Despite huge losses, the White House is again betting billions of taxpayer dollars on venture capital deals.
This article appears in the August 6 edition of Forbes magazine.
Jonathan Leitersdorf is a wheeler-dealer with Israeli and British passports—and a reputation in New York for living large. He once reportedly spent $30 million building a 177-foot yacht and used to own an 11,000-square-foot Manhattan party loft, which had a memorable cameo in Sex and the City. Jerry Seinfeld got married there, and Chelsea Clinton used it for a birthday bash before Leitersdorf sold it to billionaire Ronald Burkle. But when Leitersdorf needed cash to start a venture capital firm, he turned to a much more pedestrian set of partners for backing: U.S. taxpayers.
Their deep pockets had a lot to do with it. His L Capital Partners set up shop in Manhattan and Tel Aviv, and scored a license as a Small Business Investment Company from the federal government’s Small Business Administration. That designation let Leitersdorf nab more than $96 million in Washington-backed securities and loans, which he deployed between 2004 and 2010 for investments in medical technology and security companies in the northeastern U.S. He and an Israeli bank put up $26.5 million.
The results? A disaster for taxpayers. Like a lot of risky ventures, L Capital failed, and it now owes the SBA most of the money, according to court documents. The feds moved to liquidate L Capital in February, saying the assets had declined in value substantially. Neither Leitersdorf nor the SBA would comment, but in March L Capital did not oppose the SBA’s request to be appointed receiver of the firm.
This was hardly an isolated fiasco. The SBA currently budgets that taxpayers will lose $2.4 billion from the now defunct SBIC Participating Securities Program, which included firms like L Capital and encouraged equitylike investments in early-stage companies. In the last nine quarters the SBA has transferred 12 participating securities SBICs owing $457 million to liquidation and pursued lawsuits against another 13 SBICs for $500 million.
So what happened? To fund these SBIC venture funds the SBA has been federally guaranteeing securitized loans for more than a half-century, and that effort, called the Debenture Program, has generally gone well. It played a key role in launching the venture capital industry decades ago, nurturing Silicon Valley and funding companies like Apple and FedEx. Few of the important venture capital firms in Silicon Valley came out of the SBIC initiative, but the program helped spawn the institutional framework— law firms, accountants and research firms—that the industry originally needed to get going.
The Debenture Program, by design, does not allow the government to make money, but it also hasn’t lost a taxpayer dime in years and thus has been viewed as a success by federal lawmakers, who like to be seen as small business supporters. (Solyndra, the solar-panel producer that filed for bankruptcy after a half-billion dollars in loan guarantees, fell under a Department of Energy program, which targeted individual companies rather than diversified baskets.)
But the $12 billion Participating Securities Program, as the name suggests, essentially put the government in an equity role. Washington tried to get into the venture capital game, with predictable results. In 2004 the Bush Administration scrapped the program, which had started in the mid-1990s. But all those commitments, including L Capital, took years to unwind, and we’re now seeing the full results.
What’s perhaps more startling—and ironic, given the Obama campaign’s frequent bashing of Mitt Romney’s private equity record—is that the Obama Administration is keen on bringing back a similar approach that led to disasters like L Capital. It’s launching two new funds of $1 billion each that put money into early-stage companies, in concert with private funds. Except this time the government gets no potential upside.
To make matters more specious, one of the funds focuses on so-called impact investments, which are located in economically distressed areas or operate in the education or clean-energy sector. Good politics perhaps, but by definition these are investments that will carry even more risk.
Sean Greene, the SBA’s associate administrator for investment, argues that despite the boatloads of venture money floating around, there are still “meaningful gaps in the market” that prevent good small businesses from getting access to financing.
Greene also says that things will be different this go-round. The two new funds, he says, require that every government dollar put into a venture fund be matched with a dollar raised from private investors. The government’s money will be protected because it’s a diversified basket. “We have run the numbers seven ways to Sunday and feel pretty good that we have learned the lessons of the past,” says Greene. “We are making a targeted set of changes to make it more appropriate for early-stage.”
But that still neglects a simple fact of early-stage investing: The private investors that taxpayers are matching dollar-for-dollar are capable of making catastrophic mistakes.
“There is not a lot of institutionalized memory in Washington. They have been down this road before, and now we are going to try something very similar and expect different results,” says Fred Russell, managing partner of Virginia Capital Partners, a private equity firm that uses the traditional SBIC loan guarantees. “The loss rates of startups are too high for it to work. I don’t see how they make their money back.”
Let’s walk through how this plays out when things go south. The government’s receiver began poring over the wreckage at ECentury Capital Partners, an SBIC in Chevy Chase, Md. that was partially backed by an affiliate of the Rothschild banking family, and found seven remaining portfolio companies. The receiver closed out four of these investments, including Bitwave Semiconductor, in which ECentury had plunked down $11.3 million. Bitwave tried to allow wireless carriers and cellphone makers to deploy more services with additional functionality but was liquidated for nothing in 2010 after investment bankers couldn’t sell it.
As of March there were three remaining flops in the portfolio, including a $4.8 million investment in a semiconductor-chip maker for which the receiver determined “there is little that can be done.” In March ECentury owed the SBA $35.1 million of the $43.2 million in loans and guarantees the government had provided to the investment fund, court records show. Thomas Dann, the cofounder of ECentury, who has been running a consulting firm that advises other SBICs on how to manage regulatory risk, says the structure of SBICs and the government’s capital impairment rules undermined ECentury’s strategy.
The government sued Cardinal Growth last year, saying the Chicago SBIC owed taxpayers $21.4 million, after the Chicago Sun-Times reported that Patrick Daley, the son of the former longtime Chicago mayor, had co-invested in Cardinal projects, including a defunct sewer-inspection outfit that won $4 million in no-bid contract extensions from Chicago City Hall. The man who ran that business, Anthony Duffy, pleaded guilty in February to lying to the FBI about his failure to disclose that Daley was an investor in the company. Cardinal cofounders Robert Bobb Jr. and Joseph McInerney, a close friend of Patrick Daley’s, declined to comment. Daley did not respond to a request for comment, either.
The government has been trying to get money from David Unger, who got $38 million of taxpayer financing for his SBIC, Avalon Equity, and its strategy of building a media empire of gay publications and other properties. Last year the feds sued Unger and his business partner, Benjamin Brandes, for $2.2 million, claiming they had breached a contract by engaging in “impermissible self-dealing”: The management firm took a $593,000 interest-free loan from the fund, and Avalon provided $1.4 million in excess financing to three small businesses, including the publishers of New York Press and Genre magazine.
Brandes settled, and it appeared for a while that so did Unger, who in court papers denied wrongdoing. The feds have been trying to enforce the $130,000 settlement, but in April Unger, whose lawyer did not respond to a request for comment, said in legal papers he would not go forward because the feds had improperly altered some of the terms.
The managers of SBICs earn big management fees, which the government sometimes complains about when things don’t work out. (The managers also get rich performance fees from their private investors when things go well.) Last year the feds sued Horizon Ventures Fund II, an SBIC run by former Intel exec Jack Carsten, saying the government was owed $48.9 million and that “while the general partner was reaping at least [$5.5 million] in fees for ‘managing’ the fund, the fund’s performance has declined over the years culminating in its capital impairment.” The SBA ended up selling its interest in Horizon, and Carsten says in a statement that the SBA was “too aggressive in pursuing our case, but they recognized this and we reached a fair settlement.”
To be sure, many SBICs work out well financially. The manager and private investors make money, the government doesn’t lose any, and small business gets supported.
But there’s a larger question. What is the government doing in the private finance business when, according to research firm Preqin, there’s already $65 billion in private venture money ready to be deployed? Josh Lerner, a Harvard University professor specializing in entrepreneurial management, thinks it is a classic government subsidy that has proven impossible to kill off. “The benefits are not clear because there has been no serious evaluation of the SBIC program,” says Lerner, who in his book Boulevard of Broken Dreams (Princeton University Press, 2009) said the SBIC program had exhausted its usefulness. “Venture is now a large industry, so it’s hard to say it’s justified.”
Anita Campbell, chief of Small Business Trends, an online community for entrepreneurs, faults the government for backing venture capitalists rather than the startups themselves. “Those guys are paid to take big risks, but it shouldn’t be the American taxpayer who does it.”
And for Scott Shane, an entrepreneurial studies professor at Case Western Reserve University, the problem is simple: Nobody has made a compelling case that there is market failure requiring the government to intervene in the venture industry that backs small businesses. Private investors, not bureaucrats, should decide where the money flows. “The reason the capital markets don’t give everyone capital,” says Shane, “is some people shouldn’t get capital.”
