Banking: The Problem with Lending in a
World of Intangibles

A topic that seems to unite most small business owners is the mulishness and unreliability of banks. Banks, they argue, are slow to lend, ignorant about business realities, bureaucratic, and risk-averse.3 It’s perhaps no wonder that the idea of setting up a government bank more willing to lend to businesses regularly appears in political manifestos in the UK and, indeed, is to some extent a reality in countries like Germany, France, and the United States. It’s commonly thought that intangibles make this problem worse. In this section, we will look at why this is thought to be so, and what it means for the future of bank business financing.

Hamlet’s priggish uncle Polonius said “neither a borrower nor a lender be, for loan oft loses both itself and friend,” but he would have been taken aback by the modern economy.4 Most external financing that most businesses receive takes the form of debt. Banks, or more rarely bondholders, lend money for a fixed period of time and expect it back at the end, with interest in the interim. If the debt isn’t repaid, say, because the business fails, the creditor usually has recourse to some of the business’s assets; this may not make up their entire loss, but it significantly reduces the financial risk the lender is taking.

This is fairly straightforward if a business’s assets are tangible things. Consider buses. In 1986 Britain deregulated its long-distance bus market. A hopeful start-up called British Coachways took the opportunity to try to compete with National Express, the incumbent. But this was one disruption that wasn’t to be: British Coachways gave up the ghost two years later. What happened after their failure is instructive for our purposes: they returned the buses to their leasing company. Even though the business failed, their biggest investment, a fleet of coaches, retained quite a lot of value. Similarly, when Maxjet, a discount business-class airline, went bust in 2007, its five Boeing 767s reverted to a leasing company and lived on to fly another day.

Assets like buildings, machines, or particular plots of land can be valued too, and financiers will set up asset-backed loans secured against everything from aircraft engines to oil tankers. Loans do not have to be asset-backed to benefit from the recyclability of tangible assets: lenders often take a general charge (known in the United States as a negative lien) against a business with assets than can be liquidated, or even lend on the security of assets outside the business. Indeed, much business lending done by British (and US) banks, for example, is a disguised form of mortgage lending, since banks typically take a lien on the business owner’s house (Fraser 2012; Black, de Meza, and Jeffreys 1996). These established systems help get around Polonius’s warning: loans may still oft go wrong, but if your debtor has tangible assets, your money will not be lost and, while you may no longer be friends with your deadbeat debtor, you can at least treat them with equanimity.

Businesses that own mainly intangible assets, however, look a lot more like the world of Polonius’s imagination. As we saw in chapter 4, intangible investment is often sunk: many intangible assets are hard to sell if for some reason you find you don’t need them, especially if your business fails. Toyota invests millions in its lean production systems, but it would be impossible to separate these investments from their factories and somehow sell them off. Starbucks codifies its operations into a voluminous handbook that its branches and franchises follow, and the homogeneity and customer experience it engenders seem to increase its profitability, but it’s hard to imagine the handbook would be as valuable to someone else.

Even those intangibles that can be sold, like patents or copyrights, present problems to creditors: they are typically difficult to value because a patent or a copyright is unique in a way that a van or a building or many types of machine tools are not. The liquid markets that exist for assets like vans and office blocks, or the professional advisers who will value your mine or your chemical tanker, have fewer equivalents in the world of intellectual property: it is a newer and less developed field and is conceptually more difficult. The result is that it is much harder to offer even well-specified intangibles as security on a loan.

We see this discrepancy in typical leverage ratios among large businesses in different industries: industries with mostly tangible assets have high leverage—that is to say, they are funded more by debt than by equity—while intangible-intensive industries have less debt and more equity.

This problem becomes worse if the economy as a whole becomes more intangible-intensive. If banks are less willing and less able to lend to intangible-intensive businesses, but intangible-intensive businesses are becoming more common, we would expect to see complaints that banks refused to finance viable businesses becoming more common. And current regulation disallows (almost all) intangible assets as part of capital reserves that banks must hold in case of a banking crisis.5

A preponderance of unsaleable intangible assets could even, in due course, present a gradual problem for the stability of a banking system. Because bank runs are economically catastrophic, regulators require banks to hold a certain amount of reserves against every loan on their books. The amount of reserves depends on the type of loan: on the whole, loans secured against valuable assets that are easy to sell require less reserves; loans with little security require more. Now, given that many bank business loans are unsecured (the bank has a claim over the assets of the firm as a whole through a negative lien, but not over a particular asset), we might expect the riskiness of banks’ unsecured business loan books to increase over time: specifically, the value of the loans would fall if there was widespread business failure and need to liquidate assets.

