Venturing Forth

The great majority of institutional investment portfolios still consist of the tried and true: a mix of listed equities and bonds, generally in a ratio of 70/30, determined by the investor’s appetite for reward and tolerance for risk. In fact, until the Ford Foundation, under the aegis of McGeorge Bundy, broke the mold in the early 1960s, most institutional portfolios consisted entirely of bonds; stocks were deemed too risky. Today’s investors are generally much more aggressive and sophisticated. But the current equity/bond investment profile remains predominant among institutions, wealthy families, and individuals.

However, closer inspection reveals that the most sophisticated institutional and family investment portfolios extend well beyond these two best-known asset classes and frequently include a group of investments that fall under the rubric “alternative assets.” These investments include real estate holdings, timber properties, hedge funds, leveraged buyout funds, and venture capital partnerships. Although there have long been isolated instances of investing in these assets, they have only become commonly recognized components of sophisticated portfolios within the last 30 years.

Indeed, any family with discretionary assets of $10 million or more should consider an alternative asset allocation of up to 10% in an effort to manage risk through diversity, to hold assets that do not correlate to publicly traded equities and bonds, and to boost portfolio returns. In turn, the investor must be prepared to accept one major proviso: This portion of the portfolio will be less liquid.

From the financial advisor’s standpoint, at the very least, considering the use of alternative assets will demonstrate to your clients that you are thinking creatively about the choices available to them. They will thus be less likely to be distracted by the siren calls of other counselors seeking to win away clients by offering something new. In addition, a measure of sanity has returned to venture capital investing after several years of boom and bust. I am convinced that 2002, 2003, and 2004 will turn out to be vintage years for venture investing–and very lucrative ones for investors in venture funds launched in these years.

ERISA’s Role

While the term “alternative investments” covers a lot of territory, I will limit my discussion to my own field, which also happens to be one of the largest: venture capital. The rise of venture capital investing into the ranks of respectability dates from two seminal events in the 1970s. In 1974, Congress passed the Employee Retirement Income Security Act, popularly known as ERISA, which established investment guidelines for pension funds. The U.S. Labor Department was charged with the responsibility of interpreting the legislation, and in 1979 it ruled that it was prudent for pension funds to invest a small percentage of their assets in venture capital partnerships. In that year, pension funds invested around $210 million in venture funds, part of an investment allocation totaling approximately $560 million. In 2002, pension fund venture investments totaled $3.2 billion of a total annual venture allocation of $7.6 billion.

Venture capital investing is the provision of equity financing to promising, frequently young companies to help fuel their growth. The venture capitalist buys stock in these enterprises and often assumes a seat on the board of the firm. Normally, he provides advice to management and works with the operating team to create shareholder value over time. Generally, the investor calculates that his ability to influence the company will offset the risks associated with prolonged illiquidity. This investment model is just the opposite of investing in listed companies where the investor wields little influence, but if he becomes unhappy, can call his broker and sell his stock immediately.

Another helpful way to think about venture investing is from the standpoint of the entrepreneur who aspires to start a company or to expand one which is not yet sufficiently mature and profitable to attract debt financing. The CEO of such a company is faced with few financing choices. He can provide the money from his own pocket or from family and friends. Perhaps suppliers or customers will assist him as well. But when the CEO exhausts these resources, the next step is the venture capital community. With venture money, the entrepreneur hopes to foster the growth of his company to the point where he can tap more traditional sources of capital, such as bank financing or even public equity markets.

As a rule, the venture investor invests in technology-driven companies because these are generally characterized by explosive growth, making an exit feasible within five to seven years. Exits can either be through a “trade sale” to a large corporation or, when markets are auspicious, by offering a portion of the shares of the young company to the public through an initial public offering.

Where the Capital Comes From

Venture capital has attracted a wide range of investors including wealthy individuals and families, endowments, government, corporate, and union pension funds, and corporations and insurance companies. The pie chart below (“Where Do They Come From?”) illustrates the current participation of these groups.

Since the ERISA ruling in 1979, the industry has grown rapidly. During the 1980s and early 1990s, in a typical year in the U.S. there would be several hundred venture capital firms that would each raise approximately $3 billion to $5 billion annually and invest in hundreds of promising young companies. As Internet enthusiasm and the stock market bubble both grew in the late ’90s, the annual investment allocation grew at a dizzying pace, peaking at between $110 and $120 billion in 2000. However, in the wake of the bursting of the Internet bubble, the recession, the stock market collapse, and the reversals stemming from 9/11 and its aftermath, the venture market has retreated sharply.

But venture capital remains vibrant despite the recent setbacks. In 2003, venture funds raised and invested about $16 billion in the U.S. There are an estimated 45,000 investors today who deploy capital through 1,798 venture partnerships. Last year, they probably invested in some 1,100 operating companies, or “small- to medium-size enterprises” across the U.S. The preponderance of the capital is invested in California and the balance in Massachusetts, New York, and many other smaller markets.

Because venture capital investing is such a work-intensive process, these funds generally charge investors approximately 2% annually on committed capital–not on capital deployed. They then draw down the capital over three to four years. In addition, they charge 20% of any realized profits. In some ways, this model is similar to that used by hedge funds, which also take a share of any profits. However, hedge funds charge about 1% per annum in fees for assets under management. It also may be worth noting that hedge funds offer a degree of liquidity that venture funds do not. A hedge fund investor usually can withdraw his capital upon a 45-day notice, although some funds require more time or notice freeze an investor’s cash for the initial year of investment.

Depending on the wealth of the individual and the corresponding size of his or her venture investment allocation, there are a number of ways one can participate. It is important to note that the minimum participation for investors in venture partnerships ranges widely from perhaps $250,000 to $10 million, to be invested over a four-year period. In addition to investing directly in a venture partnership, one can also invest in a venture fund of funds, which raises capital from investors and, in turn, vets a number of venture firms and invests in a select group of them–perhaps only 15. Although an added annual 1% fee is imposed on committed capital, the benefits include the expertise brought to the assessment process, access to high-quality funds perhaps not otherwise available, enhanced risk management through greater diversity, and a way of meeting the minimum investment requirements that individual funds frequently require.

Measuring Performance

Timing can play a big part with respect to venture performance. If one could time one’s investment participation in this asset class, one would invest in a period of sluggish economic growth about four years in advance of an economic upturn and an attendant upward-moving stock market and an exuberant period for IPOs and for merger and acquisition activity. But no one can predict the future. Accordingly, a wise venture investor participates consistently over time, a method called “time averaging.”