Office of Economic Development’s Response to
“The Colorado CAPCO Program: An Analysis” by The Adams Group, Inc.
01/27/2004 — Colorado OED Staff, State of Colorado
Office of Economic Development’s Response to
“The Colorado CAPCO Program: An Analysis” by The Adams Group, Inc.
January 21, 2004
The Adams Group, Inc. prepared an analysis of the CAPCO Program on behalf of the Growth Capital Alliance. The Growth Capital Alliance is a CAPCO support association with primary backing from the CAPCOs. The Office of Economic Development received the report, dated December 23, 2003, on January 15, 2004. OED reviewed the report and found it to be significantly flawed as indicated in the following responses to the report’s major conclusions and statements. It is important to note that The Adams Group, Inc. report relies on information primarily provided by CAPCOs, trade associations supporting CAPCOs, or obscure and unpublished studies.
“History of the CAPCO Program” Section
· Report Conclusion
“By allowing insurance companies to claim tax credits for qualified investments in certified CAPCO funds, the state generates a large pool of otherwise unavailable investment capital to be invested in small businesses across the state.”
· OED Response
Through the CAPCO program, insurance companies make a loan to the CAPCOs, and the CAPCOs use the loan funds and the state’s tax credits to guarantee repayment of the loan to the insurance companies. There are alternative models that would provide such investment capital at a lower cost. The October 2003 Report of the State Auditor indicated that “… extensive research has been conducted on the costs and benefits to state governments from this form of venture capital. Research indicates that CAPCO Programs are the most inefficient means for a state to raise venture capital.”
· Report Conclusion
The table included in the “History of the CAPCO Program” concludes that a specific number of jobs have been created/retained in ten states as a result of the CAPCO program. This table cites as its source the Growth Capital Alliance and the October 2003 Report of the Colorado State Auditor.
· OED Response
OED’s research reveals significant differences in the numbers of jobs created/retained. For example, the table states that 875 jobs were created/retained in Florida; however, Florida’s 2002 annual report indicates a negative 153 jobs attributed to this program. The table states that 1,561 jobs were created/retained in New York; however, New York’s 2002 annual report indicates an increase of 38 jobs due to the program. Moreover, New York’s annual report concludes that the program’s goal of generating jobs has not been met. The State of Colorado’s Legislative Audit Committee (LAC) report dated October 2003 stated that inconsistencies were found with the data self-reported by the CAPCOs. Also, as stated in the State of Colorado’s LAC report, “Finally, the net gain in jobs may not solely be attributable to CAPCO financing.” The audit report also stated, “ In several instances, the CAPCOs’ investments represented 5% or less of all investments received.” Other states have identified similar concerns.
· Report Conclusion
The table also includes the amount of capital raised for the program in nine other states.
· OED Response
What the report omits are the efforts made by a number of these state to stop funding for the program or to significantly overhaul it. For example, Florida has stopped its next allocation of funding. Wisconsin is making efforts to revamp the program. Other states have made and are making attempts to stop or significantly overhaul this program.
“Players in Colorado” Section
· Report Conclusion
The report states that, “All of the CAPCOs interviewed said that fees only cover the actual costs of doing business and are not the motivation for participating in the program in Colorado.”
· OED Response
The fees allowed under this program are significantly higher than those allowed by traditional venture capital fund programs. The CAPCO program allows an annual 2½% management fee, 2½ % for annual operating expenses and unlimited formation fees. Unlike traditional venture capital funds, which are typically allowed 2½ % of the amount available to invest in businesses, CAPCOs can take 5%+ of the amount received from the insurance companies. This means that on an annual basis CAPCOs are allowed to take 5%+ on the full $100 million instead of the $40 million they have to invest. A venture capital company would only be allowed to take 2 ½% of $40 million. Finally, a traditional venture capital fund would return the state’s $100 million investment if their investments were successful, where CAPCOs will keep all remaining funds plus the 5%+ fees allowed on an annual basis.
· Report Conclusion
Wilshire, Colorado Partners, LLC, one of the CAPCOs, maintains that it is assisting entrepreneurs with security in the form of salary, equipment and space, as well as incentives and equity participation, while the entrepreneur builds the business. Wilshire also indicates that its investments are focused on product lines where its parent company, Newtek Business Services, Inc., also has expertise.
