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From Site Selection magazine, May 2010

A Blueprint for
‘Regional Transformation’

A proposal for a region-wide venture capital fund may be the key to future
prosperity for the Great Lakes states, but how badly do they want it?

Frank Samuel, Jr., author of “Turning Up the Heat: How Venture Capital Can Fuel Regional Transformation,” a Brookings Institution report
Frank Samuel, Jr., author of “Turning Up the Heat: How Venture Capital Can Fuel Regional Transformation,” a Brookings Institution report

f one could simply light a spark under the economic potential resident in the Great Lakes region, and transform those states into red-hot centers of enterprise, then why hasn't it happened yet? Two reasons: Every spark needs an energy source, and the region has to want the spark in the first place.

Long-term economic prosperity will elude regions and nations if businesses cannot grow and flourish and create jobs — if entrepreneurship is not rewarded and encouraged to take root and bear fruit. In the Great Lakes, this means keeping area companies with promising ideas and technologies from growing their businesses somewhere else.

A paper released in late January by The Brookings Institution explains how to do just that. "Turning Up the Heat: How Venture Capital Can Fuel Regional Transformation" was authored by Frank Samuel, Jr., a consultant and former science advisor to Ohio Gov. Bob Taft and architect of some of that state's most successful venture capital initiatives, including the Third Frontier program. The paper was also the topic of a March 2010 Global Midwest Policy Brief, "A Venture Capital Strategy for the Great Lakes," from the Chicago Council on Global Affairs.

Samuel advocates the formation of a Great Lakes 21st Century Fund, a fund of funds managed by the private sector — that's a key point — and capitalized with US$1 billion to $2 billion targeting early-stage ventures with the goal of keeping them from moving and expanding elsewhere. His premise is threefold:

  • The Great Lakes region has the ingredients in place for economic growth, including major research assets, a rich supply of human capital and a mature industrial base.
  • Venture capital investing in the region is hindered by too few "investable" deals emerging from area research institutions, the high cost of early-stage investing due to geographic and other reasons and a lack in capacity to fund initiatives further into their life cycle, prompting them to seek locations outside the region that can provide post-early-stage financing.
  • A coordinated effort in the part of multiple stakeholders is needed "to create and sustain a virtuous cycle of venture investment, entrepreneurship and firm growth in the region."

In early April, Site Selection Editor in Chief Mark Arend spoke with Frank Samuel about his case for a Great Lakes regional venture capital fund, which was first recommended in a 2006 Brookings Institution report called "The Vital Center." Following are some excerpts from that conversation.

Site Selection: How pressing is the need for a regional venture capital fund relative to other challenges the Great Lakes states face in 2010?

Frank Samuel: It's actually closer to the top of the list than most would think. In the current economic climate, everyone is focused on job losses, especially in manufacturing, and all the problems that entails for state budgets in terms of decreased tax revenues and increased obligations to pay for workers' comp, Medicaid, Medicare and so forth. Venture capital can get lost, because it's a small part of total investment, but it can have a disproportional effect if it reaches critical mass, which is what my paper explains. From a political perspective today, investing in venture capital is a long-term proposition that has to be maintained consistently over a number of years. It's really hard if you're a governor facing a huge budget deficit — and all states in the Great Lakes region have deficits of one size or another.

In Ohio, for example, it would be hard if we didn't have a program that supports venture capital to institute one under current circumstances, because you can't in all honesty promise it will create jobs next year or help people that have lost their jobs, or reduce the unemployment rate. It has to be a long-term fix. If you don't look at it long term, you're almost better off not trying to do it, because with any form of investment, particularly venture capital, if you're on again, off again, you might as well be off all the time.

The unpredictability of the source makes it really hard to develop deals. The underlying dynamic in venture capital investing is continuous identification of really promising, high-growth projects that can be turned into 'financeable' deals. If you don't do that consistently over a long period of time, you lose your pipeline and relationships with universities and inventors and so forth. It's hard to get that restarted again on a short-term basis. In some ways, venture capital is essential to any good policy or program for transforming the economy, but it takes discipline. Having been in government for six years, I really sympathize with the folks who have to deal with these budget holes they're facing today. It's not simple.

SS: Is this a chicken-and-egg problem? You make the point that there is outstanding research being done around the Great Lakes, which should attract venture capital. But it's not being adequately funded in order for commercialization to take place in the region — because the VC players have a negligible presence in the region.

