Arizona Fund of Funds

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The Arizona Growth Foundation is promoting an Arizona Fund of Funds as a way to grow jobs. Modeled after a program in Utah, it uses tax credits as an incentive for venture capitalists to invest in Arizona businesses. We’ll take an in-depth look at the pros and cons of this mechanism for economic development with John Kowalski,
Co-founder of the Arizona Growth Foundation; Gary Gibbons, professor of Entrepreneurship at the Thunderbird School of Global Management; David Beauchamp, an attorney who practices in the areas of Venture Capital and Private Equity Transactions; and Byron Schlomach, an economist with the Goldwater Institute.

Ted Simons: Good evening. Welcome to "Horizon." I'm Ted Simons. One week ago a small group of state lawmakers was presented with an idea to help Arizona businesses gain access to the money they need to start hiring employees. The proposal calls for an Arizona "Fund of Funds" similar to a successful program in Utah. The key is to raise capital which helps small businesses grow. As David Majure reports, capital is much more important than corporate tax cuts which were the cornerstones of Arizona's most recent jobs bill.

John Kowalski: From a small business perspective, we thank you for the tax cut but it's not going to help create jobs.

David Majure: John Kowalski is a former chairman of the board for the Arizona Small Business Association.

John Kowalski: Small businesses, 97% of the businesses in Arizona are small businesses. We're not helped by cuts in taxes. We thank you for the additional money in our pockets but it's not enough to hire people. Cutting the regulations, no effect. I ran a business, I built an insurance restoration contracting firm, I had a 103 employees, peak. Not once did I choose to hire or to not hire people, that decision had nothing to do with the tax rate. Never once did a regulation stand in my way to hire somebody. We have to look at something else. What's the other explanation? It's money. It's capital. What we're talking about here today is what can we do to help increase the flow of money? How can we expand the capital base in Arizona?

David Majure: Kowalski co-founded the Arizona Growth Foundation, asking state lawmakers to consider establishing an Arizona "Fund of Funds" to encourage capitalists to invest in Arizona businesses by guaranteeing their investments with state tax credits. The proposal is modeled after the Utah "Fund of Funds".

Jeremy Nielsen: The whole goal was to provide access to capital for Utah-based businesses.

David Majure: Jeremy Nielsen managed Utah's program for seven years.

Jeremy Nielsen: The Utah "Fund of Funds" after launching and beginning its investments in 2006 created over 3,000 jobs. Over 42 Utah-based businesses were funded and these businesses with their jobs were generating over $60 million a year in Utah state tax revenue. The Utah "Fund of Funds", we invested in 28 funds.

David Majure: And most of those funds are based out of state.

Jeremy Nielsen: It's one of the reasons the Utah "Fund of Funds" was so successful is we did invest outside the state of Utah. We were driving non-Utah-based into the state so we weren't really recycling money we were pulling outside money into the state. So we committed $122 million and we received over $200 million back into the state.

David Majure: And so far, according to Nielsen, Utah taxpayers haven't had to pay a cent.

Jeremy Nielsen: The Utah "Fund of Funds" receives tax credits from the state. We used those to raise money. The state put up zero money. We went out, found a third party to put in all of the money. We used the tax credits as collateral or a guarantee for the returns. So the state of Utah put up zero money and they are hoping the returns are sufficient such that the tax credits are not used and ultimately they get all the benefit for zero cost. I don't want to understate that there is risk there but when you're building diversified portfolio of managers your risk is extremely low.

Ted Simons: And joining me to talk about the Arizona "Fund of Funds" proposals is John Kowalski, founder of the Arizona Growth Foundation, Dr. Gary Gibbons, director for the Thunderbird Private Equity Center for the Thunderbird School of Global Management; David Beauchamp, a partner with the law firm Bryan Cave; Beauchamp is in charge of the firm's corporate finance and securities practice; and Bryon Schlomach, an economist who heads the Goldwater Institute Center for Economic Prosperity. It is good to have you all here. Thanks for joining us tonight on Horizon. It should be a very interesting discussion. Let's start with exactly how this fund would work.

John Kowalski: well, as Jeremy mentioned in the video, starting this off basically the state tax credits would serve as incentive to raise money from private or institutional investors. The idea is to raise $100 million into a "Fund of Funds". That money would be invested through other funds and those people would make the investment decisions on which specific companies then to invest in.

Ted Simons: Similar to what, the money market, the money fund, the mutual fund? Similar to these kinds of things?

John Kowalski: I think that's a fair way to think about it.