· OED Response
OED believes that the benefits to the entrepreneur are minimal compared to the benefits received by Wilshire/Newtek. Wilshire uses the CAPCO funds as a source of free capital to expand its parent company’s product lines and meanwhile is allowed to take fees for making these investments. Wilshire has a very significant ownership interest in the companies it funds. Although OED does not believe that this type of use was intended by the legislature, it should be noted that this is an allowable use of funds under the current CAPCO program.
· Report Conclusion
The report states that, “About half of the companies funded received seed capital or first round, early stage funding from the Colorado CAPCOs.”
· OED Response
Based upon information submitted to OED from the CAPCOs, OED concludes that 67% of the equity investments made by the CAPCOs are second round or later stage equity. Even if you were to accept the classifications assigned in this report at face value, it should be noted that Wilshire’s investments are labeled as “seed/early stage” and account for $3.9 million dollars or 41% of the total investments labeled as “seed/early stage”.
· Report Conclusion
The report maintain that, “If a CAPCO investment failed and generated negative publicity for its insurance company investors, the impact on their reputation for investing the policyholders’ premiums would be seriously damaged.”
· OED Response
Whether or not a CAPCO’s investment is successful, the CAPCOs have developed a separate, guaranteed loan repayment structure that ensures that the insurance companies will be fully repaid. Further since insurance companies do not control investment decisions made by CAPCOs and are not relying on this source for repayment and since regulators for insurance companies have determined that these investments meet their surplus and safety criteria, it is highly unlikely that insurance companies’ reputations would be impacted.
· Report Conclusion
The report concurs with OED that the program was oversubscribed by $354 million.
· OED Response
This amount of oversubscription clearly indicates that insurance companies consider this program very lucrative, thus providing the state with leverage to structure a more cost-effective program. In all times, but even more so in these economic times, it is important for the state to increase the cost-effectiveness of all of its programs when possible.
“How the CAPCO Program Works” Section
· Report Conclusion
“The initial cost of the program to the state is quite low. In Colorado, no tax credits were given during the first two years of the program.”
· OED Response
The initial cost of this program is actually high. Because tax credits are not used for the first two years, it appears on the surface that the initial program cost to the state is quite low. However, the loan agreements between the CAPCOs and the insurance companies ensure that the insurance companies receive payment/compensation for this two-year delay. Moreover, the CAPCOs provide additional funding to the insurance companies to compensate them for this delay. This further reduces the amount of funds available to invest in Colorado businesses.
· Report Conclusion
The report concludes that the program’s ultimate success will be determined by whether the jobs and revenue that flow from it more than offset the foregone tax revenues and their alternative uses.
· OED Response
OED has never questioned whether there will be some economic benefits from the current CAPCO Program (as noted briefly in the report) but has questioned at what cost. While it may be too soon to determine overall results, it is not too soon to determine that the CAPCO program is very expensive and should be replaced with a more cost effective program. Such a program will continue to provide jobs and revenues to the state, but will dramatically improve the current program by mandating lower fees, returning the $100 million invested to the state as well as a negotiated percentage of profits if the investments are successful.
· Report Conclusion
The report states “However except for that brief technology bubble, a very small percentage of US venture capital funding flows to Colorado, generally from .5%-2% (Appendix F). What is lost in the aggregate data is the fact that in a typical quarter, most of the money goes to a small number of large deals. Of the $129.9 million invested in Colorado in the third quarter of 2003, for example, 57% went to just two companies.”
· OED Response
It should be noted that the copy of the report submitted to OED and a copy found on the internet did not contain Appendix F for analysis by OED to address such comments found in this section. The CAPCO model originated in Louisiana, a state that in 1990 had $0 of venture capital (from the 1992 CFED Report Card for the States), and tied with 10 other states for 40th in that measure. These states are referred to as “flyover states” in the industry – they lack the critical mass of companies of interest to venture capital investors and thus receive no funding. By 2000, Louisiana had moved up to 33rd, as reported in the 2002 CFED Report Card for the States, certainly an improvement from 40th, but still in the bottom third. Colorado is clearly not one of those states. Colorado ranked 10th in terms of total venture capital investment investment and 3rd in venture capital investment per worker. When measures are standardized to a per capita measure, Colorado ranks even higher. Colorado has consistently ranked in the Top 10 states for venture capital investment. Sources reviewed included:
§ 2002 Venture Capital statistics – MoneyTree Survey, Investments by State, Jan. 2003
§ Venture Capital as Percent of GSP – New Economy Index 2002, Progressive Policy Institute, Washington, DC
§ Venture Capital Dollars per Worker – 2002 Development Report Card for the States, Corporation for Enterprise Development, Washington, DC
§ Venture Capital per Capita – State Competitiveness Report 2002, Beacon Hill Institute, Boston, MA
Finally, the report provides a one quarter example snapshot and indicates 57% of $129.9 million in the quarter alone was invested in two companies but does not provide a complete analysis on where the remaining 43% or approximately $56 million in the third quarter was invested or an analysis of a series of quarters.
· Report Conclusion
In the report’s “CAPCO Funding Mechanism” sub-section, it is stated that a bond investment is analogous to the CAPCO program in that investors receive interest payments and repayment of their full principal.
· OED Response
Under the CAPCO program, the state provides $100 million in tax credits (foregone revenues to the state) to CAPCOs. The CAPCOs obtain a loan from the insurance companies – and use the tax credits and a significant portion of the loan funds to fully repay the insurance companies. The only significant “investor” is the State of Colorado, which never receives its principal or interest, as typical investors would expect per the report’s bond analogy.
· Report Conclusion
The report states that the CAPCOs structure their loans in such a way as to guarantee their ability to repay the $100 million to the insurance companies. The report further states that the CAPCO structure provides an extremely safe investment for insurance companies. Numerous mentions are made of a 5.9% annual return to the insurance companies, which is compared to extremely safe investments in U.S. government securities that paid 5.2% and AAA corporate securities that paid 6.8%. The report barely mentions that a higher rate may be negotiated or that an additional percent of profits from successful investments may be provided.
· OED Response
It is obvious that the structure of these investments is extremely safe. However, information provided to OED by CAPCOs reflects negotiated rates with insurance companies as high as 9% to 10% in addition to sharing additional percentages of profits. Again, the oversubscription by $354 million dollars for this program is clear evidence of the lucrative nature of this program for insurance companies.
· Report Conclusion
The report addresses costs of the CAPCO program in various places and then states that $18,147,255 had been distributed to Colorado companies as of December 2003.
· OED Response
The report gives the impression that the costs of approximately $59 million ($44.3 million for repayment to the insurance companies, $11.3 million for formation of the CAPCOs, and $3.9 for additional CAPCO expenses) should be compared to the $18,147,255 distributed to Colorado companies. In fact, the $59 million in costs are as reported as of December 2002 and does not include additional expenses that have been incurred by CAPCOs through December 2003—the date for which the amount of distributions to Colorado companies was provided.
· Report Conclusion
“Not all CAPCOs are taking the full 2.5% management fee (typical in the venture capital industry) allowed by the legislation.
· OED Response
As stated earlier, the CAPCOs are allowed to take up to 5%+ of the $100 million instead of 2.5% of the $41 million that is actually available for investment in Colorado businesses. Standard venture capital funds would allow 2.5% of the $41 million. In essence, the CAPCO allowable fees are more than 4 times what a standard venture capital fund would allow. Further, the 2.5 % management fee is only one component of what the CAPCOs are allowed to take for expenses as described earlier and does not represent the total amounts generally taken by CAPCOs.
In addition, the CAPCOs will keep all remaining funds in this program due to flawed distribution language in the current CAPCO program—unlike a traditional venture capital fund which would repay the state’s investment and share profits with the state (in addition to the state getting other economic benefits). For the CAPCOs that stated that they may not have taken the cash out yet but are accruing such expenses, there are no restrictions in the current CAPCO program to prohibit them from taking these funds as needed. And it should be noted that the CAPCOs’ agreements with the insurance companies may be amended at any time by mutual agreement between the insurance companies and the CAPCOs.
· Report Conclusion
”There is another piece to the picture…. The Colorado program limits a CAPCO’s investment in a single portfolio company to 15% of its capital…. Successful companies often require several rounds of financing. No venture capitalist wants to chance being excluded from the second or third round of financing because it is up against its 15% single company limit. The dilution this would cause has very negative economic ramifications.”