In practice, there are three ways to fix the problem of reduced bank lending in an intangible-rich economy. The first is a traditional one: government action. As we have seen, pressuring banks to lend more or using taxpayer money to cofund or guarantee bank loans has a decades-long tradition in most developed countries. The idea that the government should do more in this vein is a mainstay of the British left and can be heard elsewhere on the political spectrum too. But in an increasingly intangible-rich economy, this approach faces a challenge: if each year the country’s capital stock becomes more intangible, the gap the government is trying to fill will become larger. To be effective, a national investment bank or loan guarantee program would need to be larger and larger each year. This is not inherently impossible, but it is certainly not what most supporters of government lending programs propose, expect, or support.

The second way to address the problem is by devising new types of lending. Financial innovation has been something of a dirty word since the financial crisis—former Federal Reserve Chairman Paul Volcker went so far as to say the only beneficial financial innovation of the decades prior to the financial crisis was the automated teller machine—but, in fact, lenders have over the years come up with novel ways to use at least some types of intangible assets as security. One recent working paper (Mann 2014) suggests that 16 percent of patents registered at the US Patent and Trademark Office have been pledged as collateral at some point. A couple of studies have looked at the impact of US banking deregulation on investment in innovation: one showed that the deregulation of interstate banking saw an increase in lending to innovating companies (based on the number and quality of their patents), implying that greater competition pushes banks to be more willing to lend to businesses making (at least one type of) intangible investment (Amore, Schneider, and Zaldokas 2012).

There are also a growing number of specific financial innovations focused on lending against intangibles. When David Bowie died in 2016, there were plenty of tributes to his musical innovations, but rather fewer to the contribution he made to intangible finance by raising a $55 million bond against his future royalties. The governments of Singapore and Malaysia (working together with UK organizations such as the Intellectual Property Office), for example, have begun programs to subsidize or guarantee bank loans against intellectual property, in the hope that these subsidies will increase the availability of intangible-backed loans.

On the whole these types of lending are most appropriate for intangibles that have associated intellectual property rights, such as patents or copyrights—this will generally be a minority of the intangible investments most businesses make. But more developed institutions for financing these types of intangibles will be increasingly in demand in a more intangible economy and will benefit both the lenders who design and offer them and, to quote Keynes again, the capital development of the nation.

The final way to respond to the difficulty of lending against intangibles is the most radical. It is for businesses to change their finance mix: specifically, to rely more on equity and less on debt. Should a business fail, equity owners have no recourse—they get nothing—so can afford to be relatively insouciant about the liquidation value of a business’s assets. This makes equity a better way of funding businesses with few tangible assets.

But increasing the amount of equity finance in an economy is easier said than done: it is a project that would take decades rather than years. Some of the barriers are institutional: outside of the very small world of venture capital (of which more later) and the even smaller and newer field of equity crowdfunding, most businesses do not raise equity, and most financial institutions do not provide it. There are established agencies that can rate the creditworthiness of even quite small businesses, and algorithms to allow banks to quickly and cheaply decide whether to lend to them. Nothing similar exists for equity investment, and the equivalent analytical task (working out a company’s likely future value, rather than its likelihood of servicing a fixed debt) is more complex. And cultural factors stand in the way too: despite a very elegant financial economics theorem that shows that business owners should be indifferent between equity and debt finance, for many small business owners there seems a cognitive and cultural bias against giving away equity.6

There is one big regulatory barrier that could be removed, however. Most developed countries’ tax systems favor debt finance over equity finance: a firm can claim interest on a loan as an operating expense and reduce its tax liability, but not the cost of equity capital. Fixing this distortion (for example, by allowing a tax deduction for the cost of equity, or removing the favorable tax status of debt and lowering overall rates to compensate) has long been a goal of tax experts. The influential Mirrlees report on the UK tax system by the Institute for Fiscal Studies recommended it (Mirrlees et al. 2011), but it has so far proved about as difficult as any other major corporate tax reform—which is to say, very difficult indeed, because there are lots of vested interests at stake.7 However, with the growing importance of intangibles, the need to make this change may be increasing over time. Now would be a good time for policymakers to bite the bullet and do it.