Ted Simons: is that how you see this as well as far as a little bit of a mutual fund activity here in.

David Beauchamp: Well a mutual fund is investing in public stocks of companies. So they are not necessarily looking at the management and the opportunities for the smaller companies. In Arizona because as Jeremy indicated or John indicated on the video, 95% of jobs in Arizona are from small businesses. So when they are trying to invest in a company, you want somebody who is familiar with a small business and can evaluate the management. In the past we have seen where government doing that has not worked. So it really does take an expert in small businesses that can work with them to help them get the people in the right order and use the capital most efficiently.

Ted Simons: Before we get to more finer points as to the benefits and perhaps not so good things about this, what you're hearing so far, what do you think?

Gary Gibbons: Well, it's always a good goal to generate jobs and bring investment capital into the state. I don't think anybody here quibbles with that objective. We may all have different ideas about how that should be done, but this is a serious proposal. We should consider it seriously. It seems to have worked some in Utah. It is an intersection between politics, economic development and investment. There's problems and promises associated with that, with all those disciplines or all those social areas coming together.

Ted Simons: Byron, a "Fund of Funds" with the state kind of as the guarantor, what do you think?

Byron Schlomach: Well, I agree with Gary that this is this interesting intersection. I think government definitely has a role to play in how successful an economy is. The only thing is that the government in my opinion should be about the business of establishing institutions. Stable institutions that encourage people to do -- to maximize their talents and maximize returns. We all benefit from that. I have some serious concerns when the government itself gets involved in investment. Quite frankly, there are some constitutional issues in the state of Arizona when it comes to that.

Ted Simons: Is the government, though, that much involved in this particular process? If so, how much involved is the government?

John Kowalski: We don't see it that way. Basically we understand the risk of the state to be extremely low. These types of programs have had great success in many cities and states across the country, so it's not a new program. It's been well vetted, so to speak. The state is simply saying that, "Look, if for any reason this fund should not meet a certain minimum threshold, eight to ten years down the road when these things start to mature, and if there's insufficient money in the redemption reserve account, then state tax credits could be exercised." So in our opinion it's a very low risk. The state is not really involved in any investment decisions or any process like that. That's all handled by the professionals that do this for a living. We think it's a pretty safe bet.

Ted Simons: who are the professionals that will be handling this and who decides who the professionals are going to be?

David Beauchamp: The professionals will be decided by the Arizona Capital Investment Board. That board will consist of the state treasurer, an appointee from the governor, an appointee from speaker of the house and from the president of the senate. There's a fifth member that I cannot remember right now. But under this concept, they will issue an RFP and select a fund manager. That fund manager will then work with finding investors and pursuant to that select where the "Fund of Funds" should be invested in individual funds that will make the investment decisions. The fund manager will in due course in pursuant to the RFP make decisions as to what matching funds the fund has to bring into Arizona to make available and also what other criteria for the investments.

Ted Simons: The idea of choosing who is going to get this particular fund, money from this particular fund, talk to us about that angle and if I'm a venture capitalist talk about it from that angle as well. What are they looking at, what are the small businesses looking at?

Gary Gibbons: Well there's thousands of private equity funds and fund managers and thousands of venture capital funds and venture capital funds managers. It would be quite a review process just to review them all or to try to assemble information on them. The fund managers themselves specialize in a number of different things. First of all they specialize in industry segments, they specialize in management styles sometimes. Every fund is motivated by its own set of objectives that it tries to put forward as being superior to other funds. So choosing who would get the money would be a difficult choice. Now, Utah, I saw the list that Utah has. Utah has chosen, oh, a large number of fund managers. I think they deployed into about maybe 50 fund managers over all. Just the infrastructure for doing that is pretty big. So it's not an easy task and it requires some expertise. The good news is that if the funds do bring matching funds with them, and if they are investing some of their fund assets into Arizona, then that is good for Arizona small businesses.

Ted Simons: why shouldn't the state consider something that a lot of folks think is good for Arizona small businesses? And if it involves the government to a certain degree, maybe eight, nine years down the line with tax credits and such, why not give it a shot? We need a shot right now.

Byron Schlomach: Well, the whole country needs a shot right now. A lot of Arizona's problems really originate at the national level. I understand that states would like to do something to get around that, but you know, we still have a situation where regardless of what we do, if you look at Utah right now, their fund of funds, which was created in 2003, did not protect them from the recession. Their poverty rate is way up, their income is down, not quite as badly as ours, but it didn't protect them. While I have no argument with the idea of doing something for business and the kinds of things I'm looking at are more basic like tax policy and when we talk about tax cuts I think there's a lot of room for tax reform in the state even without cutting overall taxes. But we have to keep in mind, though, that we do have a state constitution. It's different from Utah. It has a gift clause in it. This does present problems for the gift clause.

