Venture Capital, Public Information, and the Law of Unintended Consequences

If you follow the newspaper business pages, or take a business journal, in the last year you may have noticed stories on new revelations of the dark secrets of venture capital management. If you flipped past, dismissing this as part of the general media schadenfreude over the high technology let-down, it's time to listen up. What you don't know can hurt you, assuming you pay taxes.

Venture capital (VC) is considered a game for the sophisticated investor. The money that goes into a venture capital fund is raised from wealthy individuals, corporations, and financial institutions. Institutions come in two flavors. Private institutional investors are entities like insurance and annuity companies, diversified financial managers or corporate pension funds. Public institutions include the endowments of public universities, and the retirement trust funds for state and other governmental employees.

Generally, the annual and quarterly results and reports of venture funds are not a matter of public record. Unlike common mutual funds, the assets of a venture fund are not listed on any exchange, and there's no easy way to get a share value of the fund, or any of its private company investments. When fund returns have been disclosed, they are usually a combination of multiple funds in an institution's portfolio, or even combined with other types of assets.

Many public institutional investors are arguably subject to the Freedom of Information Act (FOIA). In the past year or so, newspapers and some others have attempted to gain access to the more detailed investment results and valuations of specific funds. These attempts include cases in Texas, California, and Massachusetts. Some of the public institutions targeted with these requests have settled, disclosing at least part of the results of their investments, for instance CalPERS, the California public employees retirement fund, and the investment arm of the University of Michigan. Some selection of these results has been published with great ado by the investigative reporters behind the requests, to at least mild interest by readers. So where's the problem? Surely the public interest is being served?

Or is it? Some of the requesters for venture information go beyond newspapers and others with an arguable interest in putting the informatiion in the public record. For instance, one frequent FOIA flyer is a California resident, Mark O'Hare. What interest does a private individual have in sueing for this information? He is using it to create a private, for profit data bank. While there are existing databases of venture capital information, these are based on the voluntary release of information by funds and invested companies.

How about the quality of analysis of data from the newspapers requesting and sueing for VC information? Here's the San Jose Mercury News' Matt Marshall:

CalPERS' online report... through September 2002, shows Arrowpath drew $825,000 from CalPERS and its investments [are] still worth $723,318. The difference is mostly the fees that went to Arrowpath managers since 2001. That's a little over $100,000.

Heinous, eh? 15% of the capital squandered on managers in one year. But take a lookat the actual CalPERS commitment to this fund. That's a matter of $5,000,000. Management fees are based on committed capital, not on the capital drawn to date (the $825,000). And 2% (on the low end of management fees) of $5,000,000 is... $100,000. This is a reporter who either does not understand how funds work, or is being disingenous to sensationalize the story.

The actual evaluation of venture returns takes a bit more sophