101687 CASE STUDY: DESIGNING A HYBRID VENTURE CAPITAL FUND, CROATIA Shanthi Divakaran Senior Financial Sector Specialist Investment Funds Group Finance & Markets Global Practice 09-09-2015 Croatia Hybrid Venture Capital Fund: Background Croatia • 4.3mn population; Member state of EU as of July 1, 2013 • Economy in recession for the prior 6 years following global financial crisis; Average unemployment rate > 20% in 2013 • Business environment ranks below average in region • DB ranking: 65/ 189; Difficulties in insolvency, enforcing contracts, protecting minority investors; getting credit World Bank Loan: • €20mn IBRD loan, to provide risk financing to SMEs/startups in sequential stages of innovation life cycle Euro • € 12mn Public/Private VC fund – Early commercialization stage (Plus 3.6mn management fees) • € 2.5mn Seed stage co investment fund – Administered by HAMAG-BICRO (Euro 30k – Euro 200k) • € 1.5mn Technical Assistance: overall implementation of program, including developing capacity of government; investors; investees; expert advisors for VC fund; M&E etc. Key Actors • Ministry of Entrepreneurship & Crafts; Ministry of Finance; HAMAG-BICRO: Croatian Agency for SMEs, Innovation & Investments; HANFA – Capital Markets Regulator 1 Why is the government setting up a venture capital fund? • Government intervention in venture capital is not unusual, and can expand the total pool of financing • Lack of risk financing undermines innovation ecosystem – prevents innovative ideas with commercial potential from reaching market • Early stage financing can have huge impact, but is consistently under-supported. • Academic research finds government VC expands total pool of financing for market as well as at enterprise level • GoC wanted to use VC as one of the levers to lift Croatia out of recession, along with addressing business environment issues • Focus on young knowledge intensive enterprises who support innovation-driven activities to help Croatia into sustained growth • But these firms were experiencing a funding gap that the private sector was not filling – current supply was less than demand • GoC wanted to create demonstration effect • No significant history of venture capital in Croatia; and unless the market is kickstarted, the market will not develop • Publicly supported risk capital initiative could help create this history, and create spillover benefits by attracting more VC funds • GoC needed to prepare for expected inflow of EU funds to support innovation and entrepreneurship • Croatia expected to receive funding for early stage financing from European Structural and Investment Funds • Government needed to prepare a framework to allow the absorption and effective use of the expected inflow of EU funds. 2 What are the key risks of government intervention in the VC ecosystem? • Government lack of savvy for venture capital investment. Select private manager to run VC fund. • Government may politically interfere in investments. Government must stay out of investment committee. • Crowding out private investors. Acknowledged gap in the market currently that the private sector is not filling; VC fund invests alongside private investors; and Project aims to ensure that size of fund is in line with demand for risk capital financing. 3 What are the key factors in designing a hybrid fund? LEGAL/ REGULATORY ENVIRONMENT CO-INVESTORS FUND MANAGER/ GOVERNANCE FUND DESIGN, LEGAL GENERAL PARTNER ARRANGEMENTS STRUCTURE, REGISTRATION & FEE STRUCTURE DEFINING THE TARGET INVESTMENTS INVESTMENT X INVESTMENT X COMMERCIAL VIABILITY FOR PRIVATE SECTOR INVESTORS/ MANAGER 4 What is the legal/ regulatory environment under which the Fund & Fund Manager would operate? • EU Alternative Investment Fund Manager (AIFM) Directive, which allows AIFMs to gain a passport to manage and market AIFs across EU, was transposed to the Croatia Alternative Investment fund Act and passed in January 2013. • Provides rules on permitted activities for AIFM, ongoing operation, guidelines on leverage; portfolio liquidity etc. • If registered in Croatia, AIFM needs to be authorized and supervised by HANFA • If registered elsewhere as an EU AIFM, fund manager needs to notify HANFA of intent to operate in Croatia • EU also issued 2013 regulation (EU Reg. 345/2013) for sub threshold AIFMs marketing VC funds • Does not need to be transposed into national law, as a regulation has immediate effect in all Member States • Sets out requirements on investment portfolio, techniques, and eligible investments – at least 70% of investments in young and innovative companies • Fund manager may decide to register as an EuVECA (European Union Venture Capital Fund) manager. • Fund would be registered in Croatia as a limited liability company in accordance with Croatia’s Alternative Investment Fund Act • Design of VC Fund has to be compatible with EU State Aid regulations on promoting risk finance • Key principle is that private sector financing must co-finance investments; and public sector financing must be capped. 5 Key features of Fund Design • Structured as a closed-ended, 10-year Euro-denominated fund, with option for 2-year extension • Consist of both public and private financing – GoC’s contribution of up to € 12 mn in equity is up to 60% of total fund • Expect two fund closes • First close, € 6mn from GoC and at least € 4mn from private sector. • Second close, up to € 6mn from GoC and at least € 4mn from private sector • Finance innovative SMEs with the locus of activity in Croatia through equity or quasi equity instruments. • Consolidated portfolio expected to have avg ticket size of € 500k. Maximum 10% of Fund invested in 1 investee (possible increase to 15%) • Managed by private fund manager selected through an international tender process. • Expected to make 10 – 15 investments. Initial investments are expected to be made within first 5 years of fund’s life; follow on investment in years 6-7. Must be fully exited over 10 years, with possible extension to 12 years. • Hurdle rate 6% •6 Investments must comply with WBG environment and social safeguards Defining the target investee • Investments in innovative SMEs and start-ups with locus of activities in Croatia • “SME” as defined in EU