SECTION: CAPITOL HILL HEARING TESTIMONY

LENGTH: 2943 words

COMMITTEE: SENATE AGRICULTURE, NUTRITION AND FORESTRY

HEADLINE: 2002 FARM BILL

TESTIMONY-BY: DEBORAH M. MARKLEY, CHAIR, RURAL POLICY RESEARCH INSTITUTE

AFFILIATION: RURAL EQUITY CAPITAL INITIATIVE

BODY:
August 2, 2001

PREPARED STATEMENT OF

DEBORAH M. MARKLEY, CHAIR, RURAL POLICY RESEARCH INSTITUTE RURAL EQUITY CAPITAL INITIATIVE

before the COMMITTEE ON AGRICULTURE, NUTRITION AND FORESTRY UNITED STATES SENATE

Chairman Harkin, Senator Lugar and Members of this Committee, I appreciate the opportunity to appear before you today to discuss rural economic development issues for consideration in the next farm bill. Specifically, I want to focus on the importance of equity or venture capital in rural America. The availability of venture capital, risk capital from outside investors, is recognized as a critical ingredient for new business start-ups and business expansions. Yet venture capital markets are unorganized and often non-existent in rural communities (RUPRI Rural Finance Task Force, 1997). Filling this venture capital gap is an important component of any strategy to create a more entrepreneurial rural economic development policy in the U.S. Background

For the past three and a half years, I have served as Chair of the Rural Policy Research Institute's Rural Equity Capital Initiative, a research project funded by the U.S. Department of Agriculture's Fund for Rural America. The research team, including Dr. David Barkley, Clemson University, Dr. David Freshwater, University of Kentucky, Dr. Ron Shaffer, University of Wisconsin-Madison, and Julia Sass Rubin, Harvard University, completed case studies of venture capital institutions and programs across the country. These institutions, some successful and others not, provide insights and lessons learned that can guide future consideration of how best to encourage expanded venture capital access in rural America.

The most significant capital gap faced by rural entrepreneurs and businesses is the lack of equity or venture capital. In a paper presented at the Federal Reserve Bank of Kansas City's 1998 conference on Equity for Rural America, Brophy and Mourtada show that entrepreneurial firms within rural America received a very small share of equity capital financings between 985 and 1998. It should be noted that this period was associated with increased venture capital investments and IPO (initial public offering) activity for the U.S. as a whole.

Nationally, venture capital investments are concentrated in a small number of regions and industries. According to the 1999 PriceWaterhouseCoopers Moneytree survey, 67.1 percent of U.S. venture capital investments were in four states (California, Massachusetts, New York and Texas), and 91.0 percent of the investments were in technology-based companies, including Internet related businesses. The distribution of venture capital investments across states indicates that many regions of the country are relatively underserved by traditional venture capital institutions. For example, per capita venture capital investments for the United States were approximately $143.00 in 1999; yet only six states exceeded the national average (Massachusetts, $597.00; California, $522.00; Colorado, $335.00; Washington, $215.00; New Hampshire, $199.00; and Connecticut, $159.00). Alternatively, 24 states had per capita venture capital investments of less than $20.00, or less than one-seventh of the national average. These states were concentrated in the Plains, Midwest, and South Central regions.

The lack of well-developed rural venture capital markets may be a response to limited good investment opportunities. However, it also may reflect market failures that result from imperfect information and high transaction costs. Specifically, traditional venture capital institutions do not aggressively seek investment opportunities in small urban areas and rural communities because of:

Limited Deal Flow. The economic base of most rural areas is relatively concentrated in low-tech, slow-growth sectors. These sectors do not provide the numerous investment opportunities with the high rates of return favored by traditional venture capital funds. As a result, even rural firms in sectors favored by traditional investors do not have access to venture capital.

Higher Costs Per Investment. Limited and spatially dispersed deal flow results in high search costs for identifying prospective deals and higher time and transportation costs for conducting due diligence and monitoring investments. As a result, traditional venture funds are not willing to look outside their established urban markets, even if some good investments exist in rural America.

