Measuring the Effectiveness of Public Policy Towards Venture Capital

The following post comes to us from Douglas Cumming, a Professor in Finance and Entrepreneurship at York University – Schulich School of Business.

A recent book by Josh Lerner and a recent article in the Journal of Public Economics has asserted that government venture capital programs in Europe have displaced or crowded out private venture capital. The result of work such as this has been to place pressure on government bodies around the world to remove or replace their existing governmental programs. In the aftermath of the financial crisis, venture capital markets around the world themselves have been in crisis. So, it is particularly timely to address the issue of whether or not government venture capital programs in regions such as Europe really have in fact crowded out private venture capital programs.

As pointed out in this Economist article and in my recent commentary and my review article, the idea that government programs crowding out private venture capital in Josh Lerner’s book and in the Journal of Public Economics is based on empirical measures that are completely flawed. The empirical tests supporting crowding out are based on methodologies that rank the Austrian and Hungarian venture capital markets as being the best in the Europe, and the U.K. venture capital market as being the worst in Europe (I am not kidding).

As one might guess, the findings reported in Josh Lerner’s book and the Journal of Public Economics are completely reversed when one use measures that generate plausible country rankings. In particular, findings reported in Josh Lerner’s book at the Journal of Public Economics are based on empirical measures that compare early stage venture capital to late stage venture capital. When one uses early stage venture capital relative to GDP or relative to population, country rankings are completely different, and not surprisingly, the regression results are completely different.

I show in my recent work with data spanning 13 countries and the years 1989-2011 that government venture capital funds in Europe have not crowded out private venture capital investment, contrary to the assertions of others that have based their findings on the use inappropriate empirical measures. In effect, many folks that are advising on public policy towards VC appear to be doing so in a way that completely misinforms policymakers, practitioners and academics alike.

Surprisingly, the authors of the Journal of Public Economics article deleted their table of summary statistics from a working paper version of their paper in April 2004, as I have explained in this paper where I replicate the table of summary statistics that was deleted and explain and provide evidence that the timing of the removal of the summary statistics was immediately following an academic conference at the Bundesbank where there authors were informed that their empirical measures were flawed.

Surprisingly, even though there is growing awareness that this work is completely flawed (after all, who would want to use public policy engineer a venture capital market that resembles Hungary or Austria and not the U.K.?), the authors of the Journal of Public Economics continue to only reference their work on public policy towards venture capital and do not acknowledge that their work is flawed and do not acknowledge the existence of other work on topic; see, for example, this paper. Similarly, Josh Lerner continues to reference the flawed work in the Journal of Public Economics in his more recent work relating institutions to venture capital; see for example, this paper. In effect, there is a persistent problem in which select authors continue to misinform the public (including policymakers, practitioners, professors and students) about public policy towards venture capital. There should be no comfort with repeating the same mistake and misinforming the public. If something is clearly and unambiguously incorrect and potentially influences the public in their thinking and/or influences policy, then someone needs the strength and nerve to stand up and say “Hey! That’s Incorrect! Please Stop!” before any further misinterpretation. I have decided to do this. As far as I understand it, it is our academic responsibility to speak up. I stress that this is not for the purpose of highlighting the mistakes others have made (indeed, I myself have made an enormous number of mistakes in my life), but instead for the purpose of disseminating full and correct information on a topic. Since the topic of public policy towards venture capital is massively important for many countries around the world, it is very important that academics report correct information and not continue to mislead and misinform others.

To conclude on a positive note, there have been some countries where government VC programs have created substantial value added. For example, in my recent paper with Sofia Johan, we empirically compare the contributions of venture capital (VC) and private equity (PE) backed firms, including those backed by government subsidized Innovation Investment Funds (IIFs), to the Australian economy by analyzing employment, R&D, patents, time to IPO, and market capitalization from market inception to August 2012. VC-backed firms exhibit no material difference in employment, but do exhibit higher levels of R&D and patents and, after the passage of sufficient time, have greater market capitalization relative to PE- and non-VC/PE/IIF-backed firms. IIF-backed firms likewise exhibit no material difference in employment, but do result in a higher percentage of investments that are publicly listed and a greater market capitalization relative to both VC- and PE- and non-VC/PE/IIF-backed firms, controlling for other things being equal. PE-backed firms generate higher levels of employment, counter to anecdotal claims to the contrary. Overall, the data highlight a central role for VC and IIF investment in facilitating R&D, innovation, and economic growth. The data indicate an expansion of venture investments would facilitate more innovation and economic growth in Australia relative to the expansion of other sources of capital, particularly in view of the comparative dearth of venture investments in Australia relative to other countries.

The full article is available for download here.

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