Venture Capital (and How You're Doing it Wrong)

(February 11, 2014) — Large, long-term investors have pulled away from venture capital (VC) portfolios after a decade of disappointing returns, say a team of academics, which has also set out a way for them to re-engage.

To illustrate how disastrous these investments have been, the authors of a paper entitled “The Valley of Opportunity, Rethinking VC for Long-Term Institutional Investors” said pensions, sovereign wealth funds, and other large investors have put more money to work into VC portfolios since 1997 than they have managed to withdraw.

Jagdeep Bachher, CIO of the University of California, aiCIO Professors Gordon Clark at Oxford University and Ashby Monk of Stanford University, along with Kiran Sridhar also at Stanford have put together what they see as the problem with VC for long term investors—and potential solutions.

Only the most mobile and nimble investors have been able to take advantage of the top performing VC firms, the authors said, meaning that only the first movers in the field were happy with their investments. Even so, there are additional problems with the lack of scalability for the asset class.

“This ‘keep-it-small’ mentality…  means that venture capital has not been able to accommodate the demands of long-term investors for opportunities in terms of scale,” said the authors. “After all, an allocation of $10 or $20 million to a top VC fund would not affect the overall return for a large pension or sovereign fund even if the underlying VC investment were highly successful. Moreover, spreading a large VC allocation across a large number of asset managers would likely result in an institutional investor paying high fees for beta exposure to what is already an underperforming asset class. This is not desirable.”

Long-term investors should only participate in VC “in niches where they add value”, according to the authors, and there are two broad domains where they think this is the case: financial technology and asset management.

“Pensions and sovereigns not only have considerable expertise in these two domains, but they also have the capacity to deliver cornerstone clients to the portfolio companies VC firms are investing in,” said the authors. “Second, long-term investors should participate in venture investments for which they can serve as an important bridge to commercialization for growth stage companies.”

However, the authors believe there are several ways for large investors to access the asset class, and set out case studies showing how some have successfully achieved it.

The paper cited the Ontario Municipal Employees Retirement System (OMERS) as setting up its own internal team to access the asset class. OMERS has a 14-strong investment team dedicated to this asset class, and has become a “go to VC” in the Canadian market, the paper said. Its model has been able to overcome an inherent time-horizon problem in the asset class as it can continue to invest in the portfolio companies as the programme expands.

“It also solves the scale problem, as the winners coming out of the VC portfolio will require ever-larger amounts of capital. Conceivably, the biggest winners coming out of the venture portfolio can be passed into the fund’s public equity portfolios and even handed off to fixed income teams. “

The UK’s Wellcome Trust was lauded as providing seed capital to biotechnology start-ups. A $325 million VC business, named Syncona Partners, has been designed as an “evergreen investment company”. It can attract top talent, the authors said, and offer the new businesses the advice and VC benefits they need.

A third option of creative collaboration could see long-term investors working together to manage the allocation pool, while reducing costs and aligning interests. The New Zealand Super Fund, Alberta Investment Management Corporation, and Abu Dhabi Investment Authority were highlighted for their joint venture in to VC, named the Innovation Alliance.

To download the full, as yet draft, paper, click here.

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