· OED Response
Already 2 CAPCOs have reported to OED that they have committed the maximum allowable amount, which is 15% of the CAPCOs capital or approximately $3.3 million each, to two seed/early stage investments in the first round of financing. It appears that additional rounds of financing are not anticipated by the CAPCOs for these projects and the CAPCOs are not concerned with the very negative economic ramifications described above.
· Report Conclusion
”There is one final piece to understanding the CAPCO program… But, the Colorado program allows no profits to be distributed until the entire capital allocation has been invested in Colorado companies.”
· OED Response
The Colorado program, meaning the legislation for this program, never mentions profit. CAPCOs may use the profits from this program for any purpose at any time and remain in compliance with the legislation.
· Report Conclusion
“Furthermore, the legislation requires that 30% of allocated capital be invested within three years and 50% within five years. This means that some of the initial investments must pay off quickly so that the money can be reinvested, which has encouraged some short-term debt financing rather than the longer term equity financing the CAPCOs would prefer.”
· OED Response
Approximately 50% of the CAPCOs’ investments have been in the form of short-term debt financing. The significant amount of funds that have to be set-aside initially to repay the insurance companies results in the CAPCOs providing short-term financing instead of the anticipated venture capital investments—just to meet the specific investment requirements (30% & 50%) in the legislation. Alternative models would provide the capital necessary to make true venture capital investments in Colorado businesses—as anticipated—and as the CAPCOs would prefer as stated in the report.
“The Economic Impact of CAPCO” Section
· Report Conclusion
The report states that 162 direct jobs have been created at CAPCO funded companies. Additionally, the report indicates that state income taxes paid for the 162 jobs appear to be roughly $234,000. From these numbers, the report extrapolates additional benefits to accrue to the State of Colorado (from induced and indirect jobs).
· OED Response
The October 2003 Report of the State Auditor noted inconsistencies in the job data provided by CAPCOs, ranging from CAPCOs reporting different employment data for the same company to no provisions made to differentiate between full-time, seasonal or part-time employees to the percentage of employees that should be attributable to CAPCO financing when the CAPCO financing is a minimal percentage of funding received by the company. OED staff has found similar inconsistencies in job data that has been submitted by the CAPCOs.
The report relies on projected increases in employment (direct, indirect and induced) over the next 5 years to quantify the economic impact of the CAPCO program. However, various states have not experienced these types of results. For example, Florida’s 2002 annual report states a negative 153 jobs created after 3 years and New York’s 2002 annual report states 38 jobs created after 4 years.
While we cannot predict the future, OED believes that the experience of other states as reported in their annual reports should be an important factor. Regardless of these findings, OED has always acknowledged that there will be some economic benefit from the CAPCO program but has questioned at what cost to the taxpayers. Alternative program models would have similar economic benefits but at less cost to the taxpayers.
“Common Misunderstandings of the Program” Section
· Report Conclusion
”According to reports from Growth Alliance Capital, Edward H. Robb and this study, the six states with funded CAPCO programs all have had direct job gains – 19,000 jobs in over 315 companies receiving funding.”
· OED Response
This conclusion is not supported by reports obtained from other states. The Growth Capital Alliance is a CAPCO support association with backing primarily from the CAPCOs. OED staff has not been able to obtain a copy of the Edward H. Robb study as of this date for analysis purposes.
· Report Conclusion
According to a study by Jason Heng a graduate student in Economics at the University of Denver, the net tax revenues to Colorado from the first round of CAPCO financing are estimated to be $42 million over 15 years.
OED Response
The basis for this conclusion is supported by reports obtained from Advantage Capital Colorado Partners, one of the CAPCOs. The statistics are based on unconfirmed job numbers, and projections are based on a very best case scenario. It is highly unlikely that continued growth would match the initial job growth numbers even if the numbers can be confirmed. Heng’s study listed the direct job growth number as 343 not the 162 as earlier reported in the Adam’s study. Finally, it should be noted that Heng’s study is not listed as a published study at the University of Denver.
· Report Conclusion
”According to data from Thompson Financial Venture Economics, Colorado CAPCOs are deploying capital faster than the national average for venture capital funds. For all funds founded in 2002, 7% of capital was deployed from 1/1/92 through 3/21/03. For Colorado CAPCOs, 13.1% of funds were deployed in the first 14 months of the program.”
