If there is any silver lining from the recent market rout, it is (hopefully) a renewed focus on how to comprehensively risk adjust returns. For some pensions, endowments and foundations, barriers to liquefying positions have come as an unpleasant surprise. Other institutional investors appear to embrace illiquidity as a gateway to possible rewards, evidenced by their allocation of monies to venture capital and private equity.
Interestingly, there seems to be something brewing on the buy side with respect to less liquid investments. One might argue that defined benefit plans and other long-term investors should query about distributable cash along the way for a company "built to last" rather than encouraging professional fund managers to back multiple start-ups and hope that at least one or two of them can be flipped within a reasonable period of time at a higher price than cost.
In "The Venture Capital Math Problem" (April 29, 2009), Fred Wilson, notable principal of Union Square Ventures, predicts that "We'll see some of the large public pension funds who have been drawn to venture capital over the past decade decide to leave the asset class because it does not scale to the levels they need to efficiently invest capital." If I understand Wilson's blog post correctly, he seems to be suggesting that a shrinking venture capital industry is a good thing. His arithmetic goes like this:
- Venture capitalists raised between $20 to $30 billion each year between 2004 and 2008 or an average of $25 billion of deployable funds.
- This money "needs to generate 2.5x net of fees and carry to the investors to deliver a decent return" or 3 times gross returns or $75 billion "in proceeds to the venture funds."
- Assuming that each venture capitalist fund owns an average of 20% of funded companies, $75 billion in gross proceeds to them "must come from exits producing $375bn in total value."
Even allowing for Wilson's estimate of average total (multiple fund) venture capital equity interest of 50% and required sales of portfolio companies equal to $150 billion, the message is clear. At a time when capital market conditions have all but shuttered traditional exits, how can the typical VC fund return "enough" to entice new limited partners and/or maintain current allocations?
Rosetta Stone, a provider of language instruction products, brought recent smiles to investment bankers everywhere with a highly successful stock issue a few weeks ago. See "Rosetta Stone IPO Soars," U.S. News & World Report, April 16, 2009. Before then, Thomson Reuters and the National Venture Capital Association had reported an absence of Initial Public Offering ("IPO") activity for two quarters, with merger and acquisition ("M&A") exits fewer than 60 transactions for Q1-2009. See "Venture-Backed Exit Market Remains a Concerns in the First Quarter" (April 1, 2009).
According to Wilson, the venture capital math problem is this. If the industry requires $150 billion per year in exits but is getting about $100 billion instead (half of which is returned to venture capital fund managers), VCs end up earning about $40 billion, net of fees and carry. This is roughly 1.6 times on investor's capital if $25 billion per year ends up in venture capital pools. "If you assume the investors' capital is tied up for an average of 5 years..." then one should expect about 10% per annum. Whether 10% (if realized or surpassed) is sufficient reward for pensions, endowments and foundations remains to be seen. As VentureBeat writter Anthony Ha suggests, venture capital returns oft compare favorably to traditional equity investments. Consider that the reported 3 year return for "All Venture" was 4.2% compared to -10.3% for NASDAQ and -10% for the S&P 500. Refer to "Don't stop believing: Venture performance didn't dip that badly," VentureBeat.com, April 27, 2009.
The reality is that information about projected return drivers is necessary but not sufficient for pension decision-makers. Financial and regulatory exigencies now confront retirement plan fiduciaries in ways that are complex and impossible to ignore. A particular venture capital fund may look appealing to certain trustees in terms of return potential but be turned away because liquidity trumps. On the other hand, underfunded plans may seek salvation by ratcheting up their exposure to investments with the potential to generate more than the commonly used 8% return on asset assumption. Cash is increasingly king for schemes that require mandatory "top ups."
If indeed fewer monies make their way to venture capital, infrastructure and private equity fund managers, what will this trend mean for future economic growth opportunities? The answer is likely to vary, depending on your belief as to whether venture capitalists can jump start innovation. Certainly, some great companies in the United States and abroad have been backed by those general and limited partners willing to take early stage company risks. See "Venture Impact: The Economic Importance of Venture Capital Backed Companies to the U.S. Economy, Fourth Edition," Global Insight, 2007. A countervailing view is that, contrary to the desires of the National Venture Capital Association, taxpayer dollars should not subsidize attempts to restore liquidity. See "Another dumb way to spend taxpayer money" by Harold Bradley, Kansas City Star, May 1, 2009.
As an advocate of free markets and the notion that necessity is the mother of invention, it is refreshing to learn that several organizations have or are formalizing mechanisms to trade otherwise illiquid economic holdings. Financial expert Roger Ehrenberg has an interesting take on the creation of private markets for venture-backed positions. See "Private Equity Markets" Not Today, Perhaps Tomorrow" (April 26, 2009).
To exit or not exit. That is the question of the day.