Public Entrepreneurial Finance around the Globe

In recent decades, governments around the world have been increasingly interested in boosting innovation and the “knowledge economy,” as opposed to the manufacturing sectors that were the traditional focus of industrial policies. One manifestation of this trend has been through public efforts to boost financing for early-stage ventures. Given the important role played by the venture capital firms in driving innovation and economic dynamism in the US, policy makers are highly interested in making the venture sector more robust.

Young high-growth businesses, however, face substantial information problems, and their financing requires significant expertise. The skillful allocation of capital to such companies may consequentially be difficult for public officials. First, substantial uncertainty and informational asymmetries surround the selection of new ventures, leading private investors to frequently make decisions based on soft information. Decision-making based on such imperfect information may be difficult for officials in bureaucracies to duplicate. Moreover, unlike virtually all government employees, private financiers’ compensation is strongly tied to the success of their investments. This approach improves investors’ incentives to devote substantial effort and make tough decisions (e.g., shut down an investment despite the pressures associated with career concerns and other agency problems).

In our paper, we assemble the first comprehensive and detailed data on the universe of government funding programs of entrepreneurial ventures around the world. We hand-collected novel data set on nationwide entrepreneurial finance policies around the world active between 1995 and 2019 (755 programs in 66 countries). We focused on national-level programs with a focus on financing domestic entrepreneurial firms or intermediaries that fund them. Using this hand collected data, we explore whether government entrepreneurial funding programs can address capital allocation through ties with private capital markets. We might anticipate that highly effective governments would anticipate the capital allocation difficulties outlined above and collaborate with private capital markets to address them.

This hypothesis can be contrasted with two alternative views. The first is that government programs’ allocation of capital is unrelated to private financing. In fact, government investments may even “crowd out” private capital. Alternatively, public funding may follow private funding. But these dynamics may also arise for reasons other than maximizing efficacy and improving capital allocations to early-stage ventures. We highlight two alternative explanations for such a pattern. First, Trend-Chasing may explain the positive correlation between private capital markets and public government programs, as both sets of actors pursue investments perceived with promising attractive private returns. Second, the literature has suggested that government financing programs subject to Rent Extraction may have a pro-cyclical bias. The abundant revenues during booms may be especially tempting for parties seeking to benefit themselves. Such forces could generate a positive correlation between private capital markets and government funding programs, but for reasons other than improving capital allocation.

Motivated by the hypotheses articulated above, we seek to understand (1) if public entrepreneurial finance programs rely on private capital, and (2) if so, is it because of an attempt to improve capital allocation to early-stage ventures or instead due to trend-chasing or rent-extraction motives? Answering these questions is challenging due to data limitations.

We find that, between 2010 and 2019, national governments’ entrepreneurial finance programs around the world had on average a cumulative annual budget of $156 billion, as opposed to an average of $153 billion of global disbursements of traditional venture funds.

Our analysis found that more private venture activity was associated with subsequent government entrepreneurial finance: the two sources of capital were positively correlated. Using panel data, we saw not just a positive correlation but that public policies followed private capital investments. Moreover, increases in venture capital activity in a given industry-country pair were followed by subsequent government funding programs that targeted those industries as well.

To better understand the mechanisms behind the positive correlation between governments’ funding programs and local private capital, we then examined the structure of these programs. Consistent with the hypothesis that the complementarity mitigated investment frictions, we found three ways in which government programs frequently structured their programs to rely on private capital markets: the involvement of private sector actors in investment screening, the funding of intermediaries rather than companies directly, and capital matching requirements by private investors. Moreover, we found that government programs were even more likely to rely on private capital markets when targeting earlier stage companies, where information asymmetries may be greater.

Consistent with the interpretation that government reliance on the private sector alleviated the information and incentive problems that the public sector may encounter, we found that the positive correlation between private and public activities was more pronounced when governments were more effective. More effective governments were more likely to structure their funding programs with greater private sector involvement. These findings were consistent with the hypothesis that highly effective governments foresaw and addressed the information and incentive problems that public programs encountered. By collaborating with private financiers of entrepreneurial firms, public bodies may have been able to head off problems proactively.

We also found consistent evidence when we looked at the impact of neighboring programs. Nations whose neighbors initiated public entrepreneurial finance programs were more likely to do so themselves. More interestingly, the evidence was consistent with knowledge spillovers regarding effective program design: countries with neighboring programs were likely to display a strong correlation between public and private funding.

Finally, we explored the innovation generated following the initiation of government funding programs. We explored different metrics based on U.S. patent filings, which we believed were well suited for this assessment. Across all innovation measures, we found similar patterns: a meaningful and statistically significant improvement following the initiation of government funding programs. Important for interpreting these results, we found no statistically significant pre-existing trends in the years leading to the government funding programs. Moreover, the improvements in innovations were particularly concentrated among the set of programs that targeted early-stage ventures or required collaboration with the private capital markets.

The results are inconsistent with the alternative interpretations offered above. There was little a priori reason why the trend-chasing or the rent-seeking stories would lead to the heavy reliance on private sector actors in the way public programs are structured. Instead, the complementarity between public and private entrepreneurial finance seemed to be mostly consistent with the hypothesis that such complementarity enabled mitigating frictions that arose in the deployment of capital to early-stage firms. This was also consistent with our finding that innovation increased following government funding programs that either targeted early-stage ventures or required collaboration with private capital investors.

The complete paper is available for download here.