FS: When I got back to Ohio after being a trade association lawyer for a number of years, I was based in Cleveland and started hearing almost immediately from the entrepreneurs: 'We need more money.' The investors would say, 'We have plenty of money — what we need is more good deals.' I concluded that both were right, that more of both were needed. It wasn't a linear situation, where you first do one side of the equation and then the other. You have to push forward on both fronts at the same time. If you don't, then they don't reinforce each other. It sounds harder to do both at once, but it's the only way for it to work.

That's why we have these twin recommendations in my paper — the recommendation to increase the supply of financing, but not that alone. You also have to build upon a lot of the things that have been started in many states in the region. [From the paper's Executive Summary: "A variety of private and public stakeholders — including federal, state and local government leaders, research institutions, the philanthropic sector and catalytic enterprises — work in parallel with the investor community to create a vigorous support system for venture investment." — Ed.] They're not starting from scratch on that side of the equation. If all you did was say 'We need to create a fund of funds,' and not worry about the 'investing ecosystem,' it wouldn't work. If you only worried about the investing ecosystem and figure the money will take care of itself, I don't think that will work either.

SS: Most, if not all, Great Lakes states have venture capital funds, but most are too new to evaluate adequately, according to your paper. Why not just let them mature and keep things on a state level?

FS: If you put aside the last couple of years, which have been really tough on VC in general, some of those funds have been successful. There has been a gradual diminution of the ability to go public, which had been the exit strategy of choice for a lot of venture firms. I was on the board of several that reached a payout for the original investors by going public. Well, after the dot-com crash, that avenue for the original investors to realize their investment and some profit withered. Then you had the problem of the recession over the last couple of years. It's been a real problem for these individual funds, which are relatively small and therefore have a relatively small portfolio, and they were banking on one or two deals doing really well. If it was difficult for even the good deals to get exits, then they couldn't perform very well. What we're trying to do with this recommendation is say that if you create a larger context within which these decisions are being made and in which capital is being supplied, then you have a better chance than if a region or metro within a state tries to do it on their own. There just won't be the attractive capacity or the critical mass of attention that helps create more good deals.

Look at the deal generation side — university research and tech transfer. If each university can do its own thing, then it will do so. It will be driven by academic standards for its faculty, and it will focus on royalties. Some universities talk a really good game about startups and some do a decent job of it [but the perspective and results are localized]. We've upped the ante and intensified the game. It's like athletics — you can have a well-qualified team that can play at an OK level, but you move them into a tougher league and the same players begin to play at a higher level. Without pressing the analogy too far, there is some of that here. If Case Western in Cleveland sees itself as playing in Cleveland, there will be a different level of intensity for all concerned than if they see themselves playing against Purdue and Michigan and Northwestern and eventually in the Stanford and MIT leagues. Everybody focuses more. They treat it as more important. They rise to the challenge.

The more successful regions have figured out a way to be more productive with what they have. That means doing things differently than the way we do them now. If we try just incrementally to do better, it won't work. We will have to think about some real changes in how faculties and student bodies and outside experts look at the research being done at our local institutions.

SS: Could the Great Lakes region and research institutions there do a better job of drawing attention to potential tech transfer opportunities and other initiatives of interest to venture capital investors? Even with the Great Lakes 21st Century Fund, can the region compete in the bigger leagues?

FS: We work hard, but we don't talk fast — that is an issue. We need to redefine our issues. Entrepreneurship is often described in terms of risk taking. That's the wrong way to look at VC investing. As Peter Drucker says, and I reference this in the paper, entrepreneurs are not risk takers, but risk reducers or risk managers. If we in the Midwest could re-conceptualize entrepreneurship as being risk management instead of risk taking, it would suit our regional psychology a little better. In any business success, large or small, before they put their money in, the investors understood the risk, they minimized and reduced it, they 'de-risked' the investment. In any business situation you take some risk, but you do your best in advance to reduce it.

Second, let's say we are risk averse in the Midwest, and we need to be less that way. How? What do you do to make the region less risk averse? I don't see any way to do it except going out and creating success. It's the kind of observation that while it is true as an analytic matter, it doesn't lead me to a pragmatic solution, except going out and doing the things I've described in the paper. I don't deny the accuracy of the observation, but wringing your hands gets you nowhere fast. To do something, you have to find more good deals and do the other things we've talked about.

SS: What sort of reception is your proposal getting?

