Restructuring of Funding Market for Unlisted Venture Businesses

The supply of funds to unlisted (pre-IPO) venture businesses has been tapering off rapidly. According to a survey conducted by the Ministry of Economy, Industry and Trade, total investment made by major venture capital (VC) firms in the April-September first half of fiscal 2001 tumbled more than 40% from the same period of the previous year. In addition to the fewer number of promising venture businesses offering the strong chances of fair returns in a relatively short period of time in the wake of the collapse of the information technology (IT) bubble, the flagging Japanese stock market is making it harder to realize sufficient capital gains upon the initial public offerings (IPOs) of venture companies.

As there remains a reserve army of ready-to-go-public venture businesses, it would still be a year or two before people in the market have to grapple in earnest with the declining number of IPOs. But that prospect alone surely brings a fresh cause of concern for the struggling equities market. Moreover, there is legitimate concern that the growth of venture businesses, which some people hope will be the ace in the hole to spearhead the revival of the Japanese economy, may be scaled back in years to come.

From the beginning, Japan's funding market for unlisted venture businesses (the funding market here is meant to be a broadly defined market where venture firms raise necessary funds, not necessarily limited to established, institutionalized markets) has been an exclusionary market, with venture capital firms and a handful of risk-taking investors as only participants. This is partly because brokerage firms, in principle, cannot sell shares in unlisted companies to the general investing public. So, the flow of funds to unlisted venture businesses has always been unstable. It is still fresh in memory that promising venture firms failed to realize their potential after being denied access to crucial funding because the funding market happened to be very tight when it was needed, while at times of easy and abundant funding, the bubble-like investment boom led to the moral hazards on the part of entrepreneurs. In order to help foster the stable growth of viable venture firms, therefore, a prompt restructuring of the funding market for venture businesses needs to be implemented.

Amidst this situation, the venture fund market was created on the Osaka Securities Exchange (OSE) in December 2001, with actual trading launched on January 15, 2002. A venture fund for investing mostly in unlisted stocks is a corporation-type investment trust, a vehicle similar to a real estate investment trust (REIT), and investment securities issued by the fund in small lots are listed on the OSE. Under OSE criteria, the exchange-listed fund must invest at least 70% of its resources in equity shares of unlisted companies or companies listed on an exchange for no longer than five years, with more than 50% in unlisted stocks. Thus, the venture fund allows an investor to invest, though indirectly, in unlisted stocks in the same simple way as investment in regular listed stocks.

Comparison with the stock markets for emerging venture businesses, such as the Mothers and JASDAQ markets, makes it easier to understand the uniqueness of the venture fund market. As for returns on investment, investors in the venture fund have a chance to reap big capital gains on IPOs (that is, sharing the founder's profits), the biggest attraction of investment in unlisted stocks. On the emerging venture business markets, all investors can expect to acquire are relatively pricey, already-publicly traded equity shares in venture businesses. In the case of a venture fund, the fund invests in venture businesses well before they go public, and any profits made from the IPOs belong to the venture fund, to be ultimately shares by investors in the listed fund.

As for investment risk, investors have to make their own investment decisions in purchasing shares in venture firms listed on the emerging venture markets. For the venture fund, investment decisions are entrusted with specialists. Considering the difficulty in evaluating investment grades of venture businesses, which requires an adequate assessment of technologies possessed by venture firms or of owners and managers of such businesses and their characteristics, leaving investment decisions in the hands of specialists naturally reduces the extent of potential investment risk. Given the risk diversification effect inherent in aggregate investment, the venture fund, though it does invest mainly in unlisted stocks with no proven track records, should not necessarily be characterized as a financial product riskier than investment in individual venture stocks listed on the emerging venture stock markets.

The inauguration of the venture fund market on the OSE has raised the possibility of the restructuring of the funding market for venture businesses being accelerated tremendously. In this paper, the author, from the standpoint of a person who had a small but direct role in the launch of the OSE venture fund market, would like to share with readers his views on the significance and potential of the new market.

Before doing that, however, it seems necessary to briefly touch on the issue of what the restructuring of Japan's funding market for unlisted venture businesses is really predicated on. On this subject, Senior Fellow Kataro Tsuru of RIETI, in his study entitled, "Venture Capital as the Hybrid Financial System: What Should Be Learned from the U.S. Experiences?", correctly describes the present state of Japan's funding market for unlisted venture firms by observing that the structures of fund-raising and fund supply by Japan's venture capital firms are "basically similar to those of banks and non-bank financial institutions, and as such are not well equipped to provide risk money." He further offers the following analysis: "In Japan, there exists equilibrium in that all components of the venture capital system have not been adequately developed: suppliers of risk money to venture capital firms; experienced and knowledgeable venture capital; a stock market supportive of IPOs; and newly established venture businesses."

What the author means by the term "restructuring" is the methodology about on which policy area the pressure should be imposed to break out of the "equilibrium of immaturity" to prod the market toward the "equilibrium of maturity." In that sense, the OSE venture fund market could induce this restructuring in the ways described below.

