Uncle Sam, Venture Capitalist

By Joseph S. Fichera and Robert M. Rubin

Published in:

Thursday, May 2, 1996

When the Berlin Wall fell in 1989 and former communist countries sought the help of capitalists, the U.S. decided to “privatize” its response. The U.S. established “enterprise funds” that are pumping more than $1.3 billion of equity and loans into businesses in 12 Eastern European countries. But seven years later it appears that the government forgot about private sector accountability and made the enterprise funds answerable to no one — not even their de facto shareholders, American taxpayers.

We learned this the hard way when in October 1994 we joined the board of the Czech and Slovak American Enterprise Fund, which many observers believe had been the most dysfunctional and ineffective of the funds since it started in 1991. After a year of wrangling, our fellow CSAEF directors pushed us out last December. Earlier this year, they all resigned. An interim board is in the works, and the fund is being “restructured,” as the euphemism goes. Its portfolio is worth far less than what was paid — maybe as much as 50% less.

Recipe for Stalemate

Enterprise Funds have provided seed capital directly to businesses in places like Slovakia and Uzbekistan. Instead of government bureaucrats deciding who gets what, prominent American business leaders, as fund directors, invest and manage the taxpayers’ money. The 10 individual country funds are Delaware corporations. The boards of directors are peopled with the good and the great of the Fortune 500, Wall Street and the like. The Agency for International Development writes the checks on the taxpayers’ account, but short of forcing out the whole board and effectively shutting down a fund — which it felt obliged to (to in the case of the CSAEF — it can only jawbone once the checks are cashed. And once the government establishes a board, that board selects its own new members. The president recommends appointees but the boards are under no legal obligation to accept them — a sure recipe for stalemate.

These funds have been humming along without much attention until recently, when the CSAEF made the newspapers and disintegrated tinder the weight of an AID inspector general’s report precipitated by an employee’s falsified competitive bids for computer services. This unfortunate matter was merely a sideshow compared to the mismanagement and deteriorating results of the fund and the government’s inability to change things without extreme action.

We were told by local investment managers we could not remove an entrepreneur who was clearly failing because it would raise the specter of “ugly Americanism.”

Many of the CSAEF’s investments were in trouble as soon as they were funded. When we joined the CSAEF’s board in late 1994, we couldn’t understand how in a country like the Czech Republic, which is one of the success stories- of the ‘90s, the fund could end up so far behind the market, despite its plentiful war chest and blue-ribbon board. By way of explanation, we were frequently told that the fund, in its early days, was merely following the wishes of the State Department to make a lot of investments quickly! So much for traditional due diligence.

We found a board that, once invested, was essentially unwilling to aggressively administer the bitter medicine of capitalism where it was warranted. In one case, we were told by local investment managers we could not remove an entrepreneur who was clearly failing because it would generate bad press. In other words, the specter of “ugly Americanism” blocked a sound business decision. However, real venture capitalists are rarely close personal friends with their investees. Under capitalism, the profit motive determines the direction of business decisions. But here, board members are unsure of their objectives.

Administrative expenses of the fund ran to as much as 10%, of invested capital or more, depending on how realistically one valued the portfolio. At a comparable private sector fund, the First Hungary Fund, the overhead is closer to 2%. While regulations capped our fund’s salaries at $150,000 and prevented anyone from having a performance-based interest in any investment — a normal way to motivate a venture capitalist — the CSAEF, in the. best traditions of big government, had no problem running its annual expenses up.

If the CSAEF were a “real world” closed-end country fund with standardized accounting and reporting, it would be trading at a huge discount to net asset value, with the attendant sobering effect on management. Instead, CSAEF issues carefully calibrated annual reports that speak of “multiplier effects.” There is little transparency, essential to accountability, on investment criteria, decision-making or ongoing management. Little, if any, public information is available on the funds. No one follows them except the bureaucrats in AID and the State Department who have no real authority over the funds in the first place. The funds are more like not-for-profit entities-also known as charities than they are venture capital funds. But prominent boards of directors are not a sufficient check against excess and inefficiency. Sometimes it works, but in the case of CSAEF it didn’t. The “privatized” structure gave us the worst of both worlds.

Some other funds have fared better; the Polish and Hungarian enterprise funds, for example, seem to be advancing foreign policy goals and preserving taxpayer capital at the same time. But there are disturbing lessons in the CSAEF debacle that potentially apply to all the funds.

The funds’ enabling legislation needs to be looked at again. Emerging markets are a lot different today than they were in 1990. And the scope of the funds is being broadened to include economies that have never known communism, like South Africa. Congress should:

• Put government representatives on the boards. This works in the case of the Overseas Private Investment Corp., where various government officials serve alongside private sector appointees.
• Give the president the power to appoint and remove private sector board members, without requiring the concurrence of the board. This more closely parallels the private sector in assigning board rights to capital.
• Decide whether the $1.3 billion earmarked for the funds so far is an investment or a grant.

“Socially Responsible” Funds

If it’s a grant, slash overhead, allocate the money wisely and hold the grantors accountable to well-defined foreign policy objectives.  If it’s an investment, set some standards. Define return on capital objectives, and more Importantly, return of capital — to the taxpayer, that is. The current legislation is silent about how and when the money is supposed to come back to the. Treasury. Perhaps the best private sector paradigm ought to be the “socially responsible” fund, which tries to meet a return objective while shunning or promoting certain specified types of Investment. Investors in these accept a lower, return but at least there is a return objective.

And if these funds are looked at as investment, lift the restriction’ on giving fund managers performance-based compensation. The bloated overheads of some of the funds show that this compensation limitation is the misplaced emphasis of bureaucrats.

Enterprise funds are supposed to be venture capital funds with a foreign policy twist-foreign aid in politically correct form. Without accountability, however, the potential for waste is the same as any government program.

Mr. Fichera. and Mr. Rubin, both Wall Street executives, served on the board of the Czech and Slovak American Enterprise Fund from 1994 to 1995.

The New York Times Coverage – February 7, 1996

The New York Times Coverage – March 3, 1996