Myopic Markets

It is not just banks that stand accused of hampering business investment. Stock markets and equity owners are also widely seen as a part of the problem. Consider the case of the chemical company ICI, once the flagship of the British chemical industry. ICI’s plants in Billingham, Runcorn, and Blackley were industrial landmarks of the north of England, and its shares were a mainstay of the London Stock Exchange. For decades it invested in research and bringing to market a wide variety of innovative products, from Crimplene to tamoxifen to Perspex. It pioneered new ways of doing business that other firms profitably adopted, and ICI-trained chemists, engineers, and managers filled the ranks of British industry. But things began to change in the 1990s: frightened by a takeover threat from an activist investor, ICI began to focus on the pursuit of short-term shareholder value. To this end, it plunged enthusiastically into the M&A market, divesting or selling billions of dollars’ worth of divisions, and acquiring several others. The pursuit of focus and efficiency proved tough, and the company faced a growing debt burden and problems integrating its acquisitions. By the 2000s ICI’s decline was obvious, and few were surprised when what remained of the company was bought by Akzo Nobel in 2008 for a mere (relative to its past value) £8 billion.

For critics like the economist John Kay (2003), ICI is an example of the malign effect that equity markets now have on business investment. In ICI’s glory days the company, in Kay’s words, “treated securities markets with disdain.” When it started to take its share price seriously, it failed in two ways: it generated fewer profitable innovations and less value for its own shareholders, and it relinquished its wider role in the UK’s business landscape as a nursery of managerial and scientific talent, as the lynchpin of industrial supply chains, and as a voice for good governance.

The ICI example encapsulates all the elements of the core critique of equity markets: that they reward short-term financial results over long-term investment, and that financialization—the growing power and salience of financial markets in business life—makes managers overly responsive to the impatient whims of shareholders. A host of troubling data back up these concerns: research by Rachelle Sampson and Yuan Shi (2016) suggested stock markets are increasingly discounting US firms’ cash flows; research by Andrew Haldane (R. Davies et al. 2014), the Bank of England’s chief economist, and Richard Davies, a Chairman of the UK government’s Council of Economic Advisers, found similar results in the UK, as did the economist David Miles (1993). A study by Graham, Harvey, and Rajgopal from 2005 suggested this view is not unusual: it found that 78 percent of executives said they would sacrifice long-term value to meet earnings targets.

Critics further allege that instead of investing, there are signs that companies are giving money back to shareholders: in 2014 companies in the US S&P 500 Index spent almost as much on share buybacks as they received in profits.8 The end result is that publicly quoted companies refrain from making investments they otherwise would, preferring to keep their cash or to give it back to shareholders.9 The innovation economist Mariana Mazzucato has made this argument, for example (2013; 2015).

Policymakers and pundits propose a number of remedies to the problems of market short-termism, including trying to encourage investors to hold stocks for longer through differential tax rates on share sales, reducing financialization by limiting or banning share buybacks or restricting the terms of options, or simply calling on owners of equities to be more responsible.

However, as we shall see, the growing importance of intangible investment changes the nature of the short-termism problem: it appears that the unusual characteristics of intangibles accentuate certain problems of underinvestment, but also create new problems that require different solutions.

What We Talk about When We Talk about Short-Termism

There are two important details of this critique of equity markets. First of all, unlike the critique of bank finance we discussed earlier, it is a critique of the indirect impact of the financial system on business decisions, not the provision of financing. Bank lending is a direct source of finance: a bank’s decision not to lend stops a company investing by directly depriving it of the money it needs to make the investment. Equity markets, on the other hand, are secondary markets: the movement of a company’s stock price does not directly affect the amount of money the company has; rather, markets might encourage managers to forego investments if they fear the investment will lower the company’s short-term share price, especially if senior managers own shares or share options.

Second, companies that are overly influenced by equity markets have two distinct failure modes. In the first, the company’s own shareholders lose out in the long run because the company turns down investments that it could reasonably expect to make it money. (In financial economics terms, they pass up projects that would have had a positive net present value.) ICI’s decision to stop investing in new materials would be an example of this, according to John Kay, if we believe that those projects were genuinely likely to make money for ICI.

