Venture Without Capital

Hawaii has great deals but lacks Venture funding

January, 2004

At least once a year for the past six years, Hawaii venture capitalists such as Bill Richardson have met with visiting representatives from New York-based Abbott Capital Management LLC, the alternative-equity manager for the $8 billion Hawaii State Employees’ Retirement Systems (Hawaii ERS). The agenda: to see if Abbott would consider investing in Hawaii-based funds.

Kimo Blaisdell, chief investment officer of the Hawaii ERS, facilitates some of those meetings between Abbott and local fund managers. “We tell Abbott to please sit down and listen to them, and if you like them, great. If you don’t, then suggest things and help them out,” he says. About 3 percent (approximate value $240 million) of the Hawaii ERS’ portfolio, is comprised of alternative investments.

It’s a sore spot for Richardson, general partner of HMS Hawaii Management Partners, which has about $14 million in active management. HMS is an early-stage venture capital group focused on software, the Internet and biotech. “They do their courtesy call every year,” he says. “Abbott has its own set of cadre of venture funds that they invest in. The funds from Hawaii will never be on their list as far as I’m concerned – unless they are forced by their Hawaii managers to look at a Hawaii-based fund.”

Typically, the Abbotts of the investment world focus on top-tiered funds, that is, seasoned performers with 5- to 10-year track records and multiple market cycles under their belts. Those meetings with HMS are not exclusive, as Abbott also has met with PacifiCap Partners, MN Capital and other Hawaii groups in recent years. “We’re trying to build relationships with these groups,” says Jonathan Roth, one of several Abbott managing directors overseeing Hawaii. “To put ourselves and our clients in a position so that when they reach a point that they’re in a position to invest in some of these funds, these groups do mature and develop over time.”

Since the Hawaii ERS hired Abbott in 1997, it has committed between $350 million and $400 million to private funds. That represents about 30 groups and more than 50 partners. But none are Hawaii-based. “It’s important that these people have a proven ability to make good money on their investments that’s consistent with the strategy they want,” Roth says. “Our primary goal is to find the best investment opportunities, the best financial-risk opportunities.”

The ERS isn’t alone in balancing fiduciary responsibilities with the desire to strengthen Hawaii-based ventures. Kamehameha Schools, the $6 billion educational endowment fund, boasts a diversified portfolio in real estate, alternative investments and equities. In-house managers oversee the estate’s investments, of which 5 percent is allocated to venture capital and private equity. Again, none are Hawaii-based.

Not to say that local funds are completely off the radar screen at Kamehameha Schools. Hawaii-based venture capitalists constantly approach the endowment’s executives, and each proposal is considered. Unfortunately, “many of the local investment funds or direct investment opportunities have a difficult time passing our level of diligence,” says Aaron Au, acting director for financial assets division for Kamehameha Schools.

An ideal investment fund would be one that commits allocations to Hawaii companies but also invests in U.S. mainland companies, adds Kirk Belsby, vice president for endowment for the estate. But until there are local efforts to mitigate risk exposure, direct Hawaii investments will likely not be an option for institutional giants, such as Kamehameha Schools and ERS.

Fair enough. After all, they are bound by investor standards. And they have fiduciary responsibility. But is it fair to local venture capitalists and investors who put faith – and funds – in Hawaii? And in the long run, is it undermining the efforts of local business executives who tout Hawaii as a place to do business?

The bottom line is Hawaii has great deal flow but not enough capital. It’s the classic chicken-and-egg problem. “We also don’t have lead investors that can pull together communities, if you will,” says John Chock, president for the Hawaii Strategic Development Corp., a venture capital source that has committed more than $13 million in seven limited partnerships, which invest in companies ranging from seed to later-stage phases. “Hawaiian Electric Industries as a corporate investor, and the number of community-oriented foundations have taken a good participative role in investing in local venture funds. However, we need more creation of the awareness that these can be very good deals.”

