GVC). But is this method of sponsoring the investment-deprived good for the traditional PE fund and the benefitting industries in general? Could the next Apple or Tesla be backed by a government co-investment?

GSFs and their purpose

Contrary to the investment strategies of PE and VC firms focused on maximizing returns, GSFs are mavericks that invest in what markets shun. In terms of their investment strategies, GSFs are somewhat similar to pension funds with long-term investment horizons. On the other hand, the conventional venture capitalists seek specific requirements in potential assets as well as shorter retention periods with more upside. In this way, the VCs cherry pick potential unicorns. Industries such as manufacturing may be a hot potato for traditional VC firms which favor start-ups with few capital assets and high growth rates. As exciting as investing in unicorns might sound, several foals remain to be taken care of. These companies are usually small, and/or in CapEx-intensive sectors which have been denied funding via conventional lending methods. So what can be done for these hopeless colts and fillies? Well, perhaps Uncle Sam might just strap on his spurs [or other appropriate government personification].

GSFs across countries:

Rather than set up investment funds, the Japanese government has been developing state-backed PE firms. In 2018, it founded Japan Investment Corp (JIC) whose shareholders (LPs) include the government itself alongside 25 private corporations. While taking prudent positions towards improving the Japanese economy, this private-public partnership yields a significant risk of government over-control preventing the fund from making the most financially beneficial decisions for its investors. However, this exposure is somewhat mitigated by the potential increase in foreign portfolio company investments in which returns are prioritized.

The German government has taken a step further. Instead of simply delegating private funds to channel capital, it controls capital allocation itself. In January 2019, for example, Germany established a €200m VC fund run by Kfw Group, a German state-owned bank group. The fund still acts as a FoF investing in privately-held sponsor portfolios. That said, it also acts as a GP in its High-Tech Start-up Fund (HTGF) by investing directly in seed enterprises and start-ups.

Governments in China and the US often take a less active LP position in private equity funds and convey principles rather than rules in regards to investment strategy. These guidelines include industries and regions to allocate in. The US, for instance, typically sponsors a small proportion (less than 30%) of funds in order to attract market participants to invest. Similarly, the Chinese government also operates with a lighter touch, allowing market forces to increase efficiency.

Based on this strategy, an industry that the Chinese government seeks to stimulate includes education technology. Shenzhen Capital Group, one of China’s most prominent government-backed VC groups, invests in this field amongst others and specializes in very early-stage deals. In the US, a well-known GSF is In-Q-Tel, the venture arm of the CIA, with a portfolio in information technology to support intelligence capabilities. Contrary to a non-government backed VC, In-Q-Tel places a higher value on the needs of its customers (the intelligence community) rather than potential financial gain.

Impact of GSFs on VC financial performance

Does it matter where venture capitalists originate their funding? This question might sound like an offhanded quip because many firms scramble for capital inflows in the first place, so why question the source if the stream is steady? Yet strings always come attached, especially when dealing with the government. So will the firm’s financial performance differ if the capital is raised from public as opposed to private investors?

The answer of course is yes, the sources of funds do matter. In terms of successful exits (IPOs and divestitures), a modest amount of capital from the government apparently improves the performance of entrepreneurial ventures. At the same time, high levels of funding from the government is associated with weaker performance. According to Brander, Du and Hellmann, government financing may be most effective when the private sector is the primary source of capital. One possible explanation for this performance gap could be an agency conflict: when backed by governments, VC managers are more (or less) willing to take risks because governments provide additional funding if the project fails. Therefore, when there is less cushion provided by the state or when the government has a recourse agreement or hurdle rate, then the investment seems to strike an ideal balance of incentivized VC management and government tax benefits.

The under-performance of ventures that receive large placements from the government could also stem from a transfer of control within a fund. This means that fund managers are required to invest in starts-ups with low expected IRRs if the government plans to support those specific industries. However, this negative effect on returns should be softened considering that VC firms experiencing significant state intervention may have greater bargaining power. The government’s reputation and subsidies can be exploited in negotiations allowing these VC firms to outbid buy side competition or to lower entry multiples and improve operating performance via political clout to achieve an acceptable IRR.