The other failure mode occurs if the pressure of the equity markets discourages a company from investing in things with a wider public benefit—such as ICI not training the managers or engineers who’ll go off to run other businesses in the future, or not doing basic research that others use. The two failure modes have an important difference: in the second, although the company is not acting in the interests of the wider economy, it may well be acting in its own shareholders’ best interests (in the short term, at least). In the first example, it is not even doing that. This distinction is especially relevant in the context of intangible investment, as we shall see.

When Equity Markets Meet Intangibles

Those who criticize equity markets for being too short-termist sometimes argue that this problem is even worse for companies that rely on intangibles. R&D, for example, is a long-term investment whose benefits are hard to predict in advance and whose costs generally are expensed on a company’s income statement rather than capitalized on its balance sheet. Cutting R&D (and most other intangibles) increases a company’s profits without any immediate obvious balance-sheet impact.

What’s more, as we saw in chapter 4, even successful R&D can slip through a company’s fingers and end up benefiting its competitors. Research shows that businesses cut R&D spending when stock markets turn against them. There is also a particularly strong correlation between R&D investment and cash flow. That is, at least in the 1990s when much of this research was done, when firms had higher cash flow, they invested more in R&D. That is consistent with the idea that businesses lack access to outside funds and so when they have the funds internally, only then can they invest (see, for example, B. H. Hall and Lerner 2010).

Equity markets seem to deter some other types of intangible investment too. William Lazonick argued that the pressures of financial markets discouraged modern companies from investing in training and employee retention, comparing the life-long careers of software engineers in the heyday of companies like Hewlett Packard and IBM with the roaming of the modern techies, who might move regularly between Facebook, Google, and start-ups, with the result that their bosses feel disinclined to invest in training them. Alex Edmans (2011) looked at the share price performance of companies that won a place on lists of the best companies to work for—these lists are compiled by researchers and journalists and tend to reflect the kinds of investments in management and processes that we would classify as organizational development and training. Edmans found that their shares persistently outperformed those of other companies, and that it is employee satisfaction that causes superior performance, rather than the reverse. This is a surprising result: if markets fairly valued the kind of organizational capital resulting from good management and workforce practices, the benefits of winning a place on this sort of list (and revealing to the market that your company is well managed) ought to be reflected in a firm’s share price straight after it wins. The fact that there is a long-term increase in price suggests that, while good management practices improve firm performance (hence the long-term share price increase), equity markets undervalue the benefits of this type of intangible (since equity analysts should be able to recognize good management at the time the award is given, rather than waiting for its results to show up on the income statement).

But, of course, correlation is not causation: just because a publicly listed firm invests less in R&D, training, or other intangibles does not mean it is being led astray by equity markets. Managers might choose to invest less because they know the investments available to them are unlikely to be profitable or, more narrowly, that they might be profitable for someone, but not necessarily for them. The business pages are full of companies that have launched new products or set up new service lines only to regret their overoptimism. If equity markets are stopping this type of intangible investment, that may be no bad thing.

To be sure of what is happening, we need data that allows us to correct for the quality of intangible investment that a public company may be making, or that allows us to compare similar companies with similar investment prospects, some of which are publicly owned and some of which are not.

Fortunately, there has been a recent flourishing of just these kinds of papers. The findings are mixed. One study, by Edmans, Fang, and Lewellen (2013), offers up what looks like a smoking gun. It looks at how firms’ R&D varies with the vesting period of senior managers’ equity. Managers at public companies are often paid in equity (shares or options), which can only be exercised after a period of years (the “vesting period”); once options vest, managers often exercise the options and sell the shares, which makes the managers particularly sensitive to their employer’s share price at that moment. It turns out that managers are unusually likely to cut R&D spending in a quarter when they have a lot of equity vesting. Since equity vesting periods are set years in advance, this seems like prima facie evidence that managers are cutting intangible investment to improve earnings to give their stock price a boost when it matters most to them.

A second study by Bernstein (2015) is also revealing, but in a different way. Bernstein began by observing that, when a private company decides to go public, it takes time—and there’s many a slip between start-up and IPO. For some companies, economic times are smooth and they go public. But for others, the stock market might collapse just before they launch. Generally, these companies don’t go public. This creates a natural experiment between other similar firms, some of which are publicly traded and some of which aren’t; more importantly, their status is generated by something beyond the firm’s control. From this, we can infer the causal effects of being public not by comparing two firms that are public or that are both private, but by comparing a firm that is public with one that is private due to an adverse shock beyond their control.

