USAID Program Operations and Assessemnt Report No. 17
              Center for Development Information and Evaluation
                                                    August 1996
The
Venture
Capital
Mirage
Assessing USAID Experience
With Equity Investment
PN-ABY-220
                                                       Page
Introduction                                           v
Glossary                                               vii
1. The Rationale for Equity Finance                    1
2. What Does the `Real' Venture Capital
   Industry Look Like?
3. Profile of the Venture Capitalist                   3
   How Venture Capital Companies Are Established       4
   Relevance of the Venture Capital Model for USAID    5
3. USAID's Experience with Venture Capital Projects    6
   Analysis and Interpretation                         11
4. The Enterprise Fund Model                           14
   Quality of the Equity Portfolio                     16
   Operational Issues                                  16
5. Experiences of Other Approaches, Other Places       18
   Private Ventures                                    18
   Multilateral Agencies and Other Governments         20
   Where Was Venture Capital in the
   `Asian Miracle' Countries?                          22
6. Why Is Venture Capital a Mirage?                    23
7. Conclusions for USAID Programs                      24
   Bibliography
INTRODUCTION
     IS USAID FUNDING for equity investment in business
enterprises a useful way to reduce poverty and stimulate
development? This study looks broadly at previous experience with
equity investment to answer that question. It examines 13 USAID
venture capital projects. It also reviews USAID's recent
experience with enterprise funds in Eastern Europe and surveys
related experience of others.
     USAID venture capital projects have almost uniformly failed,
the study finds. At the project level, USAID's approach clearly
appears flawed. Two problems are evident. First, USAID often
promoted venture capital projects in unpromising country
environments where the business climate was uncertain or the
prospects for expanding firms were poor.
     Second, the Agency usually treated an activity requiring
great flexibility and initiative as if it were straightforward
and simple. Projects were overdesigned: they set too many goals
or specified the approach to be used. A variant concept,
enterprise funds, developed in Eastern Europe, improves
substantially on USAID's traditional approach, because it
delegates most decision-making to the implementing entity. Some
enterprise funds have performed relatively well, but others have
incurred significant losses. None has yet shown promise of
substantial profitability.
     Beyond the design issues, some aspects of the experience of
USAID and other donors and enlightened private efforts suggest a
more fundamental reason for failure. The allure of equity
investment in emerging companies in developing countries is a
mirage. Conceptually, it appears likely to pay high returns. In
practice, it does poorly. (Hope springs eternal, however, and the
poor track record of venture capital in developing countries has
done little to dissuade people from seeing it as a magical
remedy. See for example "Venture Abroad," by Larry Schwartz in
the November 1994 Foreign Affairs for evidence that transplanting
the U.S. venture capital industry to developing countries
continues its allure.) Because donor programs are unable to
produce results, venture capital should be left to private
organizations willing to accept the risks.
     This report is organized as follows. Chapter 1 lays out the
traditional rationale for venture capital activity. Chapter 2
describes the structure of the industry in the developed
countries where it is most advanced. Chapter 3 summarizes USAID's
experience with venture capital projects, and chapter 4 discusses
enterprise funds, used by USAID in Eastern Europe. Chapter 5
examines the experience of private enterprises and multilateral
agencies that have promoted venture capital in developing
countries. Chapter 6 responds to the question of why venture
capital projects usually fail, and chapter 7 provides
conclusions.
GLOSSARY
ADELA     Atlantic Community Development Group for Latin America
ATI       Appropriate Technologi Incorporated (Asia)
AVT       Agricultural Venture Trust (eastern Caribbean)
BVP       Business Venture Promotion (Thailand)
CDC       Commonwealth Development Corporation
DFC       Development Finance Corporation (Haiti)
HIAMP     High Impact Agribusiness Marketing and Production
          (eastern Caribbean)
HPAEs     high-performing Asian economies
IBEC      International Basic Economy Corporation
IFC       International Finance Corporation
IIC       Inter-American Investment Corporation
JADF      Jamaica Agricultural Development Foundation
LAAD      Latin American Agribusiness Development Corporation
PED       Private Enterprise Development (Kenya)
PIC       Private Investment Corporation (Costa Rica)
PICA      Private Investment Company of Asia
SIFIDA    Socit Internationale Financire pour les
          Investissements et de Development en Afrique
CHAPTER 1. The Rationale for Equity Finance
     PEOPLE IN DEVELOPING countries are poor in part because they
have far less capital than people in industrial countries.
Because of this shortage, workers have little in the way of
specialized machinery and equipment, and firms lack money to
obtain more equipment. As a result, productivity of workers in
developing countries is low compared with that of workers in
industrial countries.
     Financial-resource flows from industrial to developing
countries are an obvious means to overcome this inequality. But
financial resources are not enough. Some developing countries
have natural resources such as oil or minerals that, when sold on
world markets, have provided large amounts of money. In many
cases (such as Ecuador, Iran, Nigeria, and Zaire) the money has
failed to stimulate sustained economic growth or increased
productivity and income for the average person.
     In part, failure to use capital productively results from
the way these resources flow. In some countries the government
gets the money, which it uses to perpetuate itself through
military spending or through increased consumption spending
("bread and circuses"). In other cases, resources flow to wealthy
individuals who use them to maintain high levels of conspicuous
consumption or to travel to the watering places of Europe.
     Donors and development strategists have proposed various
approaches to channel financial resources to "the right places"
to alleviate the shortage of capital in poor countries. In part,
this is the role of the banking system in any country. It
performs an intermediary function, hiring money from those who
need money later rather than now and renting it to people who can
use it productively now. In most developing countries, the
banking system plays this role only imperfectly. Governments are
partly responsible, because they use the financial system to
transfer resources from the private to the public sector, or they
establish policies (setting low interest rates, for example) that
interfere with banks' intermediary function.
     Even in the best of circumstances, however, banks have
limitations. Banks lend money they themselves have borrowed, and
they seek assurance that funds they lend will be repaid, so that
the bank in turn can repay its lenders at the proper time. The
borrower from the bank must repay whether the project is a
failure or a moderate or smashing success. The bank's primary
concern is security. It cares less about the use of the money
than about the assurance of repayment. Conservative practices,
such as reliance on collateral and lending only to large
established businesses, are manifestations of this quest for
assurance.
     Banking systems are inherently conservative and status quo
oriented. But conservative approaches are not enough if
developing countries are to reduce poverty quickly. Mechanisms
are needed to channel resources to the highest potential payoff,
even though the risk may be higher than for traditional uses.
Small businesses with no credit history need funding for
expansion so they can grow into large businesses. New, generally
small businesses need initial infusions of capital so the owner's
idea can be turned into sales, jobs, and profits. Even where
medium-term prospects are favorable, the near term may be
difficult to predict. It is consequently risky for such
businesses to borrow money and incur fixed obligations to repay
because the near-term repayments may exceed their cash-flow
capabilities and prevent the firm from achieving sustainability.
     There is, therefore, a need for risk capital for people with
ideas and capabilities but without money. Historically, much risk
capital has come from wealthier people who know personally the
potential user. Extended families play this role in many cases.
Among religious or ethnic minorities, group solidarity is often
helpful. Indeed, the great economic success of some groups (Jews,
Lebanese, overseas Chinese) results in part from the ability to
mobilize resources within the community for promising
enterprises. Larger firms in an industry also may provide capital
to new, smaller firms often suppliers when they know the new
firms' capabilities or promise.
