Establishing venture capital funds

Taking risk with capital
Risking capital investment
The existence of a market for risk capital would allow enterprises to diversify sources of finance and also to reduce the cost of capital, while maintaining a healthy financial structure through reasonable levels of debt/equity ratios. To date, about 50 developing countries and countries in transition have established stock markets. However, only large companies have access to these markets, because of strict disclosure and listing requirements which only mature companies can meet.

In industrialized countries, the needs of smaller companies to raise risk capital to finance start-up or expansion operations have been addressed through the creation of second-tier stock markets or informal arrangements to provide venture capital. Second-tier stock markets, with lower listing requirements and less demanding size and reporting thresholds, allow smaller firms to raise equity capital and are usually seen as an appropriate exit mechanism for venture capital investors wishing to capitalize and realize their gains.

A number of venture capital funds have been established in OECD countries to make equity investments in smaller companies that have good prospects for substantial growth over the medium term and need a relatively high initial investments Venture capital has been used to a great extent to finance high or new technology projects. In most countries, banks and large corporate investors have been the main source of investment; even today many venture capital companies in Europe are subsidiaries of major banks. However, institutional investors such as pension funds and insurance companies are increasingly active on the markets and have set up their own venture capital firms or funds. There are also private individuals or groups who see venture capital funds as an attractive investment with high potential returns. In practice, venture capital is invested in a small number of "start-up" projects, but more frequently in expansion and development projects, because of the high risks and high failure rate of new projects.

As returns on investments in the form of dividends are not forthcoming or not adequate in the short term, the main objective of venture capital investors is an early 'exit' from their investments through share redemption at good prices. Generally the timing of the share sale or "exit" is included in the original investment agreement and may range from three years to 10 years. Although a stock exchange listing is the most desirable way to sell shares, this is rarely a feasible option for small firms. In some countries, there exists an exchange mechanism of unlisted securities through "over the counter share trading of small companies. More often shares are sold to the partners or through a "trade sale" to an outside firm or other investors. The most serious problem in "exit" arrangements is to determine the right price of shares.

Experiences in developed countries have shown that venture capital funds have not generally been very profitable, because of the scarcity of good projects, high risks and difficulties to "exit". Many of these funds have diversified their investments which are not only in small business but also in medium-sized enterprises. Furthermore, as venture projects need not only equity funding but also working capital, success could be better assured by a syndication of equity financing funds which put together packages of all the financing needed (equity as well as loans) and then maintained some control on management. Equity funds for small business with a major developmental orientation should have their administrative or operational costs covered by a grant from governments or external donors.

Developing countries have also accumulated venture capital. In Asia, such countries as India, Indonesia, Republic of Korea, the Philippines, Singapore and Taiwan Province of China have set up venture capital funds.

In India, the Technology Development and Information Company of India Limited. (TDICI) was established in 1987 by the Indian Development Bank and the Unit Trust of India (a commercial banking organization). In 1988, the Bank of India issued guidelines, limiting the operations of venture capital to investments in small and medium-size industries in high or new technology sectors. In 1989, the Credit Capital Venture Fund (CVF) was jointly established by Credit Capital Finance Corporation (a leading merchant bank), the Bank of India, the Asian Development Bank and the Commonwealth Development Corporation. In addition, two state development finance institutions established Gujarat venture Capital Limited and APIDIC Venture Capital Limited. Another venture capital fund, the Risk Capital and Technology Finance Limited (RCTF), was created to provide "seed capital" to finance the development of projects before the commercial development stage. Venture capital companies in India provide equity finance and conditional loans. Conditional loans are those repaid by revenues and royalties generated by the projects. Until end-1992 none of the investments made by venture capital companies had reached the divestment stage, therefore any problems of "exit" options and evaluation of shares had not vet arisen.

In the Republic of Korea , following the adoption of the Small Business Start-up Promotion Act in 1986, some 15 venture capital companies were created; by the end of 1992, the number of such companies had increased to 58. In 1986, the government created a "start-up" promotion fund which was administered by the Small and Medium Industry Promotion Corporation. The fund made loans to or invested in venture capital companies, as well as in venture investment partnerships.

Venture capital companies invest mainly in unlisted SMEs and expect to realize capital gains when the companies go public. An "over the counter" market was established in 1987. Investments are made in technology-intensive manufacturing companies with high growth prospects and high expected profits. Venture capital companies also enjoy many tax incentives.

As these companies tended to be conservative and encountered difficulties in finding appropriate investment projects, they became increasingly involved in other activities such as lending, leasing and factoring. It has been found that the pay-back period for venture capital investment was more than ten years.

In Mexico, a government trust fund, the Fondo de Fomento Industrial (FOMIN) was established in 1972 and administered by the major National Development Bank. FOMIN's role is to help newly created SMEs or existing ones through a minority contribution to their equity capital. FOMIN offers a combined package of equity and loans. Valuation of assets to be divested has proved to be a major problem, especially in an inflationary context. In addition to FOMIN, a number of private venture capital companies have been formed.

International venture capital funds have also been created by donor institutions for investments in developing countries. One such fund is the Societe d'Investissement et de Développement International (SIDI), based in Paris and founded by the French Catholic Committee against Hunger and for Development, together with Epargne solidarité développement (a grouping of industrialists, religious congregations and associations) and Caisse centrale de coopération économique. SIDI takes equity participation in local investment and financing companies in developing countries. Through these local companies, SIDI invests as a minority shareholder in SMEs which have high potential for growth and profitability. SIDI aims to sell its shares within five years, although it has incurred losses from many of its investments. SIDI combines equity investment with loans to individual enterprises in which it invests.

The French Caisse centrale de cooperation économique established, in 1977, the Societé de promotion et de participation pour la coopération économique (PROPARCO), originally conceived as a venture capital company investing in SMEs in Africa and providing technical advice to these enterprises.2' Over the years PROPARCO shifted its activities from investing in start-up projects to participating in the expansion of capital of existing enterprises. The low profitability of its investments and high rates of failure of projects had forced PROPARCO to reorient its activities and to focus on lending to SMEs.

The Commonwealth Development Corporation started to help develop venture capital operations in developing countries in 1987, mostly in Africa.

Constrained by:
Avoiding capital risk
Type Classification:
C: Cross-sectoral strategies