Roughly 35 Hawaii companies to date have closed $400 million in equity financing – not bad for a venture capital community that is roughly 10 years old. That dollar amount is according to a report by economic development group, Enterprise Honolulu. Other sources, including the HSDC, say there has been as much as $600 million made available to Hawaii companies in the past eight years.

“We haven’t had enough money to play with the top-tiered guys,” says Bill Spencer, president of the Hawaii Venture Capital Association (HVCA). “Until the club can expand to include our VCs, they’re playing ball with somebody else, and our guys are sitting on the sidelines saying ‘Hey, look at us!'”

Hawaii businesses will need to draw $138 million from non-local venture funding and $95 million from Hawaii sources in the next five years to reach its goals, according to Enterprise Honolulu. If Hawaii’s investors want more home runs, it’s clear that a capital-formation strategy must be in place. Not only will a unified strategy ignite more wealth, but it also will build badly need track records for Hawaii’s fledgling firms.

The Oklahoma Strategy

As this story went to press, local investors were creating a capital-formation act for the upcoming legislative session. The act would most likely take this format, according to the HVCA: A state agency sells tax credits (on a dollar-for-dollar basis) to insurance firms, banks and utilities that have anticipated tax liability. The contract to purchase the credits is used as collateral to secure a line of credit from banks. The credit lines then are used to capitalize fund of funds companies, which invest in venture capital limited partnerships dedicated to Hawaii. Fund of funds are managed by professional investment managers who invest in a diversified venture fund portfolio (rather than individual companies) to reduce the risk of investing in individual companies.

The tax credits are contingent, or on a stand-by basis. Therefore, if the investors’ rate of return surpasses the guaranteed minimum, then the contracts to purchase tax credits will not be used. But if the guaranteed rate of return is not met, then the appropriate amount of tax credits will be sold to cover the obligation to the banks. The contingent tax credits are essential, as they assure collateral for the credit line and are only used if venture capital returns are less than the amount borrowed. At the time of this writing, the investors were thinking of an initial capital pool of between $50 million and $100 million.

The capital-formation strategy is based on a 10-year-old model created by the Oklahoma Capital Investment Board. So far, Oklahoma has landed more than $40 million in 11 venture capital funds, with a 29 percent return on investment, since the program’s inception. The contingent tax credits have never been tapped, either. Arkansas and Utah have spun off their own renditions with similar success.

Why Oklahoma? Prior to the 1990s, the state was akin to Hawaii: capital-starved; historically dependent on agriculture and oil; and home to budding high-techies wanting economic diversification. Oklahoma residents also were willing to work with the state government. The similarities to Hawaii are uncanny. “There is a sense there that the public has to work with the private to attract investment capital,” says Spencer, of the HVCA. And what Hawaii has that Oklahoma doesn’t is its proximity to Asia.

The executives of MN Capital Partners couldn’t agree more. Since 2001, MN Capital has been the fund of funds manager for the HSDC. Last November, co-founders Eric Martinson and Bruce Nakaoka traveled to Dallas to meet with one of the creators of the Oklahoma model, Robert Heard, who is a former president of the National Association of Seed and Venture Funds. Heard was successful in bridging the private-public partnership in the 1990s and was willing to share strategies with Nakaoka and Martinson. “We need to build a track record before we can be attractive to these top-tiered investors and what have you,” Martinson says. “That’s why this capital formation model, not a perfect model and a complicated model, will provide some capital to keep activity going on in the market.”

Capital-formation is not the sole solution, of course, but it is a move in the right direction. “Creating a lot of financial incentives doesn’t necessarily lead to great returns,” says Roth, of Abbott. “What drives great returns for private equity is talented people, surrounded by people who can help expand and acquire other ways to grow shareholder value.” Talented people? Hawaii has plenty of them.

What’s Stopping Us?

Here are other ways to attract venture capital, based on interviews with investment experts. Not only did they provide remedies, but they also identified real problems.

