(May 1, 2000) Pensions Funds: Funding Unsavory Practices of Venture Capitalists |
Enticed by spectacular returns, pension funds increasingly are allocating a percentage of their assets, typically 3% to 7%, to "alternative investments." Included in that asset class are venture capital funds and venture funds-of-funds.
Venture capital funds, like hedge funds, are investment vehicles the average investor, or pension fund executive for that matter, is likely to know the least about. Indeed, the federal securities laws prohibit most people from investing in these funds and exclude venture funds from regulation. There are no disclosure or reporting requirements that apply. These funds are secretive about virtually all matters except their performance, even in their dealings with institutional investors.
Lack of Regulation
While there are no structural requirements that a venture fund must meet, these funds are generally organized as limited partnerships. The limited partnership form of business organization permits a great deal of variance with respect to the rights of the general and limited partners. As a result, pension investors are well-advised to pay careful attention to negotiating the terms of their participation in the partnership. These partnerships may be structured in any way imaginable, often incorporating provisions that are not at all favorable to the limited partners. Due to the leverage they have, pensions regularly do succeed in negotiating more favorable terms from venture capitalists. All investors, however, are not treated equally. Smaller investors, who traditionally would have to be at least high net worth individuals to qualify, are generally not so fortunate.
Once a pension has made the decision to invest in a venture fund, it typically is locked in for an average of ten years. The securities the fund holds are rarely publicly traded and often are subject to collateral agreements that contain terms that must be considered in establishing their value. As a result of these factors, valuing the securities holdings of venture funds is far less clear than valuing real estate in a pension portfolio. Valuation of real estate holdings has in recent history been problematic for pensions. Due to the attendant vagaries, venture managers have tremendous leeway in valuing portfolio securities. After all, no one, including consultants and pension investors, has access to all the information that must be considered in establishing values.
The differences between venture funds and mutual funds are striking. A mutual fund invests in publicly traded securities with known values, provides daily pricing of its portfolio and offers investors daily redemption rights-all for a fixed advisory fee of generally less than 1%. It is true that registered investment advisers may have performance fees, however, the Securities and Exchange Commission has generally required that performance fees have a "fulcrum" feature. That is, if the adviser benefits when the fund goes up, so too must he suffer when the fund performance goes down. Not so in the case of venture capital fees. Venture funds typically charge 1.5% to 2.5% in expenses and a percentage of profits or "carry" which generally starts at 20%. Venture funds may collect their 1.5% to 2.5% asset based fee immediately from the day the investor contributes his funds and may continue to collect the fee for years before the first investment is actually made. Not bad pay for sitting on cash.
Given the fat fees in this business and the lack of regulation that gives managers the ability to inflate performance numbers, it is not surprising that many mutual fund operators with mediocre performance in traditional asset classes are getting in the act. Venture funds are virtually immune to the criticisms that investors are increasingly leveling against large mutual fund complexes. Today investors are more aware than ever that they can, with the aid of the internet, see mutual fund portfolio holdings on a timely basis, even daily in some cases, and duplicate them in their own portfolios. And they understand that mutual fund performance rarely beats an index they can purchase. And they can trade online for a lower cost than mutual funds pay. So why should investors pay fund managers an advisory fee of 1% and perhaps a sales load of 5% for this dubious service? The internet, by accelerating the dissemination of information mutual funds are required by law to disclose in a timely and uniform manner is taking the mystery out of what mutual fund managers do. A new generation of mutual fund pioneers with technological savvy is actually leading the charge to improve mutual fund disclosure beyond what the federal securities laws require. There seems to be no place for weak mutual fund managers to hide in today's world.
Venture funds are the perfect hiding place. Since there is no uniformity mandated by law and no required disclosures, investors can be kept in the dark-even in the age of the internet. The venture manager gets paid a fee at least twice that of a mutual fund, the investor has no right to redeem for years and during that time he never has to be told what's being done with his money. Finally, and this is the best part from the manager's perspective, the investor won't even know if he's getting good performance until its all over. Unfortunately, as in the case of hedge funds, I've observed that it's often the weakest portfolio managers that are attracted to unregulated investment vehicles, although it may well be that only the best managers survive and prosper over time.
