The Future of CDC

Evidence submitted by Josh Lerner

Much of my research focuses on the structure and role of venture capital and private equity organizations. (This research is collected in three books, The Venture Capital Cycle, The Money of Invention, and the recent Boulevard of Broken Dreams.) I also examine policies towards innovation, and how they impact firm strategies. (The research is discussed in the book Innovation and Its Discontents and The Comingled Code.) I founded, raised funding for, and organize two groups at the National Bureau of Economic Research: Entrepreneurship and Innovation Policy and the Economy, and serve as co-director of the overall Productivity Program.

In the 1993-94 academic year, I introduced an elective course for second-year MBAs on private equity finance. In recent years, "Venture Capital and Private Equity" has consistently been one of the largest elective courses at Harvard Business School. (The course materials are collected in Venture Capital and Private Equity: A Casebook, now in its fourth edition, and the forthcoming textbook Private Equity, Venture Capital, and the Financing of Entrepreneurship.) As part of that process, I have written three case studies on CDC and Actis over the past decade. I also teach a doctoral course on entrepreneurship and in the Owners-Presidents-Managers Program, and organize annual executive courses on private equity in Boston and Beijing. I am leading an international team of scholars in a multi-year study of the economic impact of private capital in collaboration with the World Economic Forum and the Brookings Institution, and am the winner of the 2010 Global Entrepreneurship Research Award.

Entrepreneurs have attracted increasing attention and from policymakers. These business creators and the investors who fund them play a dramatic role in creating new industries and revitalizing economies. Many nations have launched efforts to encourage this activity. Such attention is only likely to intensify as nations seek to overcome the deleterious effects of the credit crunch and its recessionary aftereffects. This approach has characterized CDC’s approach over the past decade as well.

This can be distinguished from other efforts to boost entrepreneurship at a more modest level. In recent decades, there has been an explosion in the number of efforts to provide financing and other forms of assistance to the poorest of the world’s poor, in order to facilitate their entry into entrepreneurship or the success of the small ventures they already have. Typically, these are "subsistence" businesses, offering services such as snack preparation or clothing repair. Such businesses typically allow the owner and his or her family to get by, but little else. The public policy literature-and indeed academic studies of new ventures-has not always made this distinction between the types of businesses that are being studied. But as Antoinette Schoar of MIT and I have highlighted in our recent volume for the National Bureau of Economic Research, International Differences in Entrepreneurship, a substantial literature suggests that high potential ventures are where the bulk of the job creation and economic growth come from promising entrepreneurial firms rather than subsistence businesses.

It might be obvious to the reader why governments would want to promote entrepreneurship, but why also the frequent emphasis (which CDC shares) on venture and growth equity funds as well? The answer lies in the challenges facing many start-up firms, which often require substantial capital. A firm’s founder may not have sufficient funds to finance projects alone, and therefore must seek outside financing. Entrepreneurial firms that are characterized by significant intangible assets, expect years of negative earnings, and have uncertain prospects, are unlikely to receive bank loans or other debt financing. Venture capital and growth equity-independently managed, dedicated pools of capital that focus on equity or equity-linked investments in privately held, high-growth companies-can help alleviate these problems.

Typically, venture capitalists do not primarily invest their own capital, but rather raise the bulk of their funds from institutions and individuals. Large institutional investors, such as pension funds and university endowments, want investments in their portfolio that have the potential to generate high yields, such as venture capital, and typically do not mind placing a substantial amount of capital in investments that cannot be liquidated for extended periods. Typically, these groups have neither the staff nor the expertise to make such investments themselves. Thus, they invest in partnerships sponsored by venture capital and growth equity funds, which in turn provide the funds to young firms. While venture funds finance new ventures, buyout firms are an important provider of governance and professional management to companies, especially in emerging markets.

While the public sector is important in stimulating these activities, I will note that far more often than not, public programs have been failures. Many of these failures could have been avoided, however, if leaders had taken some relatively simple steps in designing and implementing their efforts. Among the key principles associated with success have been the following:

· Let the market provide direction. Two successful efforts have been the Israeli Yozma program and the New Zealand Seed Investment Fund. While these programs differed in their details-the former was geared toward attracting foreign venture investors; the latter encouraged locally based, early-stage funds-they shared a central element: each used matching funds to determine where public subsidies should go. In using the market for guidance, policymakers should keep certain points in mind:

o These initiatives should not finance substandard firms that cannot raise private capital. Emulating successful initiatives in the past, programs should require a substantial amount of funds be raised from nonpublic sources.

o These funds should be structured in ways that mirror groups that are entirely based on private capital, in order to maximize the chances of raising outside financing.

· Resist the temptation to overengineer. In many instances, government requirements that limit the flexibility of entrepreneurs and venture investors have been detrimental. It is tempting to add restrictions on several dimensions: for instance, the locations in which the firms can operate, the type of securities venture investors can use, and the evolution of the firms (e.g., restrictions on acquisitions or secondary sales of stock). Government programs should eschew such efforts to micromanage the entrepreneurial process. While it is natural to expect that firms and groups receiving subsidies will retain a local presence or continue to target the local region for investments, these requirements should be as minimal as possible.

· Recognize the long lead times associated with public venture initiatives. One of the common failings of public entrepreneurship and venture capital initiatives has been impatience. Building an entrepreneurial sector is a long-running endeavor, not an overnight accomplishment. Programs that have initial promise should be given time to prove their merits. Far too often, promising initiatives have been abandoned on the basis of partial (and often, not the most critical) indicators: for instance, low interim rates of return of initial participants. Impatience-or creating rules that force program participants to focus on short-run returns-is a recipe for failure.

· Institutionalize careful evaluations of initiatives. All too often, in the rush to boost entrepreneurship, policymakers make no provision for the evaluation of programs. The future of initiatives should be determined by their success or failure in meeting their goals, rather than other considerations (such as the vehemence with which supporters argue for their continuation). Careful program evaluations will help ensure better decisions. These evaluations should consider not just the individual funds and companies participating in the programs, but also the broader context.

By and large, based on my knowledge, CDC has done a reasonably good job of adhering to these principles. While there are questions about the specifics of the program which can be raised (e.g., whether the apparently high staffing level of CDC is justified, given its mandate to invest in independent venture capital and growth equity funds), in general its design seems to adhere to best principles as seen across the world in the promotion of high-potential entrepreneurship.