Gentlemen:
You
unfortunately have misconstrued the structure and operation of the Iowa
Fund
of Funds, part of the new Iowa Capital Formation Act recently passed by
the
Legislature. You apparently believe
that this fund will be similar to
that
of a certified capital company, known as CAPCO, a dramatically
different
approach which was passed by the Iowa Legislature two years ago
and
vetoed by the Governor for the very reasons you cite. Your newsletter to
clients
was quoted as noting:
"In
other words, the investors in the FOF get the upside, but the state
absorbs
the downside - and even some of the upside, to the extent that there
is
a positive return lower than the amount set by the certificate. In other
words
- heads, the investors win, tails the state loses."
In
fact, you fail to notice that, due to the tax credit which provides full
repayment
security to Iowa taxpayers purchasing the preferred stock of the
Fund
of Funds, their required rate of return will be similar to that on
medium-term
governmental debt instruments. In
Oklahoma, where this plan was
first
implemented, the return on their Fund of Fund instruments (circa 1995)
was
approximately 8 percent. In today's
environment, it will approximate 5
to
5.5 percent. However, the average
long-term rate of return on
investments
in venture capital limited partnerships has been in excess of
fifteen
percent over an extended period.
Oklahoma experienced a 19 percent
positive
return during the five year period from inception through 2001.
The
Iowa Seed Capital Corporation, under its last management team,
experienced
approximately 15 percent compounded annual return. The
difference
between what is due the investors in the Fund of Funds (i.e.,
5.5%)
and the net return on the Fund's investments in VC limited
partnerships,
expected to approximate 15 to 20 percent over their lifetimes,
will
be retained by the Fund of Funds and be used for two purposes: first,
to
be reinvested in additional VC partnerships, and second, to redeem
outstanding
preferred stock in the Fund of Funds so that it becomes
self-supporting,
without the need for tax credits, once the credits expire
after
twenty years. At the end of fifty
years, the entire net assets of the
Fund
of Funds revert to the General Fund of the State of Iowa.
As
a result, appropriate compensation-for-risk-assumed is in fact given to
the
State, the grantor of the contingent tax credits. For what is likely to
be
zero cash outlay, the State of Iowa, (at the end of the FoF lifetime)
receives
all accumulated net profits above a nominal return in the range of
5.5%. Of course, the probability of this occurring
is directly related to
the
skill sets of the VC managers selected to invest the funds. Because VC
historical
returns are in fact measurable and venture managers' skills may
be
examined in detail, and because good managers tend to have consistent
track
records, the Fund should be able to select those managers able to
deliver
above-average results. Hence, the Fund
can improve its ability to
deliver
stellar returns to the State (the residual legatee) by carefully
selecting
and supervising its venture capital limited partnership managers.
It
will do so through the judicious selection of a skilled, experienced
"gatekeeper"
fund allocation manager, a common practice in the venture
industry.
I
hope that this clarifies the operation of this fund. Because your
newsletter
is disseminated to a variety of clients who have less insight
into
this new bill and may likewise confuse it with a CAPCO, I also hope
that
you will publish a correction by email so that your clients are not
misled
by the intent and operation of the new statute.
As
to your comments about tax efficiency, you are quite correct in noting
that
many investments by venture fund limited partnerships may be "tax
inefficient"
for either Iowa or federal purposes because of the form of
organization
adopted by their investee companies.
Subchapter S is
unavailable
to most VC-funded firms because the issue of a preference class
of
shares will cause an automatic conversion to C. In such cases, tax
efficiency
is traded for the benefits of a more complex capital structure.
Limited
liability companies and partnerships are increasingly being used to
avoid
the limitations of S while preserving pass-through advantages, and you
rightly
point out that they do not benefit from the apportionment changes in
Iowa. However, any LLC or LLP seeking equity
capital in public markets will
generally
convert to a C form. Despite all this, one of the least concerns
in
making a venture investment is the tax status of the entity: most
investees
are loss-making or on carryforward status through the point of
liquidation
by the fund. The fund itself, being a
pass-through entity,
passes
its capital gains and other attributes through to its partners, whose
status
in many cases is tax exempt. For all of
these reasons, your point is
therefore
only of academic or technical interest and bears little relation
to
the needs or actions of venture capital partners or the Fund of Funds.
Please
contact me with any questions.
Best
regards,
Stephen
Ringlee
Ames
sringlee@netins.net