Should Tennessee fund venture capital?

Not unless they can do it better than the millions of people who already do this for a living.

Equally direct, when asked about TNInvestco 2.0, Vanderbilt University economist Luke Froeb, who is on the faculty of the Owen Graduate School of Management, said venture investment such as that discussed here should be left to the marketplace, without State involvement. He then pointed us, once again, to his earlier comments regarding what he has termed TNInvestco's "perverse incentives" for fund managers.

In fact, if they had to do it, don't you think they should have mimicked the way that investors fund VC?  Here is a REPOST on the peculiar way that they chose to do it last time.

Monday, September 10, 2012

Perverse incentives in TN state funded investment

The state is auditing the its venture capital fund, which awards $20 Million ($25 M in future tax credits are worth about $20 M today), and then asks fund managers to invest  in early stage ventures.  After the investment pays out, the state and the managers split whatever remains.

Proponents of the program say it was an innovative attempt to steer venture capital toward economic development priorities like health care, bioscience, music and other sectors. As the Business Journal reports today, some Republicans are questioning the program’s job creation so far and want to evaluate other aspects of its financial performance.

Any audit should first understand the incentives.  To do this, lets run through some scenarios.  This is what is called a "sensitivity analysis."

 Compare the (very approximate) terms of a typical Venture Capitalist (VC) to those of TNInvestco under the following scenarios:

• Scenario A:  Good Scenario (Invest $20 million, sell investments for $50 million)
• TNinvestco gets $25 million, State gets $25 million
• Typical VC gets $6 million, investor gets $44 million


• Scenario B:  Break-even Scenario (Invest $20 million, sell investments for $20 million)
• TNInvestco gets $10 million, State gets $10 million
• Typical VC gets zilch, investor gets $20 million


• Scenario C:  Worse-case Scenario (Invest $20 million, sell investments for $10 million)
•  TNInvestco gets $5 million, State gets $5 million
• Typical VC gets zilch, investor gets $10 million

The key thing to note is that the typical VC is makes nothing (other than management fees) unless a fund makes money for investors.  This serves to align the fund manager's incentives with the profitability goals of the fund investors.

In contrast, a TNInvestco fund manager makes a substantial amount unless the fund is a total failure.  

Bottom line, TNInvestco creates incentives for the managers to not lose money, as opposed to the high level of risk taking that is typical to venture capital.  One would expect safer investments. 

Stay tuned for what the audit uncovers.