He finds two interesting things. First, the private-to-public transition does not affect a firm’s patenting—one indicator of successful intangible investment, in this case in R&D. A public firm has the same number of patents relative to its nonpublic “twin.” But, second, the types of patents the public firm files tend to change. The patents of a public firm have fewer citations than those of private firms, and many of the public firm’s scientific staff tend to leave. But the public company buys many more patents of higher quality. This is consistent with the open innovation model we discussed in chapter 4. So, Bernstein’s research suggests that the public firms might change their innovation strategy, rather than their innovation effort, at least as measured by patents.

So what is going on here? Market short-termism when it comes to intangibles seems to be real: managers cut R&D. But publicly quoted firms seem to end up with higher quality patents. One way to perhaps reconcile this is via a different strand of research, pioneered by the finance economist Alex Edmans, that suggests that who a company’s investors are may make a difference.

When you ask managers of public companies why it is important to meet earnings targets, they often talk about sending the right signals to investors and giving them confidence. Much of what managers do when they are planning investments is both difficult to explain to outsiders and commercially sensitive, but whether or not a company makes the profits it promised is relatively easy to report and to check. A shareholder might well need to be very informed and expert to know whether a company’s new product was likely to be a success, but anyone who can read an income statement can see whether it met its earnings target. You might expect informed and expert shareholders to give companies more scope to invest in risky and complex things, like intangibles.

How would you measure the expertise of a firm’s shareholders? Various researchers have used proxies: in particular, they have looked at how many of a company’s shares are owned by institutions (rather than individuals) and how concentrated these holdings are. The logic is that financial institutions tend to be more sophisticated than ordinary punters, and that the incentive to study and understand a company and its business increases the more of its shares any one institution owns. (Research is a scalable intangible investment for stockbrokers, just like anyone else!) An investor who spends time and resources to collect information will benefit if they hold one share. But they need spend no more time and resource to get much greater benefit if they own one million shares. This suggests that dispersed shareholders have a poor incentive to gather information, an argument showed formally by Alex Edmans (Edmans 2009).10

It seems that having more institutional investors and having more concentrated investors both encourage investment in R&D. Aghion, Van Reenen, and Zingales (2013) compared firms just outside the S&P 500 with those that just scraped in. On the whole, these firms had similar characteristics, but with one big difference: being in the index encouraged more institutional shareholding. They found that greater institutional ownership led to more investment in R&D. Edmans (2014) summarizes evidence showing that concentrated ownership has a similar effect: companies with shareholders who control relatively large shareholdings (so-called blockholders) invest more in R&D than ones with dispersed ownership.

This suggests that the effects of equity markets on intangible investment are mixed. There is some evidence that markets are short-termist, to the extent that management can sometimes boost their company’s share price by cutting intangible investment to preserve or increase profits, or cut investment to buy back stock. But it also seems that some of what is happening is a sharpening of managerial incentives: publicly held companies whose managers own stock focus on types of intangible investment that are more likely to be successful. And the extent of market myopia varies: companies with more concentrated, sophisticated investors are less likely to feel pressure to cut intangible investment than those with dispersed, unsophisticated ones.

The argument that having concentrated shareholders or blockholders improves outcomes makes logical sense. After all, if shareholders buy and sell shares we cannot just accuse them of short-termism: the prospects of the company might genuinely have changed. So, it is not the duration of the shareholding that matters; rather, it is the information base upon which buyers and sellers are acting. Blockholders have a sharper incentive to find out about the company’s long-term prospects, which nowadays are built on their intangible assets. So they are more likely to trade on the basis of long-term information, thus supporting managers who are making sound long-term investments and penalizing managers with a short-term horizon. The alignment of shareholder and manager incentives that blockholding brings is all the more important with intangible assets, since they are so often hidden from outside investors’ view and so effort is needed to unearth them. We’ll discuss further why they are hidden from view in chapter 9.

The Usefulness of Venture Capital, and Its Limits

Given the limitations of bank financing for intangible-intensive businesses, and the problems of underinvestment that affect public companies, it is no surprise that many people look to venture capital to finance the new economy.