     For the most part, however, budding entrepreneurs lack
access to capital from these sources. If they are to obtain
capital, it must come from a source with whom they have no
personal acquaintance. This is where venture capital enters the
development business. A venture capital financier looks for
promising enterprises to back with funding and limited technical
advice, perhaps for a considerable period of time. If the
enterprise fails, the financier simply loses his stake. If it
succeeds, the financier has acquired an equity stake in the
company that allows him to benefit in proportion to the
success and sometimes far out of proportion to his initial
investment.
     This need for venture capital is not limited to developing
countries; the United States has the most developed venture
capital industry in the world. The U.S. industry is particularly
critical to growth of new firms in high-technology industries
such as computers and biotechnology. A typical venture capitalist
expects to sell off the equity after a five- to seven-year
period, during which the firm has had time to develop its market
niche and mature financially.
     The case for equity financing is, on the surface, a
compelling one. The rationale for USAID involvement in venture
capital projects has typically been to demonstrate the existence
of a profitable market for such financing, thus catalyzing
private flows for this purpose.
     Venture capital activity is aimed primarily at small and
medium enterprises. Large enterprises are a different matter, as
they have the capital base and visibility that make them
candidates for conventional lending, as well as bond sales and
equity sales on a broad scale. There is some confusion about the
relationship of venture capital to stock market development, and
some USAID projects used stock market development as part of the
rationale for venture capital activity. This approach is not
borne out by experience. The universal experience seems to be
development of public ownership and stock markets in a gradually
broadening process, with securities of large and stable
enterprises providing the backbone of stock market expansion.
CHAPTER 2.
What does the 'Real' Venture Capital Industry Look
Like?
     THE VENTURE CAPITAL industry is well developed only in
Canada, Great Britain, the United States, and a handful of other
industrial economies. Venture capital can be furnished by an
entrepreneur's family, an informal lender, a pension fund, an
insurance company, a development finance institution, a small
bank, a commercial or investment bank, a formal venture capital
company, or any other funder willing to provide financing without
collateral in return for an equity stake in the enterprise.
Although the industry continues to evolve around the world as
entrepreneurs vary its implementation to suit their specific
financial needs, some characteristics remain the same. (This
description of the characteristics of the venture capital
industry is drawn mainly from Frustace [1994a], who reviewed
academic literature [such as Wellons et al. 1986], USAID project
documentation, and interviewed venture capitalists in the United
States.)
     The venture capital industry evolves through a combination
of a) demand for alternate, unconventional forms of financing and
b) a financial sector mature enough to absorb a higher level of
risk and uncertainty in investment decision-making.
Profile of the Venture Capitalist
     Venture capitalists are usually specialists in one or a few
industries. They make their investment decisions solely on the
basis of the profit potential they see in business proposals. The
only objective of managers of venture capital companies is
capital appreciation. Thus they channel all their energies into
choosing investments that, with technical and financial
oversight, can grow in sales and profits to the point that the
equity stake increases in value and can be converted into cash or
liquid assets. Although venture capitalists may appreciate the
need for economic development in third world countries, their
sole motivation is to seek out and invest in high value-added
companies, to influence as much profitable growth as possible in
the shortest amount of time, and to profit from that investment
through stock market divestiture or any other viable exit
strategy. (Typically, venture capitalists look to make
investments in countries or industries that can yield an expected
return of 30 percent a year by permitting divestment after five
to seven years for three to five times the original value of the
investment.)
     The high risk high reward nature of venture capital often
steers fund managers toward high-margin industries that can
benefit from value-added management and technical and financial
assistance. High margin and profit potential usually come in the
form of a company with new technology but little knowledge of how
to finance, produce, market, or distribute it. Accordingly,
venture capitalists often play a major role in moving newly
developed technologies into the commercial sector. A fund manager
sees the commercial potential of a new product and can translate
that potential into a viable and highly profitable business
undertaking.
     Investments with high growth potential are often specialized
windows of opportunity, visible only to the trained eye; venture
capitalists typically choose 3 percent or fewer of the business
plans submitted to them for financing. To pass the rigorous
standards set by venture capitalists, business proposals must
provide evidence of how a company can, with specialized
assistance from the venture capital company, earn returns well
above the market rate. Even so, venture capitalists expect to
make most of their profits from a minority of their investments.
One rule of thumb is that a fourth of the investments will fail,
half will break even or yield a modest profit, and a fourth will
be big winners.
     Most USAID projects were designed under the assumption they
could implement and influence the growth of venture capital
companies and industries without meeting the rigorous standards
venture capitalists set for themselves. Those standards include
hiring experienced and specialized fund managers who have 1) the
knowledge and expertise to choose portfolio companies with
convincing and viable business proposals, 2) the ability to
manage those investments with the attention and care needed to
nurture potential into reality, and 3) some of their own money at
risk.
How Venture Capital Companies Are Established
     Traditionally four steps are involved in putting together a
venture capital fund in the U.S. private sector:
     1. Assemble a group of professionals with proven track
records and both domestic and international connections. These
connections are needed to raise capital initially and to assist
in disposition of fund assets later.
     2. Have each of the fund's managers legitimize his
participation in the company by contributing personally
significant capitalization. Acceptable levels of internal
fundraising signal to both commercial investors and potential
investee companies that the venture capital company has a
dedicated management staff. Investment funds are generally
capitalized at $8 10 million per professional. Normally a minimum
of $25 million under management is needed to generate adequate
management fees.(Well-established venture capital companies in
the United States have pools of capital ranging from $5 million
to $30 million and have grown as large as $200 million in recent
years.)
     3. After assembling a dedicated and well-capitalized
management team, the venture capital company must raise a
predetermined external minimum amount and have a first closing.
     4. The company can now pursue proposals from companies
seeking investment capital, otherwise known as developing a
transactions flow.
Relevance of the Venture Capital Model for USAID
     Wide differences exist between financial market conditions
in the industrial countries where venture capital companies have
thrived and those in developing countries. USAID has most
commonly made two major assumptions: 1) the U.S. experience can
be transferred directly to developing countries by professionals
using techniques learned in the United States and 2) venture
capital development is a vehicle for stock-market development.
Both assumptions are open to question.
     Conditions in developing countries are sufficiently
different from those in industrial countries to call into
question the first assumption. Information about the company's
finances, about market conditions, about relevant government
policies is likely to be much scarcer in developing countries.
Legal systems are frequently less transparent, and government
policy may change more quickly and dramatically than in
industrial countries, making the prospects for any company less
predictable. Developing countries are far smaller economies a
typical developing country has a gross national product the size
of that of one U.S. city. Prospects for profits from individual
transactions are therefore likely to be much smaller. In sum,
risks are likely to be much larger, and profit prospects much
smaller, than in the United States.
     Venture capital was not a vehicle for stock-market
development in the United States. Vibrant equities markets long
preceded development of the venture capital industry here.
Moreover, emerging companies are unlikely to be an important part
of any country's stock market. The backbone of such markets has
to be equity and debt of very large and stable companies with
long track records and a need for additional capital.
     Every country has such blue-chip enterprises, ranging from
banks, breweries, and cement plants to public utilities. Public
utility debt would seem an important factor even if such
enterprises are government owned. Given efforts to privatize
utilities in many developing countries in recent years, these
enterprises would also seem a more promising means for stock
market development than unknown small companies. Overall, a
well-established market for equity and debt in large enterprises
would seem to indicate the possibility of developing trading in
smaller companies. Where no such market exits, it seems unlikely
that promotion of equities in small companies would produce one.  CHAPTER 3.
