In 2009, the UK Innovation Investment Fund raised £175m from private investors that was matched with government money – the first of several such funds.
There is a general uneasiness surrounding these sorts of schemes.
I’ve heard concerns expressed around Tech City that they are distorting the investment process.
Government money, the theory goes, is being allocated to the riskiest investments whilst private money is retained for the safer bets.
Risk and return
Now, unintended consequences abound when governments stick their oar into private matters. I accept that fully.
But it may come as something of a surprise that I’m not the card-carrying capitalist you might expect of a ‘city’ type. I do not, in fact, share these concerns.
Why not? In most cases, risk and return are high or low together.
If professional investors are really favouring the lower risk, then it is to the government’s credit. Long term, persistent high risk investors with deep pockets make high returns in the long run. This is not an unintended consequence, but an intended one.
And to be frank, at the level of VC, it’s all a massive risk. The chance of total loss is very high, and can anyone tell the difference between a company that will return you 100 or 1000 times your investment? I doubt it.
Confidence
Professional investors are notoriously fickle and short-sighted. We all are, for reasons that have much to do with our evolution. ‘Flight’ was a particularly effective technique that we find hard to shake off.
Investors are also faddy. Your teenage daughter’s crush on Harry Styles can last longer than some themes in the investment world.
As if being a start-up wasn’t volatile enough.
So government-backed schemes in which founders and investors have the same horizon such as IIF can be very helpful.
They provide confidence to private investors and although it may seem like things in the capital are pretty rosy at the moment, confidence is crucial for a functioning financial system and it can disappear quickly.
The lender of last resort
In fact the entire financial system is backed by what is known as a lender of last resort, a role administered by the Bank of England but ultimately sponsored by the government. Believe it or not, it has been wildly successful.
Being an entrepreneur in the 18th century would have been much harder: the boom and bust cycles were very short.
And let’s be clear, in the case of the IIF such segregation of investment cannot happen.
The Government raised money alongside private investors. Don’t quote me on this, but I’m pretty sure in a venture capital fund allocations cannot be divided arbitrarily between co-investors. Everyone gets an equal share.
The catch
Unfortunately though, the finance industry has a much more pernicious way of abusing government money, and that is fees. Layers and layers of them.
In the case of the IIF, the Government hired Hermes Private Equity to find four other managers to make the investments. If they choose so-called fund-of-fund groups, that could be as many as three layers of fees due.
To put this seemingly insignificant point into context take the example of Warren Buffet, widely regarded as the world’s greatest living investor.
He has compounded his firm’s money at 20% per annum, meaning that if you had invested $1,000 in his firm’s shares in 1965 they would have been worth $4.8m in 2009.
Had he charged typical hedge fund fees all this time, however, he would have pocketed a staggering $4.4m of that sum, leaving just $400,000 for investors.
Christmas bonuses all round then.
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