2002 Japan Conference: A Summary of the Papers

Promotion of entrepreneurship and innovation has become one of the primary industrial policies of developed economies around the world. The development of a venture capital (VC) industry often is regarded as a significant component of this policy. The question that this raises is to what extent the VC industry plays a similar role in different countries, and how large is the influence of its sources on its activities.

The present paper is an industry study, focusing exclusively on the VC sector and posing the question how the structure of VC funds, and especially their financing sources, relate to their investment activities. We report results from a newly constructed database consisting of about 500 venture capital firms in four countries: Germany, Israel, Japan, and the United Kingdom. The data provide unique insights on both the types of investments made by financial institutions by stage of activity, sector, and location and on the sources from which they raise their finance. Therefore it is possible to undertake new analyses of how financing relates to institutions' investment allocations and to undertake comparisons across countries.

Our analysis of the VC industry itself differs from the existing literature in several respects. First, the existing empirical literature is almost exclusively focused on the United States. VC activity is growing rapidly elsewhere and there is increasing interest in the performance of the VC industry outside of the United States. This paper considers four countries -- Germany, Japan, Israel, and the United Kingdom -- all of which have significant and/or rapidly growing VC industries. The spread of countries is interesting because it includes two bank-oriented systems (Germany and Japan), one (non-U.S.) market-oriented system, the United Kingdom, and one major high technology success story, Israel, with supposedly the largest concentration of VC investments outside of California and Massachusetts. Within Europe, Germany and the United Kingdom are particularly important for the study of the VC industry, because these two countries together account for over half of all VC investments in the Continent.

Second, most analyses of VC in different countries report aggregate statistics. In this paper we employ disaggregated data at the individual fund level. Third, to the extent that disaggregated data have been used, they have focused on firms. We focus on the VC funds themselves rather than on financed firms, posing the question: to what extent can differences in individual fund activities (in particular, the technological stage of financed firms and their sector focus) be associated with differences in the sources of finance? For example, is it the case that VC firms that are funded through banks invest in firms at different stages of their development from those that are funded by private individuals? To the best of our knowledge, no study has yet examined the relationship between sources of funds and investment strategies in the VC industry.

Our empirical analysis proceeds in four stages. We first provide descriptive statistics of the VC industries in the four countries. We then analyze the correlation between sources of finance and the types of activity financed, focusing on the technological stage of companies receiving VC finance. We examine a variety of regression specifications explaining VC activity, measured by stage, sector, and geographical focus of investment. Initially, we assume that there are similar relationships between sources of finance and activities across countries. We then relax this assumption and allow the relationships to be country-specific. This permits us to evaluate whether financial markets are integrated across countries or whether financial systems in different countries bear on the relationships between sources of finance and activities. For example, are the activities of bank-backed VC firms different in the bank-oriented financial systems in Germany and Japan from those in the market-oriented system in the United Kingdom? Our analysis sheds light on possible reasons for differences in VC activity across different funds within a country and between countries.

The results are striking. First, there are substantial differences across countries in terms of the stage of finance of VC firms. They are much more focused on early stage investments in some countries, most notably Israel, than others, in particular Japan. There is a remarkably close similarity in stage of finance between Germany and the United Kingdom, despite the frequently cited differences in their financial systems. Secondly, there are significant differences in VCs' sector focus. While biotechnology and life sciences receive a substantial level of attention in all four countries, a much larger fraction of VC firms in Israel and Japan focus on information technology (IT) and software than in Germany and the United Kingdom, where the manufacturing sector receives more attention. VC investment in electronics appears to be relatively uncommon in Japan.

Turning to institutional differences across countries, we find that there are substantial variations in the sources of finance of VC firms. Banks are a major source of external finance in all countries, particularly in Germany and Japan. Pension funds are much more significant in the United Kingdom than in the other three countries. Corporations are a more important source of finance of VC firms in Israel than elsewhere.

We find that there are significant relationships between sources of finance of VC firms and their investment activities within countries. In particular, banks, insurance, and pension fund-backed VC firms invest in later stage activities, and VC firms relying on private individual investors and corporations favor earlier stage activities. Individual and corporate-backed funds invest more in IT, software, and electronics in preference to manufacturing sectors, while the reverse holds for insurance and pension fund-backed funds. Bank and pension-backed funds invest domestically, while individual and corporate-backed funds invest globally. Financial intermediary-backed funds, therefore, are focused on late-stage investments in relatively low-tech domestic industries, while individual and corporate-backed funds invest globally in early-stage activities in high-tech industries. Finally, we find a strong focus of government-backed funds on domestic investments.

There are significant differences in the relationships between financing and investment stage across countries. While bank-backed VC firms in Israel and the United Kingdom invest in later-stage activities relative to other sources of finance, this is not the case in Germany and Japan. In contrast, investment in early-stage activities by corporate-backed funds is a feature of Germany and the United Kingdom, not of Israel and Japan. Early-stage investment by individual-backed funds is a feature of Germany and Japan, but not of Israel and the United Kingdom.

We believe that these relationships may have important implications for theories of corporate finance. In particular, they support theories that suggest that banks are associated with investments in less innovative, more traditional activities that benefit from active screening and monitoring, requiring geographic proximity to investments. The cross-country variations indicate that this is less pronounced in some countries -- those with bank-oriented financial systems where long-term relationships between banks and firms may be associated with more innovative investments -- than elsewhere. Individual and corporate-backed funds are associated with more innovative and higher-technology industries and greater international diversification. There is some evidence suggesting that this feature may be more pronounced in bank-oriented systems where there is less emphasis on diversification through financial instruments and markets.