Ted Simons: Does this present problems as far as the gift clause is concerned? Are folks getting something in return for something else here?

David Beauchamp: Well, in essence what they are trying to model this after is the state tuition tax credits. The concern I have is that's an individual investor's type approach. One of the things I had suggested here early on was that if in fact there was any level of reception at the state legislature to meet with the Goldwater Institute and to structure the incentives as a form of guarantee through the Arizona Commerce Authority so that we can try to meet the necessary constitutional requirements. I have talked with constitutional scholars on that and they believe patterned on other states with gift clause, it can be done, but I wanted to make sure the Goldwater Institute was clearly given the leader on that issue that they were involved with how we structure it so it can work.

Byron Schlomach: The tax credit program -- the major thing that sets it apart is that it funds something that the state is already funding. It funds education in an alternative way and in an alternative setting. So there are actually offsets for the state. You're not giving a gift that you're not giving to every other school child in the state. The gift clause has three major prohibitions. One is you can't give a gift in the form of, especially in the form of subsidy to any individual or corporation. If these credits were ever claimed, and it may be that on this particular issue they would have to be claimed, that starts to present a problem. There's also a prohibition against the state giving away its credit, full faith and credit basically to individuals and corporations. That is a problem here with the tax credits. Finally, there is prohibition against subscribing, stock holding, issuing bonds with individuals and corporations. And although this is a quasi governmental entity, it does create problems there. Now, Utah's constitution does not have a similar provision in it.

Ted Simons: at the bottom of all this, the question is why should the legislature, why should the state guarantee start-up money for small businesses? Again, why are we looking at privatizing the gain, if you will, and socializing the risk, or are we looking at that?

John Kowalski: I don't think that's what's happening at all. We just don't see it that way. Basically, all we're asking the state to do is create an incentive for these investors. The state has been looking at all kinds of solutions for trying to create jobs. The state doesn't just take a hands off approach and do nothing. They control the tax policy, the regulatory policy, so the government is already hand in hand with the business community to do something. I don't think the small business community is all that interested in all the reasons why this program won't work. I think the community is in finding ways to get past these barriers to figure out a solution that will actually generate some capital for the state and help to create some jobs.

Byron Schlomach: Well, the problem, though, is that look you helped create - look Fannie Mae and Freddie Mac were probably thought to be great ideas for a number of decades. Eventually, politics crept into the situation. They were using ways that they weren't supposed to be used originally and they helped create a housing bubble and we were ground zero for that bubble. Twenty-two other states already have these "Fund of Funds" type programs. What that does is it pushes every state to push the envelope in order to compete with other states. Consequently you risk building another bubble and you risk putting us in the middle of another ground zero.

David Beauchamp: Byron, I understand the concern with creating another bubble, but the numbers, 22 states have "Fund of Funds" but when you're dealing with other mechanisms in the state for venture capital early stage financing for companies, it's actually closer to 38 is the last number I saw from the national survey. I understand that you can have some distortion. The concern I have is what we're having is a number of excellent engineers and scientists from our major universities here which are getting their training and their ideas, and from Thunderbird as well, but as they are starting their companies they need early stage funding or venture capital depending how you characterize, we're seeing those get picked up an moved toward the sources of money, whether it's California, Illinois, Texas, in some cases Florida, and we're losing tremendous opportunities for job growth in very high end jobs for the people of Arizona, because it's no longer a level playing field.

Ted Simons: Gary, how do you best -- if there are problems here, if there are concerns here, how do you best unlock venture capital investment? How do you do this? If this isn't going to work, what's happening doesn't seem to be working either. What do you do?

Gary Gibbons: Well, I can give you a better of perspective on that. Maybe I'll think of a speculation about what we can do. First of all we have done some research at Thunderbird, and in the western region which would include Arizona, Utah, New Mexico and California, in the last two and a half years there's been something like 350 large private equity investments made. Fourteen of them were made in Arizona.

Ted Simons: Why?

Gary Gibbons: Well, part of it is that you need very dynamic, very rapidly growing firms to attract that kind of investment. So one of the issues here is, do we have enough of that type of firm in the state? We should because we have I think -- Byron said something about our excellent universities. We have terrific universities here. So certainly our universities and our efforts are a part of this process that we need to do, we need to have. But we need -- it's not just enough to think in terms of small firms. We have to think in terms of small firms that are rapidly growing, that have a unique niche in whatever their market is.