Limited Opportunities for Exiting Deals. Many businesses in rural communities are family owned with the goals of transferring ownership to the next generation and/or maintaining the current business location. Such goals limit exit strategies and reduce the attractiveness of investments to traditional venture capitalists. Even high tech businesses in rural areas may be tied to the local area, by family or lifestyle concerns, in ways that limit exit opportunities. Lack of Favorable Local Business Environment. Rural areas offer relatively limited business infrastructure and human capital to facilitate management of new companies, particularly firms that may require more sophisticated services such as patent attorneys. Thus venture capitalists may have the additional expense of acquiring business services and managerial and technical personnel from outside the area, or providing extensive technical assistance to existing company management.

The Importance of Nontraditional Venture Capital Institutions for Rural America

To meet the venture capital needs of rural businesses and entrepreneurs requires the creation of nontraditional venture capital institutions that represent an adaptation of the traditional model to the constraints of investing in rural markets. As part of the RUPRI research project, 23 case studies of nontraditional venture capital institutions or programs were completed between July 1998 and November 2000.* The institutions range from a community-based angel investor group to a statewide, publicly supported venture fund; from a community bank Small Business Investment Company (SBIC) to a statewide private SBIC with community bankers as investors; from a community development venture fund operating in depressed Appalachian counties to a community seed fund in the heartland.

All these institutions have one thing in common. They are nontraditional venture capital institutions that reflect important innovations or adaptations of the traditional venture capital model. These institutions differ from more traditional venture capital funds because they:

Operate outside of regions and industrial sectors where venture capital investments are concentrated such as in rural communities and non-high tech industries.

Expect a financial return on investments that is less than the annual return anticipated by traditional venture capital institutions.

Generally operate with a geographic focus or geographic restrictions such as a specific community, state, or region.

May have a dual bottom line of acceptable financial returns and social and economic benefits to the service area. Thus, nontraditional institutions are capitalized by funding sources that value economic and social returns in addition to financial returns, such as state government, local government, nonprofit foundations, Community Development Financial Institutions Fund, Small Business Administration, commercial banks, pension funds, and civic-minded individuals.

Lessons Learned and Policy Implications

While nontraditional venture capital institutions are making investments in small urban centers and rural places, the industry is relatively new and, as a result, is not widespread across rural America. However, these innovative institutions provide important lessons for policy makers considering ways to encourage the creation or expansion of nontraditional venture capital institutions in rural America.

Lesson One. There is no single best model for establishing a nontraditional venture capital institution. The RUPRI study considered a variety of institutional types including publicly funded and managed programs, publicly funded and privately managed programs, public incentive or tax credit programs, and privately funded programs including community development venture capital institutions. Some models were independent, stand alone funds while others were established as part of existing organizations. Each alternative has advantages and disadvantages that must be considered. The choice of a model depends on the goals of the program founders, whether they are focused on financial returns or economic development impacts; the funding sources available, whether private or public; the existing venture capital infrastructure; the specific industries or stages of business that are targeted; and the current political environment, whether there is public support for the creation of venture capital programs or institutions.

Policy Implication: Any federal policy encouraging the creation of nontraditional venture capital institutions should recognize the limitations of a "one size fits all" approach. The federal role should be to support innovative institutions at the local, state, and regional levels that have a well-defined business plan for providing venture capital to rural businesses and entrepreneurs.

Lesson Two. There are important advantages to a privately managed venture capital fund, including management decisions that are insulated from political influence, a salary and incentive package attractive to experienced fund managers, and greater opportunities for attracting private capitalization or co- investments with other private funds. However, some form of public involvement, either the provision of capital or incentives, may be necessary to create a nontraditional venture capital fund with a primarily rural focus. Public funding can help to offset the higher operating costs many nontraditional funds face because of the higher costs of operating in rural places and the greater technical assistance needs of rural portfolio companies and entrepreneurs. However, there may be a trade-off between private management's focus on rate of return and the public sector's interest in economic development returns from program investments.

Policy Implication: Public support of privately managed venture capital institutions provides a way of tapping the advantages of privately managed funds while leveraging positive economic development impacts through targeted, restricted public investments and incentives.

Lesson Three. To get increased venture capital into rural America will require explicit targeting to rural areas. However, imposing a rural or strict geographic constraint on the operation of a venture fund means that other constraints need to be relaxed. For example, a strictly rural fund may need to be capitalized by patient capital, investors that do not expect to achieve high levels of return over a relatively short time horizon. These investors may include the public sector, foundations, or individuals motivated by social returns. In addition, rural- focused funds must operate to overcome both limited deal flow and lack of a supportive business environment. As a result, higher operating costs are likely and must be factored into the design of a rural-focused venture fund.