As mentioned earlier, venture funds are not required to disclose their performance and there are no established standards for computing their performance. That means you can't get performance numbers to compare and any numbers you do receive, you can't be certain are accurate. Furthermore, even if the performance results disseminated are provable, remember that since there is no general disclosure obligation, a venture capitalist is free to selectively disclose the performance of only his best performing funds.
Another approach to venture investing is the "fund-of-funds." These funds have the benefit of providing investors with more diversification and an additional layer of management. Pension consultants, acknowledging their lack of expertise regarding venture funds, will often recommend that a pension initially invest in a fund-of-funds, as opposed to selecting one fund in particular. Of course, a fund-of-funds approach will have an additional layer of fees and in the case of venture funds, typically the upstream fund manager also receives a percentage of profits in addition to his asset-based fee. In return for this additional layer of fees the investor may receive access to the better venture funds. There are actually a few legendary venture funds that have such lengthy, successful track records that they do not seek investors and are difficult for even the largest institutional investors to get into. (A fund of funds operator may have longstanding relationships with these better venture managers and be able to get you in the door.) Of course, given the hot market for venture funds, there are many venture firms that are not so well known and welcome anyone who can pay the price of admission. The fund-of-funds may also offer an additional layer of due diligence oversight and bargaining power -which may be especially valuable when a manager experiences problems in his portfolio. It's at moments like these that a pension fund most needs an informed advocate to negotiate aggressively with the responsible manager. A fund-of-funds may offer consolidated reporting where statements are provided showing cash flows, dividends, distributions and IPO allocations. Without consolidated reporting any accurate assessment of performance is impossible.
Questionable Activities of VCs
Venture capitalists exert tremendous influence over the entrepreneur/business owners who sell interests in their companies to them. The venture capitalists themselves are deliberately mysterious as to how they conduct their business and little has been written on the subject to guide prospective investors, as well as owners who are considering selling to venture capitalists. (Remember that virtually every selling owner becomes an investor as well.) I can't help but wonder how many pension funds would bless the actions of the venture capitalists they invest with if they had knowledge of their business practices. In my opinion, few venture capital firms, if any, would survive the same level of scrutiny that activist pension funds require of the public companies in which they invest.
Frequently business owners enter into negotiations with venture investors without the benefit of a competent financial advisor. Some venture capitalist will actually decline to explore an otherwise interesting opportunity once they learn the owner has retained a knowledgeable financial adviser and may put the deal out for competitive bid. The success of the venture fund in large part depends upon the deal it initially strikes with the owner. The venture investor seeks to structure the investment on terms that provide assurance he will receive the return he is seeking down the road. For example, the venture capitalist may require that if the business does not meet certain financial objectives, the owner is obligated to turn over a greater ownership interest or even control of the company. Collateral agreements such as these are critical to the venture investor achieving his performance objectives and a financial advisor or competitive bidding may reduce the chances that an owner, presented with multiple financing options, will agree with such terms.
The interaction between venture investor and business owner typically begins, assuming the business is of interest to the venture firm, with a great deal of excitement on the part of the venture capitalist. He will seek to flatter the owner and persuade him that his venture firm would be the perfect partner. The brochure he hands out will impress the owner with the huge amount of institutional money his firm has available to invest and all the smart money, e.g., pension funds, colleges and banks, that have invested with the firm. The brochure will tantalize the owner with statements referring to how quickly the firm is prepared to close deals and put some of that investor money in the owner's hands (typically in 60 to 90 days). After all, venture firms are not banks that review investment decisions slowly through committees. They are, the owner will be told, fast moving, entrepreneurial organizations unencumbered with bureaucracies. They liken themselves to the business owners with whom they seek to partner. While they don't want to run the businesses they invest in, they know how to build successful businesses, they say. They will give as references other successful CEOs they have backed. The owner is likely to feel thrilled that he has been invited to become a member of an exclusive, moneyed club.
The venture capitalist's brochure may indicate the types of companies in which his firm invests. Some brochures will detail the size of the companies and industries in which they typically invest, as well as their investment criteria and types of transactions. Many venture firms do not limit themselves to a particular industry. It is truly awe-inspiring the broad knowledge of industries some venture capitalists claim to possess-even knowledge of industries they admit they have never been involved in.