Hawaii’s capital base cannot support later-stage financing

The business community likes to retell the stories of two Hawaii successes, Digital Island and Pihana Pacific Inc., which together, have snapped up about 80 percent of local venture funds to date. Pihana was founded in 2000 as an Internet data exchange firm for Asia Pacific; it raised a total of $236 million. Internet-routing company Digital Island was founded in San Francisco in 1995 but moved to Hawaii the following year. It raised $88 million and was bought for $340 million by British telecom company Cable & Wireless. Very few Hawaii companies have reached that status. “It takes between $30 million to $50 million in capital (and up to five rounds of financing) for a company to go public,” says Richardson of HMS. “Hawaii’s capital base can really only sustain right now the first two rounds.” Traditionally, local companies have secured Series-A rounds, averaging about $2 million.

Hawaii is inexperienced and not always comfortable with venture funding

In addition to Series-A rounds and beyond, there are high-asset individuals, or angel investors, who inject their own personal finances into local start-ups. The UH Angels, founded more than a year ago by University of Hawaii professor Robert Robinson, meets once a month to hear pitches from local companies. The group so far has invested about $3 million. Seed funding is relatively new and not the norm in Hawaii, given statistics from the U.S. Department of Treasury. Roughly 55 percent of Hawaii’s high-asset individuals invest in real estate, while 7 percent each invest in bonds and money markets; about 16 percent put their money in stocks. “Our investors are more real-estate people,” says Chock of the HSDC. “We need to educate our investors in more private equity, because they are very much asset-based investment oriented.”

Hawaii is a plane-ride away from potential investors

Because local start-up companies are physically removed from U.S. mainland venture capitalists, local companies are forced to leave the Islands to be closer to investors. “Venture investors need someone on the ground at the site of the portfolio company to represent their interests if they are to invest long-distance,” says Richard Sherman, a representative of Ventana Capital Management LLC, which opened a Hawaii office last year. The 29-year-old California venture group has about 70 portfolio companies and more than $3 billion in capital. Sherman says Hawaii needs more anchor investors. “If they participate in deals here, they expect the Hawaii VCs to syndicate in their deals on the U.S. mainland,” he says. At the time of this writing, Ventana was conducting due diligence on three local start-ups.

Hawaii’s businesspeople and politicians can be narrow-minded sometimes

Some call it a lack of patience; others refer to it as a fear of failure. Whatever it is, Hawaii’s entrepreneurs and politicians need to be more open-minded and think in terms of 10 to 20 years. “We seem to want instant gratification and do not want to wait for things to happen,” observes Spencer, of the HVCA.

Not all investments will be home runs, of course, and local companies may have to cut hundreds of jobs in the future. In fact, a report last year by the American Electronics Association said that Hawaii lost 445 high-tech positions between 2001 and 2003. Stories like that are disheartening, but they should not shatter the business community’s self-image. “I often hear Hawaii people criticizing Hawaii people, and it relates to whether investors are willing to invest here,” says Gregory Kim, a partner of Goodsill Anderson Quinn & Stifel and head of the firm’s technology and business group. “If you don’t think highly of yourself, you’re not going to invest in yourself.”

Hawaii will forever be marked as a vacation destination

Business travelers (Meetings, Conventions and Incentive travelers) comprised about 6.5 percent of overall visitors to Hawaii in 2002, according to the Department of Business Economic Development and Tourism. That figure excludes travelers who come to the Islands to do business independently. “Hawaii obviously is

a very desirable place to visit,” says Jonathan Roth, managing director of New York-based Abbott Capital Management. He visits the Islands about once a year. Hawaii also is a desirable place to do business. Perhaps that stigma might be the hardest one to crack. “To legitimize doing business in Hawaii, they’ve got to overcome that paradise perception,” says Eric Martinson, of MN Capital. “It’s a backwards thing, but we’ve got to fight it.” n

** Figures from “A Turning Point in Capital Formation: Assessing Hawaii’s Strategic Options,” by Enterprise Honolulu

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