USAID's Experience With Venture Capital Projects
     USAID HAS HAD a modest interest in venture capital over the
past few years. There has been a steady flow of project activity,
but not enough for the Agency to develop a cadre of experienced
specialists. USAID has approved at least 13 projects since 1970
(see table 1) that included at least one component aimed at
venture capital or equity investment.
     For this study, the author reviewed available documentation
in USAID's central documents center to learn the projects'
outcome. Where gaps existed in documentation, the author
attempted to clarify the record by contacting individuals
knowledgeable about a project. (Teri Frustace of DAI, Inc.
prepared detailed case studies of the AID projects [Frustace
1994b] which provided the basic data for this section.) Venture
capital projects, however, are generally slow to mature. USAID
disbursements typically end after all funds are committed,
usually four to five years after inception. At this point the
final evaluation report is written, and the written record (as
well as USAID staff involvement) ends. Another five years or so
are likely to elapse before a sound determination can be made of
the value of the investments. Given this difficulty, as well as
gaps in documentation, conclusions reached on available data must
be tentative.
     Project papers generally used justification in accord with
the theory above the activity would stimulate flows of funds to
high-payoff investments, which would stimulate development by
creating jobs and raising output. The USAID project would be a
catalyst, leading other private organizations to begin providing
venture capital. Often there was also the expectation the
increased supply of equities resulting from the project would
help develop the capital market, or the stock market, in the
country.
     In three projects, the venture capital component was not
implemented. For the remaining projects, the result as compared
with the venture capital expectation was uniformly disappointing.
In none of the cases did the generic venture capital scenario
proceed according to plan that is, the firm acquires shares in a
set of firms, sells them for a profit, and invests the proceeds
in new firms. The specific cases vary.
     1. Latin American Agribusiness Development Corporation
(LAAD) and its subsidiaries received six USAID loans totaling $44
million from 1971 through 1989. LAAD was established by 12 U.S.
agribusiness firms in 1970 with an initial capital of $2.4
million to invest in Central American agribusiness enterprises.
The initial USAID loan was intended to increase LAAD's
involvement as a lender and equity investor in agribusiness
enterprises in Central America. The corporation was to make
equity investments wherever possible, as a means for capital
market development.
     LAAD was to use at least two thirds of the $6 million in its
first USAID loan for equity or for loans convertible into equity.
LAAD's equity investments, however, were not particularly
successful, and LAAD saw little prospect for sales of equity
holdings that would permit it to avoid the risk of illiquidity.
In a second loan in 1976, USAID agreed to eliminate the equity
requirement and sought instead to have LAAD put greater efforts
into promoting agribusiness investments that benefited small
farmers.
     After that, LAAD established itself as an efficient
financial intermediary for private agribusiness investment in
Central America. It maintained a low administrative cost
structure and closely managed its portfolio. Commercial losses
averaged less than 1 percent of the portfolio, according to a
1989 evaluation. Nevertheless, LAAD experienced serious financial
problems in the early 1980s, when political and economic turmoil
enveloped most of Central America. Most of its Nicaragua
portfolio had to be written off, and the imposition of
debt-service restrictions by other governments in the region
undercut its financial position.
     In 1993, 91 percent of LAAD's assets were in loans, only 9
percent in equity. Its capital base had risen to $20 million, and
its loans and equity holdings to $62 million. Of all the
institutions USAID promoted in the venture capital field, LAAD is
the only one that is a sustainable, profit-making enterprise.
USAID's substantial support played a key role. Nevertheless, the
return earned by LAAD on its USAID resources was modest. Had LAAD
invested the Agency's resources in six-month U.S. Treasury bills
rather than in development projects, the corporation's
capitalization would have risen to more than $40 million.
     2. The Egyptian Private Investment Encouragement Fund was
designed in 1979 to provide financial assistance in the form of
loans and equity investment to large private sector companies.
USAID authorized up to $1 million in equity investments, but no
investments were actually made. The venture capital component of
the project had not been carefully designed. The entire project
had serious implementation problems, with four chiefs of party
during its relatively short life. Part of the funds were later
deobligated.
     3. Appropriate Technology Incorporated (ATI) venture capital
initiatives. ATI receives USAID grant assistance, which it has
used to fund several venture capital initiatives in Asia. During
the early 1980s, ATI developed venture capital funds in
Indonesia, the Philippines, Sri Lanka, and Thailand. All four
funds were managed by nonprofit organizations headquartered in
the host country. All ended poorly. Each fell far below design
objectives in number of investments, capitalization rate, and
financial self-sufficiency. ATI concluded that nonprofit
organizations cannot successfully manage funds that have the sole
purpose of making money. ATI established a second generation of
venture capital funds in Indonesia and Thailand in the late 1980s
with more experienced venture capitalists. Neither fund had begun
divestiture by 1993, but ATI considers the investments to be
satisfactory and potentially marketable.
     4. The Jamaica Agricultural Development Foundation (JADF)
was a venture capital activity initiated in 1984. The foundation
received PL 480 Title II surplus U.S. dairy commodities, which it
processed and sold to capitalize an investment and loan fund.
Problems came in the form of a lack of clear understanding
regarding sustainability. Although USAID identified
sustainability as one of the primary project goals, JADF relied
continually on granted surplus commodities as its sole source of
investment funds.
     After experiencing bottlenecks in processing and marketing
cheese and butter, the foundation met with cash-flow problems and
relied on a USAID grant facility to subsidize operating costs.
Although the project took steps to improve its operating
procedure and cash flow, the USAID project assistance completion
report indicated that JADF had not been able to build a capital
base and was still dependent on USAID-granted dairy commodities
as the sole source of operating income and investment capital.
     5. The Private Investment Corporation (PIC). This entity was
established in 1984 to promote private investment in
export-related enterprises. PIC was owned by a consortium of
Costa Rican banks, private companies, and the Coalition for
Economic Development Initiatives, a private sector export
promotion agency heavily funded by USAID. The purpose was to
provide credit, equity investment, and other services for
investors in the export sector. PIC was to emphasize risky
"nonbankable" projects in this sector, including start-ups. USAID
provided $26 million in funding $20 million for relending, $1
million for technical assistance, and $5 million in USAID-managed
local currency for equity investment.
     PIC's early lending and equity investment experience was
disastrous. Many of the projects it financed failed completely,
and others were not making interest payments. The institution
flirted with bankruptcy. Management was replaced, and operations
shifted away from high-risk efforts. PIC ended its equity
investment activities and concentrated on lending and other
financial services. The corporation's financial viability was
subsequently restored, and it has become a respectable provider
of medium-term lending.
     6. The International Fund for Ireland was established in
1986 for $50 million and was appropriated by the Reagan
administration in response to the Anglo Irish Terrorism Reduction
Agreement. The fund aimed to promote economic and social
development by stimulating private investment in troubled areas
in Northern Ireland and the adjoining provinces of the Irish Free
State.
     One of several project components involved establishing an
equity investment fund in the Republic of Ireland and another in
Northern Ireland, for "providing venture capital on normal
commercial criteria to both start-up projects and existing
businesses" (International Fund for Ireland 1992, 43). The equity
investment activity started slowly, and a U.S. Government
Accounting Office audit in 1989 criticized the fund for receiving
disbursements of several million dollars for venture capital
activities while actually committing or disbursing only a small
fraction of the allocations.