· OED Response
The report previously mentioned that 75% of the venture capital funds formed in Colorado in 2002 were CAPCOs, accounting for 61% of the new capital committed to such funds. Timing was certainly fortunate in 2002 for the CAPCOs in that the state made $100 million dollars in tax credits available which allowed them to form their funds in a year in which the market in general had declined and many traditional venture capital funds had already raised large sums of money. And traditional venture capitalists tend to create much larger funds than that of the CAPCOs and if this is the case, then it is not surprising that CAPCO’s percent of deployment would be larger when compared to much larger funds that may have had very significant dollar investments but a smaller percent of their fund size. Further analyses of these statements are needed.
· Report Conclusion
”Several companies interviewed for this study reported that the CAPCO investment was a necessary condition of obtaining additional financing.”
· OED Response
Out of 12 companies interviewed for the report, OED believes that the use of “several companies” speaks for itself about CAPCO investments being a necessary condition of obtaining additional financing. Colorado venture capital companies have reported to OED that a significant investment is typically required in order for any venture capital fund (or CAPCO) to be considered a lead investor and one that motivates other venture capital funds to invest their funds as well—and significant would not typically be a 1-5% CAPCO investment out of a total investment round.
· Report Conclusion
”With no prospect of a liquidity event, these businesses are not a good match for venture capital. This has caused the CAPCOs to encourage their portfolio companies to locate in counties such as Elbert and Clear Creek, which are contiguous to the Denver metro area, in order to meet the letter if not the spirit of the rural requirement.”
· OED Response
The rural component of the CAPCO program was a significant factor in obtaining legislative support for this program in 2001. The nature of projects in rural areas should not have been a surprise for any of the CAPCOs—who committed to make these investments in order to gain support for the program as a whole.
In the “How the CAPCO Program Works” section of the report, it states that CAPCOs must make short-term debt financing available due to the structure of the CAPCO program. But in this section of the report, it states that attractive companies in rural Colorado are uninterested in obtaining growth financing and that rural businesses are not a good match for venture capital since there is no prospect of a liquidity event (grow and sell). The CAPCOs are using different standards to justify their investments as a whole vs. their investments in rural Colorado. As a result of the state’s sponsorship of this program, the CAPCOs have specific capital that has been made available to invest in rural businesses. By circumventing the spirit of the rural requirements and meeting the “letter of the law” as stated in the report, CAPCOs are not demonstrating a real commitment to invest in rural Colorado businesses.
If the type of venture capital offered by the CAPCOs is not a good match for rural Colorado and the CAPCO program prohibits the CAPCOs from making desired long-term investments in general, then an alternative program model must be seriously considered.
· Report Conclusion
“The CAPCO Program is expensive. No one interviewed, including the CAPCOs themselves, disagreed with this statement. The issue is whether the results of the CAPCO program could be accomplished more cheaply.”
· OED Response
Numerous reports have stated that the CAPCO Program is a high cost program and the most inefficient means of raising capital. In prior responses, OED has indicated that the CAPCO Program allows up to 4 times the fees allowed by the venture capital industry. While the CAPCOs may profess future “intents” such as they did when committing to invest the CAPCO funds in rural Colorado, a typical venture capital fund’s contract with its investors details explicitly the expectations for maximum fees, fee reductions, and so forth. In addition due to flawed distribution language, the CAPCOs are allowed to keep all remaining funds instead of repaying the state its investment plus a negotiated percentage of the profits if investments are successful. Based on discussions with Colorado venture capital funds over the last two years, there are much less expensive models.
· Report Conclusion
”It isn’t surprising that CAPCO fees are at the high end of the typical venture capital range. Special requirements such as 25% rural investment add costs regular venture capitals don’t have.”
· OED Response
Allowable CAPCO fees and final distributions are more than at the high end of the typical venture capital fund range. And the special requirements such as the 25% rural investment requirement should not add material costs to the CAPCOs since the CAPCOs have already stated in the report that they are encouraging portfolio companies to locate in rural areas contiguous to Denver’s metro area in order to meet the letter of the law if not the spirit of the rural requirement per the report. A competitive process for selecting venture capital funds would ensure competitive pricing and the most cost-effective model.
· Report Conclusion
”The program will make the CAPCOs and the insurance companies rich. The Colorado legislation requires that CAPCOs be for-profit companies. This means that, like all venture capitalists, they are in business to make a profit….”