After all, VC is a form of financing that developed alongside some of the world’s fastest growing intangible-intensive businesses. Most of the intangible-rich businesses of Silicon Valley, and many high-growth businesses beyond, got their earliest investments from the venture capital firms on Sand Hill Road. This form of financing has evolved together with businesses like Intel, Google, Genentech, and Uber, whose competitive advantages depend on intangibles: valuable R&D, novel product design, software, and organizational development.

Indeed, like the beaks of Darwin’s Galapagos finches that evolved to feed on particular cacti, many of the distinctive features of venture capital relate directly to the unusual characteristics of intangible investments that VC-funded businesses tend to make.

But this adaptation is not perfect: while the best venture capital–backed businesses have grown rapidly and expanded around the world, venture capital as a form of funding has spread much more tentatively. Many governments have tried to foster indigenous VC sectors, but very few have succeeded; some sectors where the venture capital model has been applied amid great hope, such as greentech and energy, have so far shown disappointing results. Spectacular successes have so far been pretty rare. Thinking about intangibles also helps us understand the limits of VC, and why it is wrong to view it as a panacea.

The Finch’s Beak: Why VC Works for Intangibles

VC has several characteristics that make it especially well-suited to intangible-intensive businesses: VC firms take equity stakes, not debt, because intangible-rich businesses are unlikely to be worth much if they fail—all those sunk investments. Similarly, to satisfy their own investors, VC funds rely on home-run successes, made possible by the scalability of assets like Google’s algorithms, Uber’s driver network, or Genentech’s patents. Third, VC is often sequential, with rounds of funding proceeding in stages. This is a response to the inherent uncertainty of intangible investment. The nature of uncertainty in start-ups is that it tends to reduce over time. When Peter Thiel made the first external investment of $500,000 in Facebook in 2004, the company’s fortunes were considerably more uncertain than when Microsoft invested $240 million in 2007. Funding in rounds helps resolve uncertainty by working through the development of business in stages. For investors, it creates an “option value,” that is, a value to delaying follow-on investment until information is revealed. These options are particularly valuable for businesses whose cost of innovating is relatively high.

One way to understand VC is to look where it does and doesn’t work. Biotech has many VC firms that provide much funding: it seems to work. Because of the sunkenness theory, financing risk is higher for industries that have to go back to the capital market again and again and have no assets or products that can be sold at each stage. However, in biotech the process has a number of distinct stages, and there have developed institutions that can at every stage of the process sell part-approved patents, etc. In addition, intellectual property rights (IPRs) have developed that enable knowledge at the various stages to be appropriated and so marketed. By contrast, green energy has much smaller VC activity. But this is an area with massive uncertainty, few distinct stages, and poorly established property rights.

The nature of intangible investment can also explain how venture capitalists add value to the businesses they invest in. One of the odd things about venture capital is the persistence of strong performance among funds—that is to say, the fact that the best 25 percent of venture capital funds tend to be the same funds, year after year and even decade after decade. This is far from usual in financial markets. A recent UK study found in the mutual fund industry that the best-performing 20 percent of fund managers were among the worst performing 20 percent a year later (Vanguard 2015). Private equity funds show similar variability over time. But high-performing VC firms tend to do well in fund after fund year after year.

One might think this is because venture capitalists are professional, highly remunerated people who are good at picking investments or at sitting on company boards. But then again, the people who run mutual fund businesses and private equity funds are professional and highly paid too, and the superior performance of these funds does not persist.

One possibility is that this persistence stems from the characteristics of the intangible assets that VC-backed businesses invest in. We have seen that intangibles often have significant synergies with one another: for example, combining Google’s search algorithm with an e-mail application gave rise to Gmail, which was radically better and more profitable than its competitors when it launched in 2004. We have also seen that intangibles are often contested: it is harder for Uber to “own” its network of driver-partners than it is for a cab company to own a fleet of cars, and the value of the Uber asset is up for grabs in a way the fleet of cars is not.

When we look at successful VC funds and their partners, we see people who are highly networked and personally credible in their fields of investment. In the 1980s, before the Japanese economy became unfashionable, the veteran venture capitalist John Doerr used to say that his firm, Kleiner Perkins, built American “keiretsu,” the interlocking business networks that used to dominate Japanese industry; to put it another way, the firm built informal links between its portfolio companies, allowing them to exploit synergies of intangibles.11 Few people praise Japan’s keiretsu nowadays, but Silicon Valley boasts a VC firm called Keiretsu Capital, and the best funds in the United States, Israel, London, and Stockholm all strive to nurture stables of businesses and exploit commonalities among them.