     Investment activity began to pick up in 1990 and 1991. By
1994 the two funds had invested $14 million in 34 enterprises in
the two countries. Annual reports of the International Fund for
Ireland give no indication that any equity has been sold, nor do
they give any indication of performance of the portfolio. The
funds themselves had not achieved profitability. Together, their
operating deficit accumulated to about $800,000 during 1990 94.
     7. High Impact Agribusiness Marketing and Production (HIAMP)
was authorized in June 1986, for $40 million, for the eastern
Caribbean region. Centerpiece of the USAID strategy, the project
was based on a belief that entrepreneurship was critical to
growth in the region and that venture capital funding and related
activities would stimulate entrepreneurship. Of the total, $12.8
million was for equity investment in small agribusiness-related
projects.
     Because of technical and legal issues, including a
prohibition on use of Agency funds for purchase of equity,
considerable time and effort were required to establish an
intermediary to manage the funds intended for equity investment.
By 1988 a nonprofit Agricultural Venture Trust (AVT) had been
created to receive the USAID grant funds and to invest them in
promising agribusiness enterprises in the islands of the eastern
Caribbean. AVT was to establish a buy-back arrangement with each
enterprise.
     By the time of the close-out evaluation of the project in
June 1993, AVT had invested in 28 subprojects, mainly in private
agribusiness firms. But the trust had not sold its shares in any
of the firms, nor did there appear to be early prospects for
doing so. The evaluation narratives suggest that none of the
firms had become profitable, and a half dozen had ceased
operations. A notional estimate, based on the evaluation
narratives, puts the value of AVT investments in 1993 at 51
percent of its original cost in nominal terms.
     8. The Haiti Development Finance Corporation (DFC) was
designed in 1986 to provide loans and equity to investors for
industrial projects in Haiti. A small equity component was
designed into the project, although it was given little
definition. During implementation, the DFC concluded that it
lacked the capability to manage equity investments, and the
equity component of the project was never implemented.
     9. The Jordan Private Services Sector Development Project
was designed in 1986 to provide several forms of financial and
technical assistance to the Jordanian private services sector. A
$700,000 equity component was to be used to assist in
capitalizing a venture capital fund. (Although the design
document spoke about "capitalizing" the investment fund, it is
likely that the $700,000 would have been used to cover operating
costs and technical assistance associated with venture capital
industry development.) The project ran into problems at the
outset and was prematurely closed by USAID without any venture
capital activities having taken place.
     10. Thailand Business Venture Promotion, Ltd. (BVP) was
established in 1987 for slightly more than $6 million, including
$3 million in equity provided by Thai financiers, $3 million in
USAID loans, and $50,000 in a USAID grant for start-up costs.
Over its lifetime BVP drew down on only 30 percent of the total
loan and grant facilities, for a total of 10 investments. Of
those, all but two registered substantial losses or went
bankrupt.
     The main problem for BVP was its unwieldy management style.
The board of directors, made up of representatives of six
commercial banks, became involved in the fund's everyday
management decisions. Conflicts among board members resulted, and
BVP had great difficulties closing on investment decisions.
Additionally, investments that were funded were chosen without
any specialized industry knowledge.
     11. The Sri Lanka Private Sector Policy Support project was
begun in 1988 as a multipart  initiative. One part was to provide
financing for the start-up costs of a venture capital company. By
completion of project activity in 1993, the company had not yet
attempted to divest any of its holdings. The evaluators did
identify several problems with portfolio quality. The main
problem had to do with investment conservatism and the links of
the venture fund manager to the commercial banking sector. Many
fund shareholders were commercial banks, which saw the equity
fund simply as a tool for improving the borrowing capacity of
their portfolio companies: a larger capital base made them able
to lend more. The evaluation also concluded that the fund manager
lacked experience or outside connections that could help fund
portfolio companies develop export markets.
     12. The Kenya Private Enterprise Development (PED) project
was a serious effort that failed to achieve its intended result.
From prefeasibility and design through implementation, USAID made
a number of inappropriate decisions. Problems started with faulty
assumptions about the existence in Kenya of a demand for venture
capital and an enabling environment to support venture capital
investments. Owners of small and medium-size companies targeted
by the project had no perception it would be desirable to reduce
their debt in exchange for part ownership in the companies.
Moreover, many companies refused to disclose real financial
statements, making it impossible for venture capitalists to
accurately assess investment potential.
     The second problem was inadequate capitalization. Under the
project, USAID provided money for two investment funds: Kenya
Equity Management (a USAID-formed company) and Industrial
Promotion Services of Kenya. But the Agency provided insufficient
financing to support even one venture capitalist. Insufficient
funding is perhaps why 17 of the 18 firms asked to submit
proposals for the project showed no interest.
     Because of the lack of interest by potential fund managers,
the project contracted as fund managers firms inexperienced in
venture capital. Two companies were hired. One was the project
designer, and the other was a holding company based in Kenya. By
the end of the project, neither company was engaged in mainstream
venture capital activities. Each redesigned its mandate to
provide financial services more in demand one as a merchant bank
and the other as a holding company. Although the fund managers of
both companies were smart and hardworking, and although both
realized and fulfilled an unmet demand for assistance in
financial services, the project strayed widely from its intended
purpose of equity investing.
     13. The Africa Growth Fund was incorporated in 1985 with a
planned $10 million in equity participation from institutional
investors (to be raised by First Boston Corporation), buttressed
by $20 million in credit guaranteed by the Overseas Private
Investment Corporation, and a USAID grant of $150,000 to cover
start-up costs. The start-up process took much longer than
anticipated, and First Boston withdrew from participation. A
merchant banking company known as Equator Holdings Ltd. took over
management, agreeing to make at least 12 investments a year for
2.5 years, or a total of 30 investments. (Equator Holdings was
parent company of the same merchant bank that unsuccessfully
managed the Kenya Private Enterprise Development project
described above.)
     But the fund was able to raise only half the intended $10
million in capital. The shortfall jeopardized the company's cash
flow, and its ability to meet its original investment schedule
was put into serious doubt. A 1993 evaluation concluded that
although the fund had made good investments, its high costs
relative to its portfolio size made its ability to be profitable
questionable. It seemed likely the fund would have to divest
early from its holdings to meet immediate cash needs.
Analysis and Interpretation
     The USAID projects reflect differing degrees of
sophistication about the venture capital industry, ranging from
vague aspirations to detailed analyses. Many projects made poor
investments; nearly all had cost structures that made them
unsustainable. Only one institution the Latin American
Agribusiness Development Corporation has proven over time to be
clearly sustainable. It did so, however, by shifting from equity
funding to more conventional agribusiness lending, combined with
substantial subsequent USAID funding.
     For the nine USAID projects that were implemented, table 2
provides some summary judgments based on available evaluations.
These reports were reviewed for evidence of the quality of the
implementation structure, speed of implementation compared with
expectations, quality of investments, and whether the company
made any profitable divestments.
     Implementation structure. Most projects encountered
difficulties because the structure conceived in the project paper
was not feasible in practice. In some cases (e.g., High Impact
Agribusiness Marketing and Production project), the proposed
structure was found to be legally impermissible under USAID
competition guidelines. In other cases, the management structure
of the implementing institution prevented effective
decision-making.
