on 27 March 1998
ITEM FOR FINANCE COMMITTEE
HEAD 106 - MISCELLANEOUS SERVICES
New Capital Account Subhead "Applied Research Fund"
Members are invited to approve -
- a grant of $525 million to the Applied Research Council for financing applied research and development projects;
- a change in the Applied Research Council's mode of operation; and
- the consequential variation to the terms and conditions attaching to the $175 million equity previously injected from the Capital Investment Fund into the Applied Research Council.
We need to strengthen the current level of technical and financial support for the commercialisation of research and development (R&D) activities in local industries to work towards the vision of an economy of high-value added industries.
2. We propose that Members approve -
- a grant of $525 million to the Applied Research Council (ARC) for financing applied research and development projects;
- the change of ARC's mode of operation to that stated in paragraph 8; and
- the consequential variation to the terms and conditions attaching to the $175 million equity previously injected from the Capital Investment Fund (CIF) into the ARC.
3. We set up the Applied Research and Development Scheme (ARDS) in 1993 with a commitment of $200 million 1from the CIF. Its aim is to encourage technology ventures and R&D activities that have the potential to yield commercially exploitable results by providing Government funding as a catalyst. The longer-term aim is to increase the technological capability and hence the competitiveness of local industry, thereby working towards an economy of high-value added industries.
4. The ARDS is administered by the ARC, a private company fully owned by the Government and specifically formed to hold and manage Government funds 2. We expected the scheme to generate a return of at least 5% per annum 3 . This need not be paid on an annual basis and can accrue over an unspecified period.
Review of the ARDS and Co-operative Applied Research and Development Scheme (CARDS)
5. We have recently conducted a review on the effectiveness of the ARDS and examined the way forward. The review also covers the CARDS 4 which is another funding scheme managed by the ARC. Given that the two schemes are very similar in nature, the review findings and proposed improvement measures are applicable to both.
6. During the course of the review, the Audit Commission conducted an independent value for money study on the Government's funding schemes for promoting technology development in industry, which included, inter alia, the ARDS and CARDS. The Audit Commission made a number of observations and comments on their effectiveness, control and operation 5 . Our review has taken into account the Audit Commission's observations and recommendations.
7. The review concludes that ARDS fills a gap in providing a readily available source of finance for technology start-ups and technology upgrades. The scheme has also helped towards inducing private sector investment in R&D activities and technology ventures. It complements and reinforces other Government initiatives to engender an environment conducive to our industrial and technological upgrading, and is an integral part of the overall infrastructure for Hong Kong's technology development. The review recommends that the scheme should continue.
8. Based on the review findings, and subject to Members' approval, we will implement the following improvement measures to the ARDS and CARDS to maximise their effectiveness -
- the ARC should hire the services of professional fund managers to run the Applied Research Fund (paragraph 8(d) below);
- the minimum target return rate of 5% for the ARDS be dispensed with and be replaced by the best return achievable;
- the distinction between fundable and non-fundable expenses be dispensed with; and
- the ARDS should merge with the CARDS. The combined scheme will be called the Applied Research Fund (the Fund).
Hire of Professional Fund Managers
9. The review acknowledges that in overall quantitative terms, the performance of ARDS has not been impressive. The review has identified a number of weaknesses in relation to the existing institutional arrangements in managing the scheme by a part-time Secretariat staffed by civil servants; inability to identify projects proactively; inadequate commercial sense and expertise in assessment; predominance of funding through straight loans instead of equity participation; passive project management and participation; and lack of expertise in arranging investment exit.
10. To redress these weaknesses, the review recommends that the ARDS should be managed by private sector professionals who have the experience and expertise in technology investments. With the benefit of their exposure to a wider scope and larger number of projects, we believe these professional venture capitalists will provide networking advantages, as well as technical, management and marketing expertise to investee companies, thereby enhancing the technical and commercial viability of approved projects. They would also have more experience and fewer constraints in identifying potential projects. Moreover, potential applicants would be more willing to disclose to professional investors financial and technical details of their companies or projects 6.
11. Another advantage of hiring professional fund managers is the involvement of the venture capital industry in the scheme. The review has pointed out that while there is plenty of capital available in Hong Kong, little of it is channelled to technology ventures such as those which have contributed to the successful development of the computer, information technology related and biotechnology industries in the United States. We believe that, through the participation of venture capital firms, the scheme will act as a catalyst and will further promote the capital market's interest in technology projects. This will, in the long run, help build up a culture of technology investment in Hong Kong.