FS: Audiences I've talked to have largely been the converted — they think VC is important and are trying to advance it and expand it. They agree with the paper conceptually. The fundamental points in it are not in contention. But even the most favorably inclined to it say it will be difficult to do, particularly the fund of funds, for two reasons. First, it's a new concept. In financial circles, even without our current problems, that will take some selling. Second, the old venture capital model is under attack, because it hasn't brought the kind of returns investors have wanted from it in the past few years. They're a little gun-shy on it now. Capital is harder to raise, I hear, and in the earlier-stage space — before a company is really up and running — which is of interest to me, and in terms of public policy, I think we'll have to rethink how to present the case. In this paper, in effect, I'm trying to restructure the argument to say it's not just a matter of adding more VC firms. We have to view what we have as a different kind of ecosystem than we had in the past. The pieces for that are in place, they just need to be associated with each other, and across state lines, in a way that will enable us to tell a different story about what's going on here.

SS: As much as I understand your proposal conceptually, I have to wonder if in practical terms it would require too many cooks being in the kitchen for it to work well.

FS: That is a concern, and one can't ignore it. If there was some way to assemble all the university research and venture capital capacities and pension fund capacities of the Great Lakes region into, say, the state of Missouri, no one would be talking about this problem. It would be such an intense, engaged community that we would be reinforcing each other, and the political (city and county) boundaries would still be there. But you can be sure Missouri would be the venture capital center of the universe. It is an issue.

On the other hand, one of the reasons I was attracted to the VC recommendation in the first Brookings Report was because you don't really need a legislature to legislate here or a governor to issue a regulation or to sign an agreement with other governors. There are things states and metropolitan governments can do, but if private investors think they can make money, they'll do it. So the purpose here is to assemble facts in a way that will convince them there is a reasonable chance they can make money. Just like investing in oil exploration, we have a lot of holes being dug here all over the place, and the research being done is fine — no budding Google or Microsoft necessarily, but they are promising projects. So what will enable us to get the Google or Microsoft? I guess I'm saying more work. Then there are cases of a Google or Microsoft that started here and moved away, such as Netscape from the Univ. of Illinois, and Amgen in Michigan. They left when they were really small, but if we had had a more robust ecosystem here to support them, they might have stayed. [Google co-founder and President Larry Page is a Michigan native whose father Dr. Carl Victor Page was a Michigan State University computer science professor. The junior Page graduated from the University of Michigan in 1995, is a member of the National Advisory Committee (NAC) of the University of Michigan College of Engineering, and delivered UM's commencement speech in 2009. — Ed.]

SS: There's a lot of money available these days on the public side, but not so much on the private side. So who will drive this regional fund of funds initiative?

FS: Ultimately, for this to be sustainable, it has to be private-sector-driven. It cannot be publicly subsidized. It must be funded from private institutional investors. In terms of the support structure, business leaders can be bankers and others; far-sighted manufacturing organizations and others can be very influential in the political process and to the university leaderships in saying, 'Here's what needs to get done.' So there is a leadership role for the private sector in general and a very specific role for the financial community to play.

SS: Would only start-ups benefit? What if a well-established Great Lakes state company, like Caterpillar in Illinois, wanted to fund a major new R&D center for developing fuel-cell-powered heavy equipment? Could this fund work here as well, as a way of keeping them from building that center outside the Great Lakes?

FS: That's a very good illustration of this concept. Netscape was University of Illinois intellectual property developed by a student there. If there had been a private sector group there on the alert for something that was going to be big and could have provided the necessary resources, at least there would have been the chance to retain it there that would have been private-sector oriented.

It's a heck of a challenge, but what really is fascinating is when you add in all this talk of clean energy and alternative energy and so forth, which is really important in the Midwest due to the auto industry and needs to get repurposed somehow. There's a real opportunity for the Midwest to be a center of advanced energy innovation and new company formation over the next generation. We'll have to get our act together and treat ourselves as a community rather than as 12 states and 45 cities and a bunch of universities. That's easier said than done, I realize.

People can be farsighted and really inventive and creative, but they can still be bound by the jurisdictional boundaries of their institutional or political organization. It's not going to work that way. No one in those enterprises is charged in the morning with thinking of the organic whole of the Great Lakes. Not one person.

But if you said we'll have a $1-billion fund of funds in this region for investing in start-ups in advanced energy, and we'll create an ecosystem around advanced energy technology start-ups, commercialization, company-building, entrepreneurial training and work-force training in this region, I think you would galvanize attention in the Midwest around this topic like you've never seen. I guess in that case, I've chosen the chicken to come first.

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