· OED Response
OED is supportive of for-profit companies making a reasonable profit on taxpayer-funded investments. However, OED is not supportive of taxpayers paying unnecessarily high costs to for-profit companies when there are more cost-effective models. CAPCOs are required to initially demonstrate that they have $500,000 in liquid assets; however, they are never required to use those assets in the CAPCO program. Since the CAPCOs may keep all remaining funds from this program (in addition to the excessive fees allowed on an annual basis), the return should far exceed the reported typical venture capital fund return of 22.7%
if the CAPCOs make prudent investments that pay off when a liquidity event occurs—which they have indicated they are seeking. The State of Colorado will not be enriched as the report suggests due to flawed distribution language.
· Report Conclusion
”But, the State of Colorado will never share in the portfolio company profits. Of the six existing CAPCO programs, Colorado allocates the largest share of profits from successful investments to the state….”
· OED Response
Although the Colorado legislation may appear on the surface to allocate the largest share of profits from successful investments to the state, the legislative language is flawed and the provisions are not enforceable. It should be noted that a specific CAPCO representative has repeatedly taken full credit for writing the state’s CAPCO legislation—including this particular provision. If the state cannot enforce the anticipated provisions in the legislation, then the state will not receive any funds back from this program. Thus, appearances do not equal reality. And as stated in the report, the CAPCOs are certainly willing to meet the letter of the law if not the spirit of the law.
In terms of when profits can be distributed per the report, it should be noted that the CAPCO legislation never mentions “profits”. The legislation allows the CAPCOs to use profits as they desire—which OED has testified to in numerous forums beginning in mid-2001 and subsequently in legislative hearings in addition to recent testimony in the same vein by staff of the State Auditor’s Office.
It comes as no surprise to OED that the CAPCOs may have “proprietary data projecting cash distributions to the state of Colorado” which are non-binding while at the same time the CAPCOs previously have been unwilling for OED to seek clarifying legislation regarding this item.
· Report Conclusion
“Because the first premium tax credits are not granted until 2004, there was no cost to the state.”
· OED Response
There is a cost to the state and this program is actually a high cost program as discussed above. The insurance companies are and will receive payments from the CAPCOs, which fully compensate the insurance companies for not having the ability to begin using the tax credits until 2004.
· Report Conclusion
”According to Thomson Financial Venture Economics, of the eight private equity firms formed in Colorado in 2002, six (75%) were CAPCOs. Of the $165 million committed to these new funds, $100 million or 63% was insurance company raised by the CAPCOs.”
· OED Response
It is very significant to note that in this statement and elsewhere in the report (regarding how much funding the CAPCOs raised and how active the CAPCOs have been), the CAPCOs are taking credit for raising $100 million while it has been clearly demonstrated that only $40-45 million is actually available for investment in Colorado businesses and paying additional CAPCO fees. Using the actual funds available of $40-45 million, which is a more true comparison to typical venture capital fund statistics, would significantly change the perspective of the statements and conclusions contained in this report.
· Report Conclusion
”As the IPO market closed in late 2000 and venture capital investing plunged, venture capital funds nurtured existing investments rather than making new ones. They concentrated their available investments on keeping their portfolio companies alive. In Colorado, 55% of the CAPCO investments have been in early stage companies.”
· OED Response
The report clearly indicates that in Colorado (as well as nationwide), while venture capital funds investing plunged and venture capital funds nurtured existing investments rather than making new ones, venture capital funds still managed to invest $4,291 million in 2000, $1,292 million in 2001, $578 million in 2002 and $507 million through the 3rd quarter of 2003. Many of the investments made by the CAPCOs participated with these same venture capital funds as described by the CAPCOs when trying to take credit for the “follow-on investment numbers” in other sections of the report.
As noted previously, we disagree with the CAPCOs’ classifications, which results in 55% of the CAPCO investments having been invested in early stage companies. However even if you were to accept the classifications assigned in this report at face value, it should be noted that Wilshire’s investments, as discussed previously, are labeled as “seed/early stage” and account for $3.9 million dollars or 41% of the total investments of $9,604,000 that have been labeled as “seed/early stage”. These investments certainly should be examined more closely. Although they meet the letter of the law, we question again whether these investments are meeting the spirit of the law as intended.