Policy Implication: Federal policies to increase venture capital access in rural America should be explicitly targeted to rural areas. At the same time, public policy should encourage and reward a regional or interjurisdictional approach to the creation of nontraditional venture capital institutions. While a single rural community may be able to create a small angel network, a multi-county region or a statewide angel network is likely to face fewer operating constraints, have access to greater deal flow and, as a result, have a greater likelihood of success.

Lesson Four. Establishing a nontraditional venture capital institution is a complicated, time consuming, and expensive process. This process includes analysis of the market, estimation of potential deal flow, identification of potential investors and partners to provide technical assistance, consideration of alternative models for the institution, and identification of the fund management team. Venture fund managers estimate that one year and $300,000 - $400,000 is required to complete this process. For some organizers, such a capital commitment presents a significant obstacle to the creation of a nontraditional venture capital institution.

Policy Implication: One means of federal support for the creation of venture capital capacity in rural America is through the provision of grants to cover the start-up costs associated with establishing nontraditional venture capital institutions.

Lesson Five. Successful nontraditional venture capital institutions generally shared the following characteristics:

A skilled management team was rewarded through an appropriate incentive structure recognizing sound investment behavior that achieved institutional goals.

Adequate resources were devoted to deal flow development and/or creation.

Capitalization of the fund was optimal to provide for a diverse portfolio and follow-on investments.

Managers gave significant, but not always primary, attention to fund rate of return to maintain the long-run sustainability of the program.

Fund managers conducted rigorous due diligence prior to investments and adequate technical and management assistance post- investment.

Fund was structured to minimize political interference in investment decisions, even when public capital was used.

Policy Implication: To encourage the creation of new nontraditional venture funds in rural America, public policy should reinforce these success factors. Public support should be directed toward existing or new institutions that:

Have devoted the time and resources to identifying and developing deals in their rural regions.

Have strong, experienced managers capable of investing in and providing support to rural businesses and entrepreneurs.

Operate within the rural environment, permitting close contact and interaction with portfolio companies.

Give significant attention to fund sustainability while targeting resources to rural businesses.

Concluding Comments

In conclusion, Mr. Chairman, one part of a strong rural economy is a dynamic, entrepreneurial small business sector. Future rural economic development policies must recognize the importance of the small business sector, both farm and nonfarm, to rural communities and reward innovative, entrepreneurial strategies to grow and sustain this sector. While access to venture capital will not ensure the success of rural businesses and entrepreneurs, its absence presents a significant constraint on the growth prospects of these rural enterprises.

While the impetus for creating rural venture funds is likely to come from the local level, the federal government can play a supportive role in this process. This federal role may be direct or indirect. The federal government can be involved in the creation of nontraditional, rural-focused venture capital funds through direct public investment in partnership with private investors and managers. Since many nontraditional venture capital institutions must rely on patient sources of capital, expanding or maintaining federal financial support for these initiatives is one way to support the development of new or expanded rural venture capital investment activities. The Community Development Financial Institutions (CDFI) Fund is an ongoing federal program that provides support to community development financial institutions. Several of the funds included in the RUPRI study received CDFI grants to support their deal flow development and technical assistance activities. The New Markets Venture Capital Program is another federal program that has the potential to support the creation of new venture capital capacity in rural America.

There is also an indirect federal role through programs that support the start-up process, deal flow development and technical assistance activities of nontraditional venture funds. One public policy option is to establish a fund that can make grants to cover the costs of this process. Without such a fund, smaller rural areas will be less likely to undertake the rigorous start- up process and will either (1) decide against pursuing the creation of a venture fund without adequately investigating the potential or (2) jump into the creation process without doing the groundwork necessary for success. Supporting this start-up process would help encourage the thoughtful creation of rural venture funds.

Local communities, regions and states have already taken the lead in designing innovative models for nontraditional venture capital institutions that can overcome the constraints on venture capital investing in rural America. The RUPRI study has identified the lessons learned from these programs. Federal support of these efforts, both direct and indirect, is a vital component of the set of policy options needed to promote economic development throughout rural America.

Thank you, Chairman Harkin, Senator Lugar, and Members of the Committee, for the opportunity to share these policy ideas with you today. I would be pleased to share more detailed information from the RUPRI study with you and your staff if desired. I commend your consideration of these innovative rural economic development policies as part of the next farm bill.



LOAD-DATE: August 8, 2001