Use of Confidentiality Agreements
How do venture capitalists acquire knowledge of industries? A great deal of their information comes to them pursuant to confidentiality agreements. By dangling funds they have available for investment before business owners, venture firms are capable of persuading even a reluctant business owner to disclose his financial records and reveal the secrets of his company's success in a given industry. Owners are told that the confidentiality agreement the venture capitalist signs with the owner ensures that any information disclosed will not be used to his detriment. You could say that investor funds are the lure venture capitalists use to entice successful business owners to educate them in the secrets of an industry. The confidentiality agreement is the security blanket offered to owners. But what happens if the owner ultimately fails to partner with the venture investor? Does the information the investor has acquired get erased from memory? Not likely. If a venture capitalist remains interested in an industry after failing to strike a deal with one owner in that industry-perhaps because the parties could not agree on price-he may use the information he has acquired to identify and analyze other competing firms. It happens all the time and owners are frequently left feeling betrayed.
Role of "Finders"
How do venture capitalists locate suitable companies in which to invest? Most venture capitalists state in their brochures that they encourage intermediaries, such as investment banks, business brokers, attorneys, accountants, consultants and other "finders" to contact them regarding appropriate investments. They often represent in their brochures that they will honor fees in cash or equity for introductions that lead to completed transactions. The deals, in other words, come to the people with the money generally and not vice versa. (Of course, technology/internet companies are a notable current exception.) Do venture capitalists really honor their obligations to "finders?" There is very little known litigation on this point but my discussions with lawyers who are familiar with such cases suggest that venture capitalists frequently do not. The venture capitalist may simply leave the issue of compensating the "finder" in the hands of the business owner and refuse to get involved. Another device employed by venture firms is to "use" executives well-connected in an industry to advertise the firm's interest in that industry. The executive is issued a letter on the venture firm's letterhead (that he is encouraged to show to business owners), indicating that the firm will back him financially to an impressive dollar amount in purchasing companies in a particular industry. The excited executive can be counted on to travel the country (at his own expense) presenting this letter to prospective sellers, with the unwritten understanding that he will be an equity participant and member of the management team of any completed acquisition. The venture firm gets word of its interest to would-be sellers in that industry at no expense and only later has to determine whether it will honor its unwritten promise to the executive. Again, investor dollars are used to further the interests of the venture firm and the industry executive may be left out in the cold. Some venture firms may have a dozen such letters outstanding at a given time involving different industries.
The venture capitalist's brochure also generally includes a list of references-CEOs of companies he has successfully partnered with who will sing his praises. The business owner will be encouraged to contact these successful CEOs. However, if, as many venture capitalists will readily admit, many of the investments they make do not achieve impressive results, you have to wonder how many CEOs of problem companies are on good terms with their venture partners? Chances are you will never know how many lawsuits have been brought against a venture capitalist by owners who feel they were not fairly treated. Lawsuits against venture capitalists by business owners are not commonplace. This may be due to venture capitalists requiring owners of companies in which they invest to sign confidentiality and non-disparagement agreements at the time of investment. (The trend in the money management business is to prevent disclosure of adverse events at money management firms by requiring employees to sign such agreements that include severe financial penalties for employees who violate them.) So don't be fooled into thinking that because there are few lawsuits against venture firms, there are no problems. It may simply mean that a legally imposed "wall of silence" is being effective.
In conclusion, pensions that invest in venture capital funds should begin asking the same difficult questions of these funds that they would ask of a public company or registered investment adviser with which they invest. As the body of knowledge about how these funds operate grows, the questions to ask and the risks unique to these funds are emerging. In my opinion, the spectacular returns many funds quote are fraudulent-if not outright, then by omission. The way these funds conduct business is intentionally kept secret to conceal questionable business practices and mistreatment of "finders," business owners, and employees of the companies acquired. Ethical and professional standards are nonexistent. It would not be too harsh to refer to venture capitalists as "socially irresponsible" investors or investors without accountability. Pensions, in effect, "arm" venture capitalist by committing funds to their use and becoming "marquis" institutional clients. A pension that invests in a venture fund without investigating how its monies will be used is, in my opinion, doing a great disservice to its contributors and society in general.