Impact of GSFs on industry performance

If government intervention is not always positively correlated with VC firms’ financial performance, perhaps it’s advantageous for the industries receiving investment? Not entirely. Evidence from the Canadian Labour Sponsored Venture Capital Corporations (LSVCCs) suggests that government investment could displace more effective VC funding. This phenomenon has been dubbed the ‘crowding out effect’. Due to generous tax credits, LSVCCs can enter investments at higher multiples than non-LSVCCs while still meeting their required rate of return. In other words, LSVCCs’ tax benefits partially substitute their rate of return. As a result, private funds, unwilling to pay the artificially inflated price, forgo investments in these industries or geographies – thus, being ‘crowded out.”

Another channel of government support via VC is through the promotion of entrepreneurship in underserved regions. For instance, U.S. government VC programs targeted Arkansas and Hawaii as Silicon Valley and New York are already flush with capital. Cross-country evidence from Canada however, suggests that these initiatives sometimes backfire. From a macro point of view, these policy interventions are beneficial only if an organic need for entrepreneurship exists. Furthermore, when it comes to public money influxes, investees might become “too big to fail”. The target companies might not be qualified to meet traditional VC requirements, but managers may downplay these risks because they are insured by the government.

While evident that several drawbacks exist in the GSF model, let’s not rush to the conclusion that public capital in this form is always useless. Since 2015, the Chinese government has been strengthening its position as a LP with strong market participation. Many new VC funds have been partially sponsored by the Chinese government. In 2018, the overall VC industry in China suffered from a lack of financing which was moderately offset by the government’s provision of liquidity. In more general terms, government involvement in the VC industry can remove information asymmetries between private investors and start-ups as well as have a positive signaling effect for the market. The reasons for this are that public LP’s commitments are usually stable, due diligence standards are high and investing activity is made transparent. While the market might disregard a certain industry or region, the government can help it develop through capital and awareness. Based on this, perhaps GSFs can stimulate specific economic areas and industries after all.

In conclusion, the impact of the government-sponsored funds is certainly not negligible. It is best summarized as a double-edged sword – ushering in private investment in some cases and crowding it out in others. GSFs seem to be most effective when market forces are not suffocated by an overbearing public sector. However, if the invisible hand is misdirected, then some government involvement in the form of GSFs is probably best to guide a semi-efficient market.

Editor: Eric Peghini

Authors: Dong Chen, Valeria Ryabchina

Further reading:

 J. Acs, Zoltan & Åstebro, Thomas & Audretsch, David & Robinson, David. (2016). Public policy to promote entrepreneurship: a call to arms. Small Business Economics.

Brander, James & Du, Qianqian & Hellmann, Thomas (2015). “The Effects of Government-Sponsored Venture Capital: International Evidence,” Review of Finance, European Finance Association, vol. 19(2), pages 571-618.

Brander, James & Egan, Edward & Hellmann, Thomas, (2010). Government Sponsored versus Private Venture Capital: Canadian Evidence, p. 275-320 in , International Differences in Entrepreneurship, National Bureau of Economic Research, Inc.

Colombo, M.G., Cumming, D.J. & Vismara, S. J. (2016) The Journal of Technology Transfer, vol. 41(10).

Cumming, Douglas J. & MacIntosh, Jeffrey G. (2006). “Crowding out private equity: Canadian evidence,” Journal of Business Venturing, Elsevier, vol. 21(5), pages 569-609, September.

Fei, Yue. (2018). Can Governments Foster the Development of Venture Capital?.SSRN Electronic Journal.

Kraemer-Eis, Helmut & Signore, Simone & Prencipe, Dario.(2016). “The European venture capital landscape: an EIF perspective. Volume I: The impact of EIF on the VC ecosystem,” EIF Working Paper Series 2016/34, European Investment Fund (EIF).

Schnabel, Jacques A. (1992). “Small Business Capital Structure Choice,” Journal of Small Business Finance: Vol. 2: Iss. 1, pp. 13-21.

Federal Ministry of Finance:



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Bocconi Students PE Club
Bocconi Students PE Club
The Bocconi Students Private Equity Club (BSPEC) is a student-led organization at Bocconi University. The club publishes articles related to private equity and venture capital, conducts interviews with active PE professionals and hosts events featuring funds and advisors. BSPEC is one of the oldest and most active student associations at Bocconi University and its alumni are currently employed at top tier investment banks and PE funds. Learn more at

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