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A New Market for "Patient Capital"

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This article was inspired by The Economist's "Ideas Economy" Conference, which took place at the Haas School of Business at Berkeley last week.

"Patient capital" is a crucial ingredient for two components of global economic growth: innovation and the development of poor countries. The owners of patient capital have long time horizons, meaning that they can endure the uncertain early years of an investment to reap high returns in the long term. In today's volatile markets, patient capital can be hard to find. A new, government-backed swaps market could change that.

Investments in innovation can take decades to pay off, and the uncertainty inherent in the innovative process makes it difficult to pick winners. Government already invests in innovation by funding basic research and education, but there are other opportunities that arise in the business sector -- opportunities that go unfunded because private sources of finance can't bear the risk. Most private sources either aren't big enough to be sufficiently diversified (they can't take on hundreds of these investments at a time), or they aren't patient enough (their backers demand a return within a few years).

The same is true of investments in development. Emerging economies are often risky environments for investors, be they foreign or domestic. These economies' political and business cycles may be too erratic to assure a steady return, and they may have frequent crises that threaten to wipe out young ventures. Even if the returns are high -- as they often are in emerging economies -- private sources of finance can't bear the risk. Some governments offer foreign aid to the countries where these opportunities arise, but they rarely invest in specific commercial ventures.

Yet successful investments in both innovation and development can have positive, global effects. Innovation is a public good; its benefits accrue not just to innovators but to society as a whole, which enjoys innovation's end products and is inspired to push the innovation process further. Likewise, rising living standards in developing countries help people around the world; they tend to correspond to lower levels of conflict and disease, and higher levels of trade and the exchange of ideas.

Because of these positive spillovers, society as a whole has an interest in providing the patient capital needed to realize investments in innovation and development. So far, governments have only done so indirectly, via domestic grant programs, tax credits, trade preferences, and foreign aid. Yet a new mechanism could offer a much more targeted and fruitful way of funding productive opportunities.

First, consider what is special about governments. The stable ones can plan decades in advance, even when the political leadership changes along the way. This is a much longer time horizon than most venture capitalists and private equity funds can claim. Governments are also big; they can commit billions of dollars at the stroke of a pen, as long as the spending plan matches their priorities.

So far, however, governments have not fully applied the benefits of their time horizons and size to the problem of patient capital. In a government-backed swaps market, they could -- and the benefits would accrue not just to investors and recipients of financing, but also to taxpayers.

A swaps market is exactly what it sounds like: a market where investors swap one kind of return for another. If you're holding an asset slated to pay a high return but with significant risks attached, you might prefer to swap it for a more stable, if lower, return. For example, you might prefer to exchange the payments owed to you on a floating rate commercial loan for the payments from a fixed-rate government bond. Of course, you may have to pay someone to make this swap with you; that amount is the price of the swap in the market.

Private swaps markets are huge, with billions of dollars changing hands every day as financial institutions and other companies try to balance the risks in their portfolios. But many investments in innovation and development aren't in the swaps markets. In fact, they're not in any market; no investor is patient enough, and no investor can diversify enough, to take them on.

Governments can change that. By offering to swap the returns on these high-risk, high-payoff investments for more stable cash flows, governments could encourage private sources of finance to fund these investments for the first time.

For instance, let's say a cashew producer in Senegal needs $5 million to build a new processing plant. The plant would have equal chances of delivering an annual return of 20 percent or going bust. If the plant is successful, though, it would also creates hundreds of jobs and be an anchor for the development of its community. So far, no one wants to invest. But a venture capital firm might be willing to put up the $5 million if, instead of the 50-50 chance of a 20 percent return after a few years, it received 7 percent per year starting now.

Who would make this swap? A foreign government interested in Senegal's development might. With a big, diversified portfolio full of investments just like this one, that government could expect a 10 percent annual return, on average, after a few years. That's not a very long time to wait, considering government's time horizon; what's a few years, when you're worried about funding Social Security until 2075?

Moreover, the investment would be a quadruple winner: the cashew producer would get its plant, Senegal would develop, the venture capitalist would get a good return, and taxpayers would get an even better one. The government would not be crowding private investors out of this market; rather, it would be facilitating a new market that otherwise would not exist, and then sharing in the gains from trade.

There is plenty of precedent for government's facilitation of markets, even in the United States. The Export-Import Bank finances exports of American merchandise to countries considered too risky by private credit markets. The Federal Reserve offers liquidity to banks and acts as a lender of last resort through its discount window. In both cases, a diversified portfolio and a long time horizon make the mechanism work.

In fact, both of these mechanisms have made money for the American taxpayer. Swaps markets for innovation and development would make money, too -- not because they were stealing business from the private sector, but because they were opening up a set of economic opportunities that no other mechanism could provide. They're not just win-win; they're win-win-win-win.