12. Under this new arrangement, the ARC will continue to maintain a supervisory role and oversee the performance of the fund managers.
13. The professional fund managers will charge ARC a standard fee of 3 to 4% of the amount to be managed plus a formula-based share of profits 7. The standard fee will be deducted from the fund available under the scheme, and the profit-sharing portion will be invoked when profits are generated from the investment.
14. We have informally sounded out the venture capital industry and understand that there are firms which have the experience and expertise in managing technology-related projects and which would be interested in managing the fund.
Outlook on Return
15. The review also proposes that the target rate of return of at least 5% for the ARDS should be dropped. It has pointed out that the need to protect the seed capital and the requirement for a 5% return have created a hampering effect on the ARC in providing equity injection to approved projects because the return in the form of dividend is less certain. Consequently, most of the approved projects have been given loans with rather stringent conditions, such as guarantee requirements and interest at around prime rate. This has in turn a dampening effect on potential applications and the scheme has therefore failed to attract quality applications. This inflexibility has a wider implication, that is, the ARDS would not be able to achieve its public mission, which is to facilitate more R&D activities and technology ventures in Hong Kong.
16. More importantly, it should be recognised that applied R&D work is risky by its very nature, and the commercial viability of individual products and hence the financial return are in no way guaranteed. This was noted in the submission to the Finance Committee in 1991 in that, given the risks inherent in R&D, the Government is unlikely to be able to recoup its investment in all supported projects 8. We therefore recommend that the requirement to achieve a fixed rate of return be dispensed with.
17. In its place, we will ask the ARC to aim for the best return rate achievable from its investment as it, through the professional fund managers, works within the parameters of the scheme's public mission. This would provide more flexibility in deciding the terms of the projects. The revised arrangement would provide an incentive for all parties involved, including the fund managers and the investee companies, to try to make the projects commercially viable and profitable. This in turn will help to ensure that the best achievable rate of return is secured.
Scope of Funding
18. At present, under the ARDS, fundable expenses cover staffing, equipment, consumables and marketing costs. All other expenses are non-fundable 9. With the new arrangement where venture capital firms are hired to be fund managers, the current distinction between fundable and non-fundable expenses would not be relevant. We understand fund managers normally take a broadbrush approach to venture capital investment, i.e. they will assess a project's technological and commercial viability in broad terms, and decide on that basis whether it should be supported, instead of considering whether individual expenditure items are fundable or not. The mode of funding support would normally be equity participation. Accordingly, we propose to remove the distinction between fundable and non-fundable expenses.
Merger of ARDS and CARDS
19.Currently, ARC manages the ARDS and the CARDS. However, the two schemes are very similar in nature. The only distinction is the requirement for participation by Mainland researcher in projects funded under CARDS. The purpose of this requirement is to encourage technological collaboration between Hong Kong and the Mainland. In view of the growing technological collaboration that is happening between Hong Kong and the Mainland, we consider that this requirement is no longer necessary. We therefore propose to merge the ARDS and the CARDS schemes into one, and rename it as the Applied Research Fund. With this arrangement, all technology ventures, whether or not there are Mainland collaborators, will be considered. The total amount to be managed by ARC under the Fund will thus become $750 million.
20. With the improvement measures suggested in paragraphs 10 to 19 above, we are confident that more technology ventures will be identified and supported. Currently, we have injected $175 million under the CIF into the ARC as capital with a target return of 5% on investment. In view of the fact that the scheme has to achieve an important public mission, i.e. to increase the volume of applied R&D activities and to enhance the technological capability and competitiveness of the local industry, we will no longer seek a fixed return on investment. Accordingly, it would be more appropriate to fund the combined scheme from now on with a grant from the General Revenue Account, rather than through further equity payments from the CIF. The initial capital of $175 million will, however, remain as equity in the ARC.
21. The additional capital grant of $525 million will ensure that we have an amount substantive enough to encourage the participation of the venture capital industry in the scheme. It will also give a greater impetus for the promotion of applied research, product development, and commercialisation of research results in the private sector.
22. To allow for maximum flexibility, the grant of $525 million is on the condition that if the ARC has cash surplus to requirements, the Financial Secretary may recover the full amount of this grant or any part thereof from the ARC. It is however envisaged that such power would only be exercised under exceptional circumstances, such as when the ARC has built up excessive cash for which it has no further purpose.
23. On the basis of the proposed grant of $525 million, ARC will be able to run the scheme in a self-sufficient manner. We will approve supplementary provision under delegated authority for release of the grant in this financial year.
