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Review of 2016 budget proposals to boost Venture Capital and SMEs

22 November 2015 06:30 pm - 0     - {{hitsCtrl.values.hits}}

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The budget proposals for 2016 have several initiatives aimed at developing Venture Capital (VC) and Small and Medium 

Enterprises (SMEs). 
Government’s decision to recognize the need to give a new lease of life to the ailing and highly disorganized VC industry is a timely decision. This is the third attempt by the state to boost VC in the Sri Lankan history. Interestingly, previous two initiatives were also associated with 
UNP administrations. 
In order to make sure that proposed measures will result in actual development in the VC industry, and thereby giving a boost to SMEs, policy makers must ensure effective implementation of these proposals. In implementing these proposals, government must take into consideration the lessons in the past, current local, regional, and global dynamics in VC and Private Equity (“PE”) space.  

Budget Proposals relating to VC and SMEs
 Out of the several proposals relating to VC and SMEs, perhaps the most relevant and important is the decision to set up a government backed Fund of Fund (FoF). Such government sponsored FoFs are common in developing and developed countries. Recently India also launched a similar FoF aimed to boosting investments into SMEs. Setting up of a FoF will no doubt have positive impact on in VC/PE landscape in the country, provided that the investment program of the proposed FoF is executed in line with internationally accepted norms. The proposal relating to the setting up of a FoF states that it will lend to VC funds. The usual practice is that FoFs invest in equity in a fund as investing in debt could create a mismatch in risk profiles in the VC fund. Nevertheless there are FoFs like the US government owned OPIC which lends to other funds.    
However, the proposed tax concession to VC firms is unlikely to be a significant and a relevant measure to boost VC. This could potentially block formalizations of currently disorganized VC activities. This is because at present investors who invest in VC/PE do not anyway pay tax on profits made from investments as capital gains are not taxed. Hence organizing such scattered VC activities into more formal VC programs is likely to force them to pay taxes. Because capital gains from VC exist in specialized VC firm are treated as normal business profit. 
This tax concession is unlikely to have any impact on attracting foreign capital. Because foreign funders prefer to invest in VC/PE funds through offshore vehicles domiciled in an established offshore financial center like Mauritius or Cayman Islands. This is not to evade taxes or to bypass local laws, but because of historical developments, and efficiency in establishing and administering VC/PE funds in such centers. Further, the proposed five-year tax concession period appears to be a mismatch, as a typical VC/PE fund has a life cycle more 
than 5 years.
Another proposal aimed at boosting VC and SMEs is the creation of a separate board in Colombo Stock Exchange (“CSE”) for SMEs. Potential impact and practicality of this proposal is also unclear – especially when there is no clear definition of a SME. Further, this proposal appears to be meaningless as majority of new listings in CSE are anyway SMEs. Out of the 26 companies listed in CSE since 2012, 15 companies were SMEs (at the time of listing and according to Central Bank’s definition 
of a SME).  
Creation of a separate board for SMEs, and possibly further relaxing listing rules for SMEs could only create a discriminatory basis for valuing such SMEs. 
This is because investors are likely to attach a risk premium for the “SME” label. Furthermore, further relaxing of listing rules to accommodate much smaller companies could actually have a negative impact on CSE. 
Although separate SME boards are viable in large markets such as India, due to Sri Lanka’s small size of the economy and stock market, separate SMEs boards are not practical.  

History of tax benefits to VCs and their impact 
The first policy-driven initiative to boost VCs was in 1990, when government offered tax concessions to VC firms and their invertors.  This resulted in establishment of seven VC firms by 1992, and all these firms were promoted by banks and financial institutions. Second policy-driven boost to VC included similar tax concessions through the budget in 2002. However, unlike in the previous occasion, second round of tax concessions did not result in setting up of new VC firms. 
Out of the seven VC firms established in early 1990s, only few exist today. Even the existing ones have significantly changed their core business and are not operating as a typical VC firm. Main reason for the decline of VC firms is the poor performance of investments they made (initially) thus depriving them from accumulating capital for further investment and to attract 
new funding.  
An assessment on the performance of the VC industry was carried out in 2000. This assessment was carried out by USAID which played a key role in promoting first fiscal incentives. This assessment showed that main reason for the failure of first generation VC firms was the lack of experienced managers of the VC firms, and adopting a typical “bank lending” approach in operating a VC firms. This report also highlighted that some VC firms made investments in very high risk companies without proper evaluations.    
However, there were many additional reasons for the poor performance of VCs in Sri Lanka.  Given below are several such reasons: 
Making unsuitable investments  
 When we analyze investments made by first generation VC firms, many investments were made in companies which lacked fundamental requirements for a VC investment (some types of businesses and industries are not suitable for VC investments). Many VC investments were made in companies suitable, for project financing. For example, some VC firms invested in projects such as prawn farming which are definitely not suitable for VC investments. 

Furthermore most of the VC investments were structured poorly and were not in line with basic principles in structuring a VC/PE investment. For examples, some investments were structured in a manner which encouraged promoters of companies to cheat VC investor.  
As a result many VC firms lost money or were unable earn a decent profit although some investee firms continued to perform 
reasonably well.  
 