     Implementation speed. Most projects were far slower
disbursing than anticipated. This usually reflected a scarcity of
investment opportunities of the desired quality. In turn, that
reflected a poor country climate. Project papers were usually
optimistic about the demand for funding, but such optimism seldom
proved justified in practice.
     Average investment quality. The information base for this
variable is limited, and judgments are often based on qualitative
statements in evaluation reports. Nevertheless, the evaluation
reports contain no evidence of big winners, nor do they document
any improvements in national capital markets as having resulted
from the project.
     Profitable divestments. The ultimate test of the venture
capital concept is in the sale of equity investments in the
marketplace for a profit. This enables the venture capital
company to reinvest in new companies. Although information is
incomplete for several projects, no record of profitable
divestments exists for any company. (If such divestments had been
made, it is reasonable to assume they would have been publicized
as evidencing success of the project.)
     Four characteristics of USAID projects seem responsible for
the poor performance:
     1. Choosing the wrong implementer. In most projects, the
implementing institution had little or no previous venture
capital experience. As discussed above, private sector venture
capital operations start with the management team, which then
finds the money and the investments. USAID projects typically
skip this step and go straight to capitalizing the investment
fund. In fact, the Agency's procurement process is predicated on
allocating and obligating funds before a management team is even
identified. Characteristically, a request for proposals is
released. The request contains the fund's financial and
administrative management provisions but lacks any input from the
implementors-to-be who are at this stage unknown.
     This approach works on USAID projects in other industries
but does not work with venture capital initiatives. That is
because venture capital companies can be successful only if their
managers have a sense of ownership and vested interest in the
fund's success. By following the standard bureaucratic approach
to procuring the services of a fund manager, USAID supports
creation and perpetuation of venture capital companies
administered by groups of inexperienced individuals who a) lack
the skills and experience required to choose or manage the
profitable growth of investments, b) are unable to provide
adequate internal capitalization, and c) are incapable of raising
funds from financial sector institutions and typically fall
seriously behind USAID's project design capitalization
projections. The model followed in USAID projects for creating a
venture capital company was so different from the typical fund
manager's way of operating that USAID has not been able to
interest mainstream venture capitalists in managing USAID
projects.
     2. Excessive constraints on the implementer. Venture capital
projects tried to target too narrowly. Particular USAID concerns
(very small businesses, the agricultural sector, women-owned
businesses) were written into projects. Finding good investment
opportunities in developing countries is difficult enough.
Further limiting the ability of the implementer to select
investments can make sustainable operation impossible. The HIAMP
project aimed to provide up to $20 million in equity and
quasi-equity to firms in the small islands of the eastern
Caribbean, with a population of less than one million. This
already difficult task was compounded by limiting activity to
agribusiness.
     3. Rigid design. In some projects, actual conditions during
implementation differed sharply from those anticipated in the
design. Adaptation to such problems was slow. USAID project
designs are based on the supposition that the problem is
understood and that a specific remedy is the appropriate one. In
developing-country capital markets, this assumption of knowledge
is simply unwarranted.
     4. Inadequate demand. In most countries, entrepreneurs were
extremely reluctant to sell a share of their equity. USAID's
tendency is to target development of small and medium-size
enterprises and of capital markets as two primary purposes of
venture capital activity. However, a strong small and medium-size
enterprise sector and an operating capital market are better
understood as the elementary building blocks on which a venture
capital industry must grow. Stock markets do not develop because
a handful of venture capitalists are ready to divest their
holdings in small and medium-size enterprises. Rather,
established investment bankers making public equity investments
in high-value stocks expand the securities market, gradually
creating a market for such less-than-blue-chip companies. They
thus partly set the stage for development of a venture capital
industry for small and medium-size enterprises. In short, USAID
is putting the venture capital cart before the equity market
horse.
     The first three problems are closely linked to the ways
USAID plans and implements projects. The fourth is more generic.
CHAPTER 4.
The Enterprise Model
     IN 1989 PRESIDENT George Bush proposed creation of
"enterprise funds" for Hungary and Poland. Later that year,
Congress passed the Support for Eastern European Democracies Act,
which defines a broad structure and goals for enterprise funds in
Hungary and Poland. The funds were to speed the transition to
market economies by supporting establishment and expansion of
private business firms. They were to be established as nonprofit
U.S. corporations operating under the guidance of a board of
directors made up of a combination of U.S. and host-country
members.
     A wide range of activities was permitted by the legislation
and subsequent grant agreements between USAID and the enterprise
funds, including debt and equity investments, leasing, grants,
and technical assistance. The expectation was that they would be
"venture capital" funds, providing a mix of equity and debt
financing to emerging businesses in recipient countries. The
enterprise funds were to operate for a limited period (expected
to be 10 15 years, though this was vague), after which assets of
the funds were to be sold off and the proceeds redeployed for
other purposes.
     To ensure rapid implementation of the enterprise fund
concept, management of the funds was to be largely independent of
the U.S. government, which was to grant the resources to each
fund. Board members were to be the best minds in the U.S. private
sector and were to be appointed by the President. As shown in
table 3, enterprise funds for Hungary and Poland were organized
in 1990, and funds for Bulgaria and the Czech Republic began
operations in 1991. Seven more funds were added in 1994 95, but
these are only beginning to have significant operational
activity.
     The relationship of the funds to the U.S. government was
initially confused. The government provided the resources but had
no membership on the boards of directors nor any voice in
disposition of funds. No clear reporting or monitoring
relationship with USAID or other U.S. agencies was established,
and fund managers initially resisted such oversight.
     But use of public funds without public oversight proved
unfeasible. Unfavorable press reports in 1993 about one of the
funds led to a requirement for semiannual reports to USAID and an
agreement on audits by U.S. government agencies. The funds agreed
formally or informally to a variety of other procedures, such as
a ceiling on salaries of fund officials and safeguards against
export of U.S. jobs procedures that already applied to direct
U.S. government assistance programs.
     Each enterprise fund took a different approach to its
mandate. The Hungarian and Czech funds invested almost
exclusively in equities, whereas the Polish fund implemented a
substantial lending program. (This fund subsequently created
Czech and Slovak funds as separate operations. The general
approach is the same, though, so they will be treated as one
entity.) The Polish and Hungarian funds sought larger enterprises
and made investments averaging $1 3 million, while the Czech and
Bulgarian funds sought smaller companies. The funds also varied
substantially in their approach to staffing, in economic sectors
emphasized, in geographical diversification, and in the extent to
which joint ventures with U.S. firms were emphasized.
     The funds were established for the broad foreign policy
purpose of speeding the transition of Eastern Europe to a market
economy. The mere act of creating the funds was itself a factor
in achieving this purpose. It provided a clear statement of U.S.
government support that probably encouraged private investment in
the region. An assessment of the success of the funds in this
broader perspective is beyond the scope of this report, though an
overview of the operations and impact of the four operating funds
is contained in a recent (1995) report by Development
Alternatives, Inc. The present report is concerned only with the
venture capital aspect of their operations.
Quality of the Equity Portfolio
     It is still too early to measure the success or failure of
the European enterprise funds. Though they have been formally in
operation for four to five years, many of their investments were
made only in the last two years. Another five years of experience
is needed before we can arrive at definitive conclusions.
Moreover, the ultimate performance of a fund can be affected
dramatically by one or two investments (e.g., a Microsoft of the
future) that can compensate for many poor investments. Despite
this imperfect state of knowledge, the experience so far appears
to provide some reasonable expectations about the success of the
individual funds.
     In principle, Eastern Europe should be an ideal setting for
venture capital activities. Since the funds were launched in
1990 91, the private sector in each country has grown
dramatically, with governments divesting themselves of assets,
and opportunities for new businesses appearing everywhere. Labor
forces are much more educated than in developing countries, and
the policy climate for private business has improved rapidly.
Overall economic activity has begun to recover in most
countries though private economic activity was rising rapidly
even in the early 1990s. Moreover, the Eastern European countries
lacked a banking sector either experienced or interested in
lending to small and medium-size private enterprises. Therefore,
venture capital providers faced less competition from banks than
in other countries.
     All these considerations would make one expect funds in
Eastern Europe to perform extremely well in comparison with
venture capital funds launched in developing countries.
     It is still too soon to judge with any precision the
performance of fund portfolios, but available evidence suggests
it has not been particularly favorable. Two of the four funds (in
Czechoslovakia and Bulgaria) have suffered large losses unlikely
to be offset by gains elsewhere in the portfolio. The value of
the portfolios of the other two funds appears so far to have
increased only slightly, if at all. (Both have, however, sold a
small number of equity holdings for a profit an achievement not
documented for any of the USAID funds discussed earlier.) None of
the funds has achieved operational sustainability. All have had
difficulty finding equity investments that offer high
payoffs calling into question the basic hypothesis of a severe
shortage of equity capital. The Development Alternatives study
concludes, "It is clear that the market for conventional venture
capital is narrower and less profitable than might have been
originally anticipated." (FDAI 1995, p. v.)
Operational Issues
     The funds did avoid some of the problems with USAID projects
described in chapter 3. Boards of directors selected by the
President were largely financial-market professionals,
emphasizing private sector profitability and sustainability.
Nevertheless, board members with investment banking experience
predominated over venture capitalists. Some have argued that this
biased the funds' operations toward conservatism. USAID gave fund
staffs total freedom of action, imposing none of the constraints
or rigid approaches characteristic of Agency-designed venture
capital projects.
     The new institutions did begin operations quickly. In
comparison with the European Bank for Reconstruction and
Development the major governmental institution with the same
general mandate the enterprise funds took one year less to
achieve normal operations. Almost certainly, they got off to a
faster start than would have been the case had they been designed
as USAID projects.
     Enterprise funds also adapted flexibly to changing
investment opportunities and country conditions. The Polish fund
shifted substantial resources to its small-lending program in
response to its initial favorable experience, and created a major
niche in the marketplace. The other funds each did useful
experimentation. A typical USAID project would have limited the
scope for such experimentation. Since uncertainties in these
countries substantially outweighed certainties, the usual USAID
project, with its rigid design, would have been less successful.
     Despite these operational advantages, the experience with
enterprise funds so far is mixed. Freedom from constraints
appears to have produced innovation and flexibility, but it also
produced mistakes and errors in judgment in some funds. With
strong internal management, some funds avoided such problems. In
other cases, greater USAID oversight might have prevented them.
CHAPTER 5.
Experiences of Other Approaches, Other Places
     USAID IS ONLY ONE OF A number of actors promoting venture
capital in developing countries. Both private entities with a
development goal and multilateral agencies have been active in
this field. These other experiences provide a perspective for
assessing the failure of USAID to identify a successful approach.
Private Ventures
     1. International Basic Economy Corporation. IBEC was
established in 1947 by the Rockefeller Foundation. Its creator,
Nelson Rockefeller, saw it as a model of enlightened American
capitalism, to demonstrate that fostering profitable business
activities would contribute to economic and social development of
poor countries.
     Originally involved in Latin America, by 1968 IBEC operated
in 33 countries through 119 subsidiaries and principal
affiliates. Emphasizing enterprises that contributed to a
nation's food and housing supply, IBEC funded such ventures as
mutual funds, agricultural services, home building, poultry
breeding, and manufacturing.
     IBEC had some notable successes. It pione<%-2>ered
supermarket chains in Latin America that generally helped reduce
retail prices. It helped to improve egg output through scientific
poultry breeding in several countries. In Br<%0>azil, IBEC
developed a hybrid seed plant that has increased corn crop
yields. More often, though, IBEC acquired unproductive and
marginal facilities that cost millions of dollars. It got into
ventures in which it had no expertise, and it failed to make
consistently good profits.
     During its first two decades, IBEC experienced steady, if
only marginally profitable, growth. Stockholders' equity grew
steadily to $16 million, and assets totaled $30 million after the
first decade. By 1966 equity amounted to $42 million, and total
assets had grown to $157 million.
     The company decided in the mid-1950s to invest in the United
States to provide a steadier cash flow than it was getting from
developing countries. In 1955 57, IBEC purchased two successful
U.S. manufacturing companies, V.D. Anderson Co. and Bellows Co.
These companies provided a continuing cash flow to finance IBEC's
foreign investments (Broehl 1968, 260). IBEC's merger with the
U.S. based Arbor Acres chicken company in 1964 also contributed
to the company's profitability. The merger significantly
increased the company's size, with gross sales for 1965 climbing
to $197 million.
     By the early 1970s, however, IBEC faced serious financial
troubles. In 1973 a group of banks led by Chase Manhattan
extended IBEC a $45 million line of credit. But by 1975, the
company was unable to meet its financial obligations to some
financial institutions. IBEC again turned to Chase Manhattan for
help. This led to later charges of conflict of interest with
respect to Rockefeller family involvement in both institutions.
IBEC's revenues peaked in 1974 at $300 million, but management
aggressively reduced both the work force and IBEC's affiliations
from that time on. By 1979 revenues had fallen to $66 million,
and the Rockefeller family decided to dissolve IBEC.
     Dismantling IBEC was undertaken for a variety of reasons,
not all of which had to do with lackluster performance in
developing countries. Its investments in U.S. manufacturing
companies were also weakening by this time. Also, in the early
1970s as a result of actions by the Organization of Petroleum
Exporting Countries, IBEC found itself operating in increasingly
hostile political environments in Venezuela because of the rise
of nationalism and suspicion of multinationals, and in Brazil
because of hyperinflation due to balance-of-payments problems.
     IBEC's problems continued to mount. By 1979, when Nelson
Rockefeller died, IBEC faced increasing losses and a string of
lawsuits. In 1980 the enterprise was sold to a British
conglomerate, Booker McConnell, Ltd. There it existed for several
years as a subsidiary before disappearing entirely.
     2. The Atlantic Community Development Group for Latin
America (ADELA) was established in 1964 with private American and
European funding to promote venture capital funding in Latin
America. The concept of a private venture fund for Latin America
had been proposed by Senators Jacob Javits and Hubert Humphrey,
who generated international support. Initial investors consisted
of 54 major multinational manufacturing and financial firms,
which provided $17 million in capital. ADELA later grew to have
$61 million in capital, with 240 investors, none of whom held
more than 1 percent of equity. With no dominant shareholder,
ADELA's large board of directors provided little effective
oversight over the company's management.
     ADELA investments grew rapidly. By 1970 the corporation had
invested $217 million in loans and equity in 100 companies and
had offices in 11 Latin American countries. By 1977, investments
had grown to $485 million in 600 companies in 18 countries, about
two thirds of which were in loans. The rapid growth was financed
by borrowing from commercial banks and by issuing Eurobonds, and
ADELA became steadily more leveraged. It reached a debt equity
ratio of 5.3 in 1979.
     The company was consistently profitable on paper through the
1970s, though its financial statements misrepresented its real
condition, which was deteriorating. For example, stock dividends
were treated as income, and nonperforming loans continued to
accrue income. Lack of financial controls and a decentralized
structure permitted deceptive practices by branch offices. In
January 1980, the corporation declared itself unable to meet its
debt obligations, and it suspended payments.
     For the next decade, ADELA was, in effect, in receivership,
as assets were liquidated to repay debt. Tessler & Cloherty
(1985) estimate that ADELA's annualized rate of return on its
capital over 1969 83 was minus 60 percent a year. It managed to
reduce capitalization of $90 million to $14 million. The company
was finally liquidated in 1992.
     3. Private Investment Company of Asia (PICA), like ADELA,
had been promoted by Senator Javits as a vehicle for private
sector development. Conceived in 1969, it was built on the same
model as ADELA (as was SIFIDA later see below), with ownership
distributed among more than 100 corporations, each owning only a
tiny share, and a mandate to engage in equity investment and
lending to private business. With an initial capitalization of
$40 million, it began operations in 1972 from a Tokyo office. It
later moved to Singapore, establishing eight other offices and
building its staff up to 65.
     PICA provided a variety of financial services as well as
loan and equity financing. Its equity portfolio grew to $40
million by 1984. But the combination of increasing competition
from other financial entities, relatively high administrative
costs, and the recession of the early 1980s created severe
difficulties for the enterprise. In 1987 it was absorbed by
Elders Finance and Investment Company of Australia.
     4. Socit Internationale Financire pour les
Investissements et le Development en Afrique (SIFIDA) was
established in 1970 to provide equity and long-term capital
investment in Africa. SIFIDA's stockholders included more than a
hundred private and public institutions from the industrial
countries as well as multilateral agencies. As with ADELA, SIFIDA
had a large (27-member) board of directors with no single
dominant shareholder: the African Development Bank was the
largest, with 6 percent of shares.
     SIFIDA's approach was much more conservative than ADELA's.
The company concentrated initially on constructing a headquarters
building and staffing its Geneva, Switzerland, headquarters, from
which all staff operated. Its investment portfolio grew only
slowly during its first decade, from $6 million in 1974 to $38
million by 1981. It was only slightly leveraged, as paid-in
capital was $21 million. SIFIDA's strategy emphasized equity
investments, but this proved difficult in practice. The
corporation had placed $5 million in equity (compared with $9
million in debt) by <%-2>1977, but equity holdings stagnated for
the next five years, whereas debt grew to $37 million. During its
first decade, SIFIDA had only one sizable capital gain a profit
of $1.5 million on the sale of its Geneva headquarters building.
     SIFIDA's conservatism did protect it from illiquidity during
the early 1980s. One estimate of its return on investment during
1975 82 puts the annualized rate at 2.6 percent. Had SIFIDA's
capital been invested in U.S. Treasury bills, the rate of return
would have been 9.3 percent (Tessler and Cloherty 1985, 19).
Worse was to come, though. The economic difficulties of African
countries during the 1980s led to a gradual deterioration of the
company's financial position. In 1994 it became insolvent.
     Thus, all four "enlightened" private sector efforts to
promote venture capital in developing countries ultimately
failed. All four can be considered "benevolent," in the sense
they intended to do well by doing good: their creators sought to
promote economic development and to enjoy profits as a
by-product. All four institutions had difficulties in making
business decisions. IBEC was reluctant to contest breach of
contract by partners because of the adverse publicity for the
Rockefeller name. The other three institutions lacked a dominant
shareholder to enforce a clear purpose or to control management.
Multilateral Agencies and Other Governments
     1. International Finance Corporation (IFC). The
International Finance Corporation was established in 1956 as an
affiliate of the World Bank to directly fund private businesses
in developing countries. The IFC operates in the venture capital
field at two levels. First, it has provided direct lending and
investment in emerging enterprises in developing countries.
Second, it has invested in venture capital companies in
developing countries, having taken an equity stake in eight such
companies during 1975 85.
     IFC as an equity investor. U.S. opposition initially
prevented the IFC from investing in equity, but its mandate was
broadened in 1961 to include both equity investment and lending.
IFC equity investments rose rapidly after 1961, and the portfolio
in 1970 was 60 percent in loans and 40 percent in equities. (The
IFC values its equity investment portfolio on a historic cost
basis, so the market value of the equity share may be somewhat
different.) After 1970, however, the IFC shifted sharply away
from equity investments and toward lending. Equity investment
continued to grow during this period, but only slowly, whereas
lending increased rapidly. At the end of FY 1995, 81 <%-2>percent
of the IFC's total portfolio of $9.5 billion was in loans, only
19 percent in equities.
     The average IFC operation is considerably larger than those
typically pursued in USAID venture capital projects. The average
new commitment in 1995 was $12 million, and many of the
investments are in very large enterprises: steel mills, mining
companies, public utilities. Such firms are visible, and their
large capital requirements create the possibility for widespread
public ownership. Consequently, the IFC operates in a segment of
the market where prospects for public sale of equities are far
more promising than they are for the smaller firms favored by
USAID. Nevertheless, the IFC's equity portfolio has not seen
rapid turnover. In 1995 the IFC sold equity with a cost basis of
only $42 million, compared with a cost basis for its total equity
portfolio of well over $1 billion. That implies an average
holding period for equity substantially longer than the five to
seven years of which venture capitalists typically speak.
     No studies were found of the relative profitability of the
IFC's equity portfolio in relation to its lending. (One IFC study
(IFC 1989) examines the economic and financial rates of return to
projects in which the corporation has invested. It includes
breakdowns by sector of activity for such variables but,
curiously, does not consider the question of whether equity or
lending activities have yielded better results.) The IFC's
gradual reduction in the equity share of its operations suggests
that staff did not consider it favorable. (Alternatively, equity
lending could on average be more profitable but hampered by lack
of opportunities.)
     One apparent benefit of the IFC's concentration on private
sector lending is the opportunity to be selective about where it
places its resources. Country conditions are generally considered
important to the prospects of business enterprises, but the IFC
portfolio does not appear to have been particularly successful in
this regard. Its portfolio has historically emphasized Latin
America over Asia. Even within Asia, its resources flowed more to
India and Pakistan than to the fast-growing countries of East
Asia. (In 1983 the IFC's portfolio in Yugoslavia was larger than
that of the seven "Asian Miracle" countries combined. In that
year, the 10 largest users of IFC resources were, in declining
order, Brazil, Yugoslavia, Mexico, India, Turkey, Egypt,
Argentina, the Philippines, Pakistan, and Zambia.) In the 12
years since then, most of these countries have been relatively
poor performers.
     IFC as investor in venture capital companies. The IFC has
also provided resources for venture capital companies. A recent
evaluation of eight such enterprises (IFC 1992) in which the IFC
invested $40 million from 1976 through 1986 concluded that this
indirect support had serious problems. The venture capital
companies had difficulty persuading owners of promising
businesses to sell part of their equity; managers of venture
capital companies were usually inexperienced and had to learn by
doing; and developing a management structure that created proper
incentives was difficult.
     Overall, the IFC's venture capital portfolio performed
poorly. Estimated real rate of return on its projects in venture
capital companies was minus 5 percent, compared with +6 percent
on its overall portfolio. (Even though the 1992 evaluation
covered only investments made in 1986 or earlier, the slowness of
many venture capital operations to mature makes valuation
uncertain except after a long time lapse. The IFC evaluators
considered their estimates to be conservative. Thus, a later
evaluation might produce less unfavorable results.) In other
words, the IFC's investment in venture capital companies lost 5
percent of its value for each year it was invested.
     Inter-American Investment Corporation (IIC). In 1987 the
Inter-American Development Bank established an affiliate for
investment in private sector projects, the Inter-American
Investment Corporation, along the lines of the IFC. It is too
early to make judgments of the effectiveness of the IIC's
investment portfolio. Nevertheless, the IIC's early experience is
similar to cases described earlier. Start-up took longer than
expected, and administrative costs mounted before the corporation
began to generate income. It encountered early difficulties
finding suitable investments. By 1994 it had fully committed its
resources, but inflows were inadequate to cover operational
costs, and the IIC had to sharply reduce its staffing.
     3. Commonwealth Development Corporation (CDC) was
established by the British government in 1947 to promote
development in present and former colonies. The corporation has
operated as a financial intermediary, with a capital stock and
borrowing authority, rather than as an aid agency. At least
between 1955 and the early 1980s, the corporation was
consistently profitable, though this may owe much to the fact
that its debt is to the British government at concessional
interest rates.
     CDC financing has consisted primarily of loans, particularly
for public utilities and housing. Equity investment has
represented 10 20 percent of the corporation's portfolio. The
corporation has maintained a relatively lean organization, with
administrative costs held to about 2 percent of the portfolio.
Moreover, its country portfolio mix appears to have generally
been better than that of the IFC. Initially confined to the
Commonwealth, it expanded after 1972 into other developing
countries. This was done selectively, with initial investments in
Costa Rica, Cte d'Ivoire, Indonesia, Liberia, and Thailand. Even
within the Commonwealth, CDC made no investments in India or
Pakistan until the 1980s.
     CDC's early experience was unfavorable, and it apparently
lost 11 million on the first 12 million of investments.
Subsequent portfolio performance has apparently been reasonably
satisfactory, though no specific information was available on the
equity portion of the portfolio. It has had at least one big
winner a share of a Hong Kong container ship terminal. A 1972
loan of 2 million, later converted to equity, was sold in 1992
for 45 million. Analysis of CDC's total portfolio for 1972 81
(Tessler & Cloherty, 1985) showed that it substantially
outperformed both ADELA and SIFIDA, producing an internal rate of
return on its portfolio of 5.4 percent. (This return is not
impressive for the period; it compares with an 8.2 percent return
that CDC would have earned by investing in U.S. Treasury bills
rather than its actual portfolio.)
Where Was Venture Capital in the 'Asian Miracle' Countries?
     The most rapid economic growth in recent decades has
occurred in East Asia, where the seven countries called
high-performing Asian economies (HPAEs) by the World Bank have
grown rapidly and have dramatically transformed the structure of
their production to become manufacturing centers. In 1992
dollars, the value of industrial output from these economies grew
tenfold to more than $200 billion from 1965 through 1990. What
role did venture capital play in this transformation?
     The answer seems to be very little. The World Bank report
The East Asia Miracle (World Bank 1993, p. 223) concludes that
bond and equity markets "were not generally a key factor in
mobilizing investment during the HPAEs' economic takeoffs."
Stiglitz (1993) has calculated that only a small fraction of the
growth in capitalization of enterprises in either the HPAEs or in
industrial countries has come from outside equity. Retained
earnings were the primary factor, usually accounting for more
than half of financing requirements, but loans and bonds were
each more important than equity financing in most cases. The
study concludes (p. 226) that stock market activity, which has
boomed in recent years in East Asia, is "a result rather than a
cause of East Asia's rapid growth."
CHAPTER 6.
Why is Venture Capital a Mirage?
     CONCLUSIONS ABOUT the success or failure of USAID venture
capital projects must generally be tentative, as the
documentation trail in most cases ends with a final project
evaluation report. Such reports are typically written after
project activity has ended, perhaps five years after the project
began. For venture capital projects particularly since they often
take several years to get up to speed this time period may be too
short. It is possible that a few winners will emerge that pay
such handsome gains that all else can be forgotten. Although this
is possible, the weight of available evidence suggests it is
unlikely.
     Moreover, the experience of IBEC, ADELA, PICA, and SIFIDA is
not encouraging in this regard. All had a decade or two of
experience that, in theory, allowed for the emergence of big
winners. Some winners did emerge, but they were inadequate to
compensate for the losers. Even working with enterprises far
larger than those USAID has tried to encourage, the IFC's record
leaves no indication that this area is one of high payoffs. The
CDC's experience similarly suggests low payoffs. Quite simply,
there is just no evidence that donor-supported equity financing
activity is a desirable or sustainable use of scarce resources.
     It is important to emphasize that this is quite different
from concluding that venture capital is not an important source
of developing-country growth. It is possible that private venture
capital may be useful or important to future growth in developing
countries. Experience simply suggests that donors cannot do it
successfully, and that venture capital activity, at whatever
level, should take place in the private sector.
     The main characteristics of venture capital in the private
sector seem to be
    Quick decision-making
    Investment officers with direct financial interest in
     results
    Relentless concern about profitability
    Relentless cost control
     Donors are not particularly good at any of these. Although
the first and fourth could conceivably be designed into donor
projects, the second and third characteristics pose serious
problems. Donors find it difficult to justify enriching a private
individual or group through use of public funds. This is an
almost insurmountable obstacle except in exceptional
circumstances such as the opening of Eastern Europe. The third
characteristic is a serious challenge because donors usually are
seeking multiple goals. They want profitability, of course, but
they seek to achieve it while supporting particular activities
(such as agribusiness or women's enterprise) and in particular
places (the more remote or backward parts of a country).
Inability to concentrate on the bottom line almost invariably
leads to failure in this keenly competitive business.
CHAPTER 7.
Conclusions
     SIX CONCLUSIONS FLOW from the analysis in this paper:
     1. The Agency's experience with venture capital projects has
been unsatisfactory. Poor project design, partly caused by USAID
procedural requirements, has contributed to this failure.
     2. The experience of other "official" and "benevolent"
venture capital funds strongly reinforces the conclusion that
this is a sector where donors, or socially oriented private
institutions, are likely to perform poorly. Moreover, evidence
from the rapidly growing Asian economies suggests that dynamic
activity in the equity market is more likely an effect than a
cause of rapid private-sector growth.
     3. The enterprise fund concept avoids many problems
associated with USAID venture capital projects, but the funds so
far have had only mixed success. A fund's success depends heavily
on the quality of its management and the clarity of its purpose.
     4. Even successful enterprise funds have not demonstrated
that lack of equity capital is a problem that donor funding can
solve. There is no evidence so far suggesting their portfolios
will yield as much as a 10 percent rate of return, and the return
could well be much lower.
     5. Enterprise funds do, however, provide a means for
developing instruments adapted to a country's private sector
financial needs. It is the flexibility of the enterprise funds'
ability to innovate and to look for market niches that provides
the likely payoff. Such niches are unlikely to be in equity
financing.
     6. In sum, there is no basis for believing that equity
funding either as venture capital or in some other form is a
high-payoff activity for donors. Experience suggests the
opposite. Consequently, USAID should leave this activity to
others.
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