Bear with me on this one. Regional capital formation is an arcane topic, but a critically important one for any innovation ecosystem that sits outside a major money center like San Francisco or New York.
The subject is very fresh in my mind because we just finished raising our third fund for Founders’ Co-op: a new $20 million pool for “first-dollar” investments in high-growth technology companies based here in the Pacific Northwest. As with our prior funds, more than 80% of our fund capital came from high net worth individual investors who share our passion for building global technology leaders here in Cascadia. But for the first time, we also received support from a handful of institutional funds which — in addition to their financial return mandate — have an explicit institutional commitment to regional economic development.
With the patient support of these institutional investors, and facilitated by the tight-knit network of consultants and advisors who help large funds deploy capital at scale, we took our first small step as a fund into the world of institutional capital allocation. In doing so, we also got an up-close look at a large-scale market failure that’s holding back our region’s innovation ecosystem — and which exists to a similar extent in many high-potential regional economies across North America and around the world.
What do I mean by market failure? And why does it exist specifically at a regional level?
One of the things I learned early in my work as a professional investor is that the world is literally awash in capital. There is so much money seeking return — from traditional mutual funds and university endowments, to family offices and family foundations, to Middle Eastern sovereign wealth funds and developing-world oligarchs with global investment appetites — that there simply aren’t enough places for it all to flow. Further, because these pools of capital are so large, managers need to deploy capital in large increments simply to make it feasible to manage and track their portfolios.
The upshot of this excess of global wealth is that capital flows freely and in huge blocks at the very top of the “capital stack”, meaning into large public companies, late-stage growth companies and multi-billion-dollar private equity transactions. But as you get lower down in the stack — into early-growth companies and sub-billion-dollar private equity transactions — the deal discovery, diligence and investment management costs go up while the ability to move money in volume goes down. Past a certain point, it no longer makes sense for global capital allocators to play in sub-scale capital markets — not because there aren’t returns to be had, but simply because the strategies can’t be applied to large enough blocks of capital.
We see this large-scale market failure play out at a micro-scale in our own work at Founders’ Co-op. The Pacific Northwest has a strong track record of producing global-scale technology leaders like Amazon and Microsoft, as well as an engineering talent pool that continues to attract out-of-region innovation leaders like Google and Facebook. The global venture capital industry is well aware of the excellence in our regional market and — when local companies reach sufficient scale that they can absorb capital in volume — are always ready to write checks in the Pacific Northwest.
But below that scale — which for high-growth technology companies typically means fundraises of $5 million or less — our regional capital market quickly tightens up. Yes, our small cluster of regional venture capital firms periodically dips into the seed-stage market. And yes, we have a handful of angel investing networks that do yeoman’s work shaking the local money tree to support local entrepreneurs. But relative to the scale of our region’s private, investable wealth, the share that flows to regional innovation is a tiny drop in a very large bucket.
When I started raising money for Founders’ Co-op, I just assumed that those investors didn’t care about building the next generation of growth companies here in the region. I couldn’t have been more wrong.
It’s no secret that most net new job creation comes from young, high-growth companies; and that large, incumbent firms are neutral to negative in terms of generating new high-wage jobs. Wealthy families know this too, especially if their wealth was created by entrepreneurial family members within the past few generations. Unsurprisingly, many legacy-minded family wealth managers have an explicit goal of investing locally to help drive job creation and prosperity in the place they and their children and grandchildren call home.
But the same conditions that shape investment flows at a global level also apply down in regional markets: the larger the pool of capital to be invested, the harder it is to put that money to work in local opportunities, where the costs of discovery, diligence and ongoing management are higher, and the increments of capital deployment smaller.
The global capital markets have evolved a large and diverse private fund industry to help solve this problem. Financial entrepreneurs create highly targeted fund products that take on large blocks of institutional capital and then “break bulk” into smaller, more specialized investment allocations targeting specific asset classes or return profiles. These specialty fund managers are paid for their efforts through a combination of fees and “carried interest”, meaning a share of the total profits produced by the fund. But at regional scale this approach breaks down as well, because the total fees and carried interest from small funds are generally too limited to attract and retain high-quality managers.
So what’s a high-performing regional innovation economy to do? How do we unblock capital flows between the best regional-impact investors and the highest potential early-stage investment opportunities in the region?
As with any complex problem, there’s no single answer, but here are a few specific thoughts — as well as pointers to others who are thinking about and working on the issue here in the Pacific Northwest:
1. Support the market-makers you have
Every regional ecosystem has its trailblazers — the small funds, investment groups and family offices that collectively provide whatever current liquidity there is in the regional innovation market, despite high discovery costs and sub-scale fund economics. In the Pacific Northwest, these include small funds like Founders’ Co-op and Portland Seed Fund; family office investors like Trilogy Partnership and Rolling Bay; and regional angel networks like Alliance of Angels, Oregon Angel Fund and Element8.
Each of these fills an important niche in the regional capital markets and represent a store of institutional memory, deal flow and market access for investors higher up the stack and/or outside the market geography. Wherever possible, steering new investors into these existing platforms will boost local market liquidity without requiring new structures or overhead, and is the fastest way to move the market forward in the short- to medium-term.
2. Stimulate the creation of new intermediaries
Every investment platform brings its own unique approach to innovation finance, so the more different flavors of investor you have in a market, the more diverse that market is likely to become. Regional capital allocators should work to support the broadest possible range of local investment platforms to ensure the widest possible spread of entrepreneurial efforts.
Washington State is a laggard in this respect, but the State of Oregon is fortunate to have two major allocators that have seeded a wide range of new innovation investment platforms: The Oregon Growth Board is a State-funded agency that deploys public capital in private innovation funding platforms; and The Meyer Memorial Trust is a large private foundation with an explicit mandate for in-state economic development investing (in addition to direct grants and charitable contributions). Thanks in large part to the capital allocated by these two non-market players, Oregon has a more robust early-stage finance ecosystem than Washington, an innovation market more than twice its size.
3. Pool information and share best practices
High-performance innovation investing is a highly specialized niche and most traditional asset allocators are reluctant to participate in the market due to a lack of knowledge and a perception of outsized risk for new entrants. Reducing these informational barriers to entry is a critical step to bring new pools of capital to any regional innovation market.
The Pacific Northwest is home to The Canopy Project, a pioneering new effort to collect and share best practices among regional innovation and impact investors to help bootstrap the knowledge and confidence of new entrants. Funded by a group of regional foundations and multi-family offices — including The Russell Family Foundation and (once again) the Meyer Memorial Trust — Canopy is a “for benefit, member-owned research company… that enables investors to share costs, learn together and get involved in a more coordinated approach to regional investing.” Despite its Pacific Northwest roots, Canopy is explicitly designed for scale, with approaches that can be replicated and shared with other regional ecosystems.
4. Shine a light on your successes
Nothing draws new investors to a market like other investors’ success stories. Whenever your local market produces a winner, make sure that story gets told in the regional impact investment community — and then open the door to new investors when they come looking for the next big win in your regional ecosystem.
Every innovation investor in Seattle knows someone who was a seed investor in Amazon or Starbucks — and the extraordinary returns those investors realized have been recycled many times over with successive generations of regional entrepreneurs. The dream of huge returns — and huge regional impact — is what draws new impact investors into your region’s capital markets, and the more widely the stories are shared, the more capital will flow.
Compared to most global innovation markets, the Pacific Northwest is fortunate to have such a strong track record of success, and such a diverse set of players in our regional capital markets ecosystem. But compared to the world’s leading innovation markets we have our work cut out for us, and I’m grateful for every new investor who sticks their neck out to make a difference for the next generation of founders — and all citizens — of this great place.