Less developed capital market eco-systems   
In order for VC to be sustainable, an efficient capital market (“CM”) is essential. 
Due to the small size of the Sri Lankan economy, it is also important that the CM is well integrated with rest of the world. As a result of under-developed CM eco-system, some VC backed firms with good prospects could not secure additional growth funding to “graduate to the next level”. 
There were many very good technology businesses supported by at least one VC firms in early 2000 (during first internet boom). However, due to lack of further growth funding curtailed their growth, and many had natural 
death subsequently. 
One example of such unfortunate death is one firm which pioneered a technology where on-line shoppers could “fit on” wearable items by uploading in their photographs. Today, more than a decade later, on-line shopping has expanded as never before, and this technology is 
becoming popular. 
The local firms were obviously an early mover in this business, and could have become a major international firm if it secured second round funding or appropriate strategic partnership. Only a few local VC backed firms like Millenniums Information Technologies secured second round funding to grow further and become leading 
IT firms.
Recent developments in Sri Lankan CM are very encouraging for VC/PE. There is an increase in local and foreign investment activity in the strategic and financial investment space. Further increase in number of SMEs getting listed in CSE is also a very positive development.
 
Subdued corporate entrepreneurship   
For a VC/ PE investments to thrive, a good corporate entrepreneurial culture is imperative. Again, due to the small size of the local economy, it is important that local corporates are well integrated with the rest of the world to ensure sustainable growth.  
Many VC investors realize gains when their investee firms are being acquired by or merged with other firms. Unfortunately, due to the civil conflict, Sri Lankan corporate sector operated with subdued entrepreneurial spirit, and did not expand to its full potential. 
This environment reduced opportunities for smaller firms including VC backed SMEs. Moreover there were not many foreign firms interested in entering into Sri Lanka due to its perceived high risk associated with civil conflict.    
However, since 2009, there are very positive trends including growth in entrepreneurial culture. Sri Lankan businesses are fast being integrated with businesses of other countries. This is clearly seen through increase in Merger and Acquisition and buyout activities among local firms as well as with foreign businesses. Further there have been many foreign acquisitions of Sri Lanka businesses.  

Lack of funding 
Another major reason for lack of development in VCs is the lack of funding into formal VC/PE space. It is difficult to attract foreign funding for VC/PE unless sufficient level of local capital is deployed in (formal) VC/PE space, and there is adequate local expertise with track records. Sri Lanka’s case to attract foreign funding for VC/PE has many challenges due to other regional and emerging/frontier countries like India, Vietnam and Myanmar having many advantages over 
Sri Lanka.  
Even though there are local investors who have appetite and capacity to invest in (formal) VC/PE sector, they do not like to take a “passive” approach by investing through independent/ professional VC managers.   Investors in VC/PE funds must necessarily have many qualifying criteria. Commitment for long term and ability to tale a passive approach are two important criteria. 

Steps to ensure effective implementation of proposed policies 
Sometimes policy measures aimed at providing benefits to a target segment actually results in creating benefits to a 
different segment.
Hence it is the responsibility of the policy planners to make sure that actual benefits of proposed measure to boost VC and SMEs are channeled to deserving recipients. 
One recent example of policies aimed at benefiting one segment actually benefiting a different segment is the tax concessions given to unit trusts (or mutual funds). Tax breaks given to unit trusts were aimed at encouraging more retail investors (individual savers) by offering them higher return. However this initiative actually resulted in creation of large number of (fixed income) unit trusts which are operating as captive cash management schemes benefiting cash rich companies, wealthy individuals and fund managers. 
Funding from the proposed FoF must be channeled to deserving SMEs through genuine VC/PE investment programs. There are possibilities for misuse in implementing such investment programs. For example, is it is possible to use such investment programs to the benefit large corporates. 
VC funds could be set up simply as a way to subsidize (directly and indirectly) corporate investment programs as well as away to support growth programs of owned and/or related businesses. Another possibility is setting up VC fund by financial institutions to indirectly support their 
core activities.  
Given below are some points policy planner should consider in implementing the proposed FoF program: 

Provide funding through independent and professional managers  
VC is a very specialized business where persons engaged in this business must adhere to high professional standards, and retain ability function independently with high level of responsibility and integrity. 
Independently organized managers (which are not directly or indirectly linked to other corporates, banks or short term deal-makers) have capacity to align interest with investors and work towards betterment of SMEs. 
Independent managers are in a better position to secure funding from specialized foreign institutions which provide funds to VC/PE funds (foreign commercial investors do not back managers who are not independent). Recent developments in the VC/PE space in Sri Lanka also suggest that non-independent managers face constraints in executing investment programs effectively as they are unable to attract sufficient deal flow. 
Another fact to consider is to provide preference to local managers as opposed to foreign or foreign affiliated managers. Many foreign or foreign affiliated VC/PE managers have repeatedly failed to make progress in Sri Lanka. Many VC/PE firms with emerging/frontier markets backgrounds fail to make progress in Sri Lanka due to mismatch of their approach to Sri Lankan market. Further foreign managers lack commitment to long term development of VC/PE in Sri Lanka, whereas local managers are committed for long term development of VC.   

Refrain from overcrowding the market   
Another important point authorities must be mindful is not to overcrowd the market with too many VC firms. It is natural that many firms (new and existing) would want to float new VC firms to benefit from the proposed FoF. However, authorities much make sure that having too many VC/PE firms could disrupt emerging CM eco-system. 
Sri Lanka is a very small market compared to other established VC/PE markets, and hence it could accommodate limited number of firms. Growth in number of VC/PE firms should match the expansion of the economy. Too much competition could increase competition for investments and result in increased risk taking behavior. Furthermore too many players could encourage establishment high risk ventures (due to feely available capital) as well as encourage VC firms to invest in businesses with low 
growth prospects.    
(Indika Hettiarachchi is a PE/VC professional and is the founder of Jupiter Capital Partners.  He can be contacted via Indika.h@jupitercapitalpartners.com)
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