First, individual investors who have a broad perspective can be brought into the venture business funding market that has long been exclusionary and dominated by venture capital firms and a select group of big investors. In particular, there is the likelihood of a massive amount of individuals' financial assets flowing in for the purpose of long-term investment of funds stashed away to provide for their old age as well as diversification of portfolios. The expansion of equity-type funds through this process and the emergence of fund providers with the posture for long-term investment will likely transform the way venture capital firms raise funds as well as their investment behavior.

Second, the venture fund market may help the emergence of new types of venture capital firms and security companies. The size of each venture fund is likely to be limited to several billion yen to several tens of billion yen. Reasons behind this expectation are that in making investment in unlisted companies, it is difficult to commit a large sum of money to a single company and it is important to scout for promising venture firms and also provide support to them after making equity investment. A large venture fund thus would risk low efficiency in investment management. Therefore, underwriting brokerage firms are expected to come from local small and medium-size securities companies, instead of major brokerage houses. The OSE venture fund market provides new business opportunities to these local brokers, now being squeezed by the liberalization of brokerage commissions. If "boutique brokers" specializing in investment in and the fostering of venture businesses grow in clusters by gaining a foothold in the OSE venture fund market, they have the potential to become mentors or venture capitalists in Japan. In Japan, where non-bank-type venture capital firms are still dominant, the OSE venture fund market could prove to be a major source of funding for independent venture capital firms with behavior patterns similar to that of U.S. venture capital.

Third, the venture fund market would also help coerce unlisted venture firms to disclose more information about their operations. It has long been pointed out that the biggest problem with Japan's funding market for unlisted venture businesses is that their information disclosure is far from sufficient or complete. It is not simply an issue of the awareness of venture business management. It cannot be denied that the ad hoc and opaque nature of the funding market for venture businesses itself has contributed to the situation.

It is hoped that an expansion of investment in unlisted stocks through an institutionalized market, such as the OSE venture fund market, will prompt the funding market for unlisted venture firms to embrace disclosure standards of an institutionalized market as its own standards, with accompanying changes in the mentality of venture business management as well as in the industry's market practices.

Fourth, the launch of the venture fund market should help increase social interest in venture businesses and may also raise their profile positively. Unless the startup of a venture business is recognized as one of the success stories of life, Japan could not possibly expect to create an environment that spawns promising venture businesses in large numbers over a long period of time. In Japan, there have been few opportunities available for investors in general to get to know owners and managers of unlisted venture businesses as they really are and the their type of operation. If an investor invests in the venture fund, the investor has ready access to up-to-date and "raw" information on venture businesses at a relatively early stage. The transformation of calculative interest into interest in the whole personality of ventures is not totally new to the realities of life. The OSE venture fund market has the potential to shake up the holy ground of such values from the level of the public.

Tax reform is the most important thing to be addressed now if the OSE venture fund market is to serve as the trigger for the restructuring of Japan's funding market for unlisted venture businesses.

The London Stock Exchange already has a market devoted to exchange-traded, corporation-type investment trusts specializing in unlisted venture businesses like the OSE venture fund market. In Britain, the dramatic growth of this segment of the financial markets was triggered by the introduction of the "venture capital trust (VCT) taxation" system in 1995. The far-reaching features of the preferential tax treatment include the exemption from income tax on dividends from ordinary shares in VCTs and from capital gains tax on gains arising on disposals of ordinary shares in VCTs if the VCT involved meets a set of criteria including a requirement that the VCT invests at least 70% of its funds in unlisted equity shares within three years of its establishment. If an investor holds newly issued shares in VCTs for at least five years, the investor is entitled to an income relief at the rate of 20% for the tax year in which an investment is made in the VCTs.

In stark contrast, all Japan has to offer at the moment in the way of tax incentives for the promotion of investment in venture businesses is the "Angel" tax system. The biggest drawback of the Angel tax system is the very limited scope of investors eligible for its benefits. This is because the preferential system is applicable only to newly issued equity shares of unlisted companies that meet certain qualifications. But it is nearly impossible for ordinary investors to regularly obtain information on issuance of such equity shares. Consequently, the Angel tax system has so far failed to make any significant contribution to the promotion of investment in unlisted venture businesses.

In addition, the tax system for investment trusts, an assets tool expected to have a key role in attracting personal financial assets, is the "labyrinth of taxes," being compartmentalized and subdivided for each type of investment trust vehicles and having a mixture of elements of income tax on interest income and that on securities investment. All this makes it pretty hard for ordinary investors to understand the mechanism of the tax system.

If the latest round of discussions on tax reform on the coming fiscal year and beyond can address drastic changes to the tax system for venture funds, the tax changes could work as the trump card to solve the problems of long standing, including the promotion of investment in venture businesses, the broadening of the base of individual investors, and revitalization of the securities market at large.

If the revival of Japan's sluggish economy is to be staked on the natural power of venture businesses, we must act quickly to let the funding market for unlisted venture businesses grow out of the exclusionary market dominated by venture capitalists and a small group of investors and create a never-sinking sun that provides funds to venture firms through the securities market.