24. To ensure that the ARC will properly utilise the grant, we will agree the broad investment guidelines with the ARC and require the ARC to produce annual audited reports to the Administration.
25. To enable proper supervision by the ARC, it will conclude management agreements with the selected fund managers. These agreements will set out, amongst other things, the duties of the fund managers, performance indicators and the relationship between the fund managers, Board of Directors and the Government.
26. Specifically, we will require the fund managers to invest in projects of locally incorporated companies. The projects must have a technology or R&D element. The fund managers' performance will be measured by a number of indicators, including adherence to the public mission and objectives of the Fund, the number and types of projects supported, the level of technical and management support provided to investee companies and the overall return on investment.
27. The fund managers will be required to report to the ARC their investment decisions, the business conditions of the funds and the progress of funded projects. The Board of Directors will have access to the accounts of the funds being managed and the accounts of the investee companies. There will also be a mechanism for the ARC to ensure that individual investment decisions are in accordance with the public mission of the Fund, as well as provisions for the termination of the fund managers' service before due term.
28. We propose to look for more than one private sector firm to be the fund managers, with each of them managing part of the fund available. We believe the involvement of more venture capital firms will create more synergy between the Government and the venture capital industry, and will gradually build up a culture of technology investment in Hong Kong. From a management point of view, having more firms involved in the scheme will diversify the risks involved, and will also introduce an element of competition thereby ensuring the quality of services obtained from the fund managers.
29. The Board of Directors of the ARC has endorsed the recommendations of the review. The Industry and Technology Development Council, the advisory body on industrial and technology matters, has also considered the review report and is supportive of the above recommendations.
30. A copy of the review report has earlier been issued to all Members of this Council. The Trade and Industry Panel discussed the findings and recommendations of the review and the operation of the scheme at its meeting on 12 January 1998. Members were generally supportive of the broad directions of the proposals of the review.
31. The ARC has received 75 applications under ARDS since its inception in 1993. The total amount sought is $466 million. Eighteen of these applications have been given funding support involving a total financial commitment of $53 million 10. Funds are allocated either as straight or convertible loans, and in a few cases, through equity participation.
32. Recognising the importance of innovation, adapting to new technologies and developing new industries, the Chief Executive stated in his October 1997 Policy Address that once it was made clear that the fund continued to be effective in meeting the objective of upgrading our industry in terms of value and technology, the Government was prepared to inject up to $500 million into the ARDS. Taking into account the current balance of the funding already committed, this would increase Government's total commitment to $700 million.
Trade and Industry Bureau
1. The commitment approved by the Finance Committee then was $200 million. However, so far, the ARC has only drawn down $175 million, and we do not expect to make further payments from this source.
2. The ARC is managed by a Board of Directors appointed by the Government. The Directors are drawn from prominent members of the professional, industrial and academic communities in Hong Kong. The Director-General of Industry is also a Director of the Council.
3.This was stipulated in paragraph 19 of FCR(91-92)121 submitted to the Finance Committee on 13 December 1991.
4.The CARDS was set up in 1995 with a one-off grant of $50 million from the Government. The scheme basically follows the modus operandi of the ARDS, but it has an additional requirement that the applicant company must team up with a Mainland researcher. The ARC is responsible for managing the CARDS.
5.The Director of Audit's Report on the results of the Value for Money Study (Report No. 29) was tabled in this Council on 19 November 1997. Chapter 7 of the Report entitled " The Government's Funding Schemes for Promoting Technology Development in Industry " focuses on the various funding schemes for promoting technology development in Hong Kong.
6.The review has suggested that one possible reason for the lukewarm response to the existing scheme is the confidentiality problem i.e. the potential applicants' reluctance to disclose financial and technical details to a government department and the external assessors.
7.The proposed remuneration package for the fund managers has taken into account the prevailing practice in the venture capital industry. The review has also studied the cost of creating an "in-house" full-time professional team to replace the existing part-time Secretariat staffed by Industry Department. It is found that the cost for setting up a full-time office is comparable to the hiring of services from venture capital firms.
8. This was stipulated in paragraph 13 of FCR(91-92)121 submitted to the Finance Committee on 13 December 1991.
9.When the ARDS began in 1993, the fundable expenses only covered staffing, equipment and consumables costs, and the funding ceiling was 50% of the fundable costs. In 1995, marketing was included as a fundable item and the funding ceiling was increased to 75% of the fundable costs. These changes to the scope and level of funding were elaborated in FCR(95-96)28 which was submitted to and approv ed by this Committee on 23 June 1995.
10. Figures as at 2 March 1998.