Ted Simons: Is this a chicken or the egg -- is this a solution in search of a problem? A chicken - we could use all sorts of metaphors here but if those businesses aren't here and aren't attracting workers --

John Kowalski: I don't agree. I don't agree. I think there are some fantastic companies here. This program isn't limited to just start-ups. We're looking at early stage, seed, more advanced companies that could use the capital to grow and create jobs. You're looking at the whole range of businesses. There are outstanding companies here in Arizona. I sometimes think that Arizona companies oftentimes simply get overlooked. We don't have a thriving venture capital community here in Arizona. I don't know that we have the infrastructure in place where these companies can get noticed.

Ted Simons: Why don't we have a thriving D.C. community here?

John Kowalski: We don't do things like what we're talking about today. Arizona has never stepped its foot into this.

Byron Schlomach: Arizona got hooked on real estate development. Arizona got hooked on housing, and again, to a great extent and I think that was government driven, not federal government driven but there was some government driven, and tax driven here. The most part the United States has exactly the economy that it should have given its tax structure, which is pretty bad. Our tax structure in the state is pretty bad. So when you say tax cuts aren't going to make any difference I think that tax restructuring would make a big difference. We need to keep in mind that I'm an economist. I look at states, I look at the big picture and compare them. They do make a big difference. All those marginal decisions add up.

John Kowalski: They do but let's take that tax cut issue back a second. I have a client of mine who paid $60,000 in taxes last year. You'd have to cut the corporate tax rate by 50% in order for that company to be left with enough money to hire another employee. It's just not going to happen. When you talk about cutting taxes from 7 percent to six percent or to five percent, and the jobs bill isn't kicking in until 2014 anyway.

Byron Schlomach: You have a lot of different companies with the same tax cuts, it's a lot of marginals, but they add up.

John Kowalski: They add up separately.

Byron Schlomach: It adds up to more opportunity.

David Beauchamp: Let's go back for a second. Byron, you're 100 percent right, Arizona has in many respects used real estate as the fall-back for investments. Executives of middle market companies and higher companies have gone into limited partnerships or LLCs to in fact make a very good return on their money investing in Arizona real estate. Accordingly, and we did a study in the 1990's. We looked at this, why Arizona start-ups were not getting the friends, family and fools, the "FFF" the initial money to get started. As you indicated, the money was going into real estate. That wasn't the case in other places. The Arizona Chamber and I had worked on a program to try and start angel investor communities here. We have since added some which has had tremendous impact on the state. That is, in fact, bringing some of the businesses here that are growing. Unfortunately like I indicated earlier, and client confidentiality prohibits me from listing names, but there are 17 companies that I'm familiar with in the last five years that have been pulled out of this state by sources of money to give them the working capital to grow and scale up. One that's been publicly reported has a facility here, but they moved to Carlsbad and they moved a lot of jobs that we had anticipated would grow here and for all practicalities should have. There's a number of other companies, and we have to look at the capital structure. To the extent that we have a system here that can't compete with other states, just as you indicated, the sucking sound is going to be Arizona jobs and Arizona businesses leaving the state.

Gary Gibbons: Some of these fundamentals, we are making some progress on them. Byron, I'm sorry, David mentions the angel networks. At Thunderbird we have an angel network. There's a very active one in Tucson and one that's run out at ASU that's called desert -- I forget their name offhand. We are beginning to get more interest in the state. One of the advantages we have is a lot of partners and investors in venture funds actually live in this state. By last count I think we had in terms of people, in terms of funds in the state, fund managers, we had about 30. So we have the nascent kinds of things are beginning to happen to help get more attention to the state, and to start looking at some of our better companies. I still think that John may be overoptimistic. We have great companies, but when you're talking about this kinds of institutional investment you need not just great companies but you need a lot of them and they need to be a little larger than, we're seeing the ones when we do our research, a little larger than those companies are.

Ted Simons: Okay. We have to stop. We have to stop it right there. We're out of time. Great discussion. We'll look forward to seeing more where this heads and more discussion as to where it should go. Good stuff. Thanks, guys. We appreciate it.

John Kowalski:Co-founder of the Arizona Growth Foundation, Gary Gibbons:Professor of Entrepreneurship at the Thunderbird School of Global Management, David Beauchamp:Venture Capital and Private Equity Transactions Attorney, Byron Schlomach:Goldwater Institute Economist

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