Regulation 651/2014 (General Block Exemption Regulation) • Enterprises which employ < 250 persons and with annual turnover <= € 50 million, and/or an annual balance sheet <= € 43 million (same definition as in EuVECA regulation) • SME within 7 years of operation from its first commercial sale • EU 651/2014 Regulation also defines “innovative enterprise” • Develop products, services or processes which are new or substantially improved compared to state of the art in its industry, and which carry risk of technological or industrial failure,, • R&D represents at least 10% of operating costs in at least one of the three years preceding investment • Sector neutral, although expect ICT, consumer/ computer electronics to be significant beneficiaries 7 Expected co-investors • Development Financial Institutions (e.g. European Investment Fund, EBRD, IFC) • Not interested in small single country funds, the market is too small. • EU’s European Investment Fund (EIF) already supporting the Western Balkans Innovation Fund (ENIF). This fund is to invest in countries across the region, including Croatia. • Local pension funds • Up to 15% of the net asset value of pension fund assets can be invested in units/shares of AIFs. • May acquire <= 20% of units/shares of a single AIF authorised in Croatia, other EU member state or OECD member. • Learning curve from experience co-investing with government on Economic Cooperation Funds. • Local insurance companies • Up to 10% of assets covering mathematical/technical provisions of insurance company can be invested in units /shares of AIFs. • New Croatia Insurance Act (to be in effect January 2016) aligns with Solvency II, a risk-based regime. 8 Hiring a private fund manager • Defining the criteria for a good Fund Manager • Blended global-local team: can raise funds from both international and domestic institutional investors; has local knowledge • Track record; Experience and skills of proposed team • Letter of intent from prospective investors; Committed capital from fund management company • Location of management team so that Fund can effectively invest in, and work with, local entrepreneurs in Croatia • Proposed investment strategy, potential pipeline, exit strategy • Level and structure of management fees • What is the process to hire – Competitive international tender process • Bids evaluated by an Independent Evaluation Committee of private sector experts selected under the Global Advisory Network, and a representative of HAMAG-BICRO • Committee provides a recommendation to HAMAG-BICRO Management Board • If selected Fund manager does not successfully constitute Fund within 6 months of being awarded bid, runner up selected • If no Fund Manager after two years, component cancelled • Procurement process should allow for selecting the most optimal structure for this PPP • Winning bid would be selected through ranking of both financial proposal and technical quality of bids • Mechanism expected to reduce info asymmetries inherent in process (such as cost of managing fund) and reveal cost the private sector is willing to take on, and required contribution from government to make fund viable. 9 Ensuring commercial viability of fund and private sector uptake • Why is a subsidy needed? • High risk and comparatively low expected returns from VC fund provide rationale for concessional finance, to increase private sector returns. • Overall VC Funds in emerging markets have earned returns of around 10%, low in light of risk and illiquidity. • Successful investments can pay 5-100x initial investment; however, < 20% of investments expected to earn high return. 30-50% of VC funds could lose all capital invested. • Absent public support for VC Fund’s management fees, economics of VC fund would be unfavorable • Size of VC fund is small, so costs of managing fund will be a higher proportion of amount invested. • 2% benchmark fee is too low to operate effectively • Designing subsidy • Management fees. GoC to contribute up to € 100K for cost of establishing Fund and up to € 3.5mn to cover management fees over first 5 years (in effect, lowering cost to private investors from management fees) in the following schedule designed to incentivize deployment of capital in years 1 – 5. • Year 1-2: Up to 2.5% of committed capital • Year 3-4: Up to 1.5% of committed capital and 1% of invested capital • Year 5: Up to 1% of committed capital and 1% of invested capital • Distribution of returns. Returns from the Fund will be distributed to public and private shareholders on a pro-rata 10 basis based on their investments in Fund. Governance Arrangements • Key governance arrangements • Fund manager solely responsible for investment and exit decisions through an Investment Committee constituted by Fund Manager (including principals and independent experts appointed by Fund Manager) • Advisory Committee comprised of a small number of voting reps of investors (including HAMAG-BICRO as government representative) and experts (funded by TA component). Responsible for overall oversight in line with original objectives of Project, the Operations Manual etc. • Governance documents outlined in Project Operational Manual and Articles of Association (shareholder agreement) as well as Management Agreement between shareholders and the fund manager 11 Select Risks & Mitigants • VC Fund invests in larger stage enterprises rather than startups. • Advisory Committee role in monitoring portfolio which is supposed to have an avg of € 500K in financing • If EuVECA manager, regulations require it to invest in qualifying investments to maintain passport. • Insufficient deal flow; difficulty exiting. • The first close is set at Euro 10mn. The management company start operating after this close. They will need to demonstrate pipeline of firms to invest in before raising $ for an additional close. • VC Fund can invest in companies willing to relocate to Croatia. • Government will continue to invest in R&D to boost the ecosystem. • Fund Manager to discuss exit strategy in bid. Global Advisory Network of experts to help with exit strategies. • Difficulty in finding good management company. Fund is free of political interference; subsidy offered to help with fund- raising 12