The social connections and reputation that the best VC firms enjoy help them not only to build networks to exploit synergies, but also to increase the value of contested assets. Particularly in fields like software and Internet services, the value of an intangible investment depends heavily on how it fits into a wider technological ecosystem: a new app may be worth a lot more if it integrates with Google Calendar; an analytical software business may be worth more if it can develop a partnership with an online ad distribution business. Well-connected VC firms also ensure their start-ups are plugged into open innovation networks. This has a direct financial benefit for the VC funds to the extent that it makes it easier for companies to be sold to trade buyers, thus earning a return for the fund; it also helps limit the amount of capital the fund itself needs to raise to get to an exit. The connections and reputations of VC funds and their partners add value to the intangible investments of the companies they invest in. What’s more, it is plausible that this advantage persists over time, since it depends not only on the networks of partners but also on the portfolios of companies a firm is invested in.

Indeed, the recurrent critiques of the lack of diversity of Silicon Valley’s VC sector and the companies that it backs can be seen as a reflection of the importance of social capital. We might speculate that the reason VCs can seem like a clique is not because the venture capitalists are unusually bad or cliquish people, but because the underlying model of the VC business thrives on dense social networks, which will always tend to gravitate to cliquishness in the absence of countervailing effort, and perhaps even then.

What Venture Capital Can’t Do

So there is a strong case for saying that venture capital is well suited to investing in intangible-rich businesses and should be rightly held up as a positive type of financial innovation. But VC is not a panacea for business investment, and on its own VC will struggle to solve the problem of how to finance the capital development of an intangible economy.

There are three problems that face VC firms and VC-backed companies, some of which arise from the nature of intangible investments themselves.

The first is the problem of spillovers. The managers of VC-backed firms have strong incentives to create valuable companies—really successful founders can, after all, become very rich. But as we saw in the context of publicly owned companies, strong incentives on managers make them less willing to invest in intangibles whose returns will more likely than not go to other companies. So expecting VC-backed firms to do Bell Labs–style basic research is unrealistic. More often than not, Silicon Valley (and other tech ecosystems, like Israel’s) relies on publicly funded university research for these basic intangibles.

The same is true where the size of intangible investment required is very large and very uncertain: developing commercially viable fourth-generation nuclear reactors or new green energy processes, for example, requires investments much larger than most VC funds will make, with high spillovers.

Finally, it turns out that the remarkable ability of VC funds to manage contestedness and spillovers is, unlike an algorithm or a brand, very hard to scale up. Silicon Valley’s VC sector took four decades to mature, in the presence of considerable public subsidy, both direct (from Small Business Investment Companies) and indirect (from defense contracts that provided revenue streams for VC-backed companies). Part of what took so long was the process of embedding venture capital in the ecosystem of the tech industry, such that entrepreneurs sought out funds, large companies bought start-ups, and generations of entrepreneurs and venture capitalists mentored one another. Replicating this in a new industry, even with the help of an open-handed government, takes time. It is no surprise that of the many developed countries that have spent decent slugs of taxpayer money over the past thirty years trying to create their own equivalent, most, as Josh Lerner points out in his aptly titled book The Boulevard of Broken Dreams, have had limited success.

If venture capital is well tailored to some aspects of intangible investment, but very hard to scale, where does this leave policymakers? On the one hand, they should moderate their expectations about what VC can do for capital development in the short term in countries and places that do not already have a globally significant VC sector: growing a VC sector is a twenty-year project, not something that can be achieved between elections; and while public subsidy is helpful, it cannot substitute for time.

We should also be cautious about the potential for VC to transform established sectors where it currently has little traction. Again, the social ties on which VC depends seem to take time to establish in new industries. The challenge is an order of magnitude harder in sectors where innovation involves much larger capital investment, such as energy generation. It would be presumptuous to say that VC cannot work in a field like nuclear energy, but it would require funds of a scale not seen before, with plenty of opportunities for pioneers to lose money along the way. Even in a well-functioning VC sector, then, the need for government to fund spillover-rich intangibles and the need for established larger companies to find a separate way to finance them will persist. The government might do that funding directly, or maybe through other publicly funded institutions: universities perhaps.