Register Exclusive: Fund’s bailout costs Iowans $26 million

The Iowa Fund of Funds for startups never took off and a deal was needed to avoid a ‘train wreck.’

From the Des Moines Register:

A decade after the state tried to spark investment in young innovative companies, Iowa taxpayers will foot a $26 million bill — and potentially more — to meet the program’s obligations.

State attorneys reached an agreement in August to avoid a lawsuit from two lenders who backed the Iowa Fund of Funds, a program lawmakers created in 2002 to attract more venture capital investment in Iowa startups.

In August? And we’re just hearing about this now?  Maybe it’s because it’s an embarrassment to the entire Iowa political class that they just want to have go away.  While signed by a Democratic governor, it passed the Iowa House 90-3 and the Senate 39-5  — lots of votes from both parties there.  When the state is giving millions in new tax credits for fertilizer companies, it would poop the party.

Let’s set the wayback machine to one of the earliest Tax Update posts — number 48 of over 8,000 — to see what we had to say about the Funds of Funds when it was enacted:

HEADS YOU WIN, TAILS WE LOSE?

…is the concept behind the venture capital legislation. A state-owned for-profit corporation will set up a “fund of funds” partnership to invest in venture capital pools. The venture capital pools are to be chosen based on their commitment of funds to Iowa.

Investors in the “fund of funds,” which we will call the FOF, will receive certificates maturing no sooner than 2005 entitling them to a tax credit. This credit will reduce their Iowa tax dollar for dollar to the extent the return on the FOF is less than a fixed return computed on the certificate. In other words, the investors in the FOF get the upside, but the state absorbs the downside – and even some of the upside, to the extent that there is a positive return lower than the amount set by the certificate.

At the time we received a note from Steven Ringlee, described in today’s Register story as “an architect of the program,” telling us that this was still a terrific deal for Iowa taxpayers because the bill also had a cap on investor return as well as a taxpayer-funded guarantee against losses:

In fact, you fail to notice that, due to the tax credit which provides full repayment security to Iowa taxpayers purchasing the preferred stock of the Fund of Funds, their required rate of return will be similar to that on medium-term governmental debt instruments.  In Oklahoma, where this plan was first implemented, the return on their Fund of Fund instruments (circa 1995) was approximately 8 percent.  In today’s environment, it will approximate 5 to 5.5 percent.  However, the average long-term rate of return on investments in venture capital limited partnerships has been in excess of fifteen percent over an extended period.  Oklahoma experienced a 19 percent positive return during the five year period from inception through 2001.

So how did those 15 percent returns work out?  From the Des Moines Register story:

“It’s been a disaster. As a model for creating jobs, it doesn’t work. … It’s turning into another bad deal for taxpayers,” said Sen. Joe Bolkcom, D-Iowa City.

Jeff Thompson, a deputy attorney general who helped negotiate the agreement, says Iowa taxpayers have always been on the hook for the program, originally authorized at $100 million and later limited to $60 million. This agreement reduces the potential costs and, perhaps more important, prevented lenders from cashing in up to $40 million in tax credits this summer to cover their loans, he said.

That sounds like a return of something less than 15%.  The Register story doesn’t quantify the losses.  Mr. Ringlee didn’t exactly rule out the possibility of losses in 2002, but he made them seem unlikely (my emphasis):

As a result, appropriate compensation-for-risk-assumed is in fact given to the State, the grantor of the contingent tax credits.  For what is likely to be zero cash outlay, the State of Iowa, (at the end of the FoF lifetime) receives all accumulated net profits above a nominal return in the range of 5.5%.  Of course, the probability of this occurring is directly related to the skill sets of the VC managers selected to invest the funds.  Because VC historical returns are in fact measurable and venture managers’ skills may be examined in detail, and because good managers tend to have consistent track records, the Fund should be able to select those managers able to deliver above-average results.  Hence, the Fund can improve its ability to deliver stellar returns to the State (the residual legatee) by carefully selecting and supervising its venture capital limited partnership managers.  It will do so through the judicious selection of a skilled, experienced “gatekeeper” fund allocation manager, a common practice in the venture industry.

Oops.

Folks, when the government guarantees something, the proper assumption is that the guarantee will be called upon (Solyndra, anyone?).  If private investors aren’t willing to make a deal, they probably have good reasons.  If it’s a good company, private money will probably be there, if perhaps on stiffer terms.  And just because the guarantees are run through tax returns doesn’t make them somehow not spending.

Senator Joe Bolkcom  (D-Iowa City)– who was one of the few who voted against the program in 2002 – makes a good point:

Bolkcom said the state needs to rethink how it approaches economic development.

“The idea that we can create these third-party arrangements, where we turn over taxpayers’ money and not expect problems to develop, is folly. We have very little control after the law was created,” he said.

The best the state can do for economic development is to leave it alone.  The Quick and Dirty Iowa Tax Reform would get rid of all of the dozens of ”economic development” tax credits, and do more for the Iowa economy than all of them.

TaxProf,  NY Times: Tax Arithmetic Shows Top Rate Is Just a Starter

Oh, Goody:  “Taxpayers and the IRS could be looking at three filing seasons in 2013 if Congress and President Obama fail to prevent the government from going over the fiscal cliff at year’s end, according to National Taxpayer Advocate Nina Olson.”  (Tax Analysts, $link)

Greg Mankiw,  Fiscal Cliff Fact of the Day:

As reported in the NY Times:

Like I say, the rich guy isn’t buying.

Gene Steurle,  Current Revenue Solutions Will Barely Reduce the Deficit.  (TaxVox)

Patrick Temple-West,  Fiscal talks spur charitable giving, and more

TaxGrrrl,  Obama, Boehner Reach Compromise?  No.

Scott Drenkard,  New Federal-State Rate Calculation in Full Fiscal Cliff/Obamacare Scenario (Tax Policy Blog)

Christopher Bergin,  ‘Small Ball’ — Obsessing about the Rich:  “Sticking it to rich people may play well to a populist theme, but it’s “small ball” and does little to address our fiscal problems or our broken tax system.”  (Tax.com)

Martin Sullivan,  Is the Charitable Deduction a Sacred Cow? (Tax.com)

So how are the tax increases working out for you? California Revenues Below Expectations (Russ Fox)

TaxProf,  Supreme Court Grants Cert to Decide Whether Estate Tax Marital Deduction Applies to Same-Sex Couple.  I predict the court will reverse DOMA.  If your taxes have been boosted by the denial of marriage benefits to same-sex couples, you should consider filing a protective refund claim; 2009 is the oldest year still open.

Kay Bell,  Supreme Court to review estate tax challenge to Defense of Marriage Act

KCCI.com:  GOP to introduce death penalty bill.  Apply it first to legislators who vote for new tax credits and I’ll be interested.

Great tool for understanding new net investment income tax regs: Cheat Sheets To The Obamacare Investment Income Tax (Anthony Nitti)

Peter Reilly,  Can Real Estate Professionals Beat The 3.8% Obamacare Tax ?

Jack Townsend,  DOJ Tax and IRS Entreaties to Join OVDP 2012:

These are in effect pleas / warnings to taxpayers to turn themselves in by joining OVDP 2012.  I suspect that the truth is that, if a significant number of taxpayers do not turn themselves in, the IRS will have limited ability to discover, investigate and prosecute criminally or civilly all of that dataset.  DOJ Tax and the  IRS are trying to convince taxpayers that the form of audit lottery they play going far now will have worse odds than it had previously.  Perhaps everyone involved will not suffer the consequences, but many will and, among the many that will, could be you.  And the consequences could be far worse than if you come clean now and get right for the past and going forward.

 If you really are a tax cheat, by all means consider using the OVDP program.  Still, it would probably be much more attractive if the IRS didn’t treat foot-fault violators as international tax criminals.

Robert D. Flach gets it right in WHY WE NEED TAX REFORM:

The purpose of the Tax Code is to raise the income necessary to run the government.  It should not be used to solve all the financial and social problems of the country.  It should not be used as a method of distributing social welfare program benefits.  It should not be used as a means of “redistributing” income among the “classes”.  The Tax Code is not Robin Hood.

It’s hard enough to determine taxable income, compute a correct tax, and remit it.  You can’t also ask Iowa tax authorities to administer filmmaking or venture capital.   And to expect the undertrained and undermotivated members of the shrinking IRS work force to administer industrial growth, social justice and, oh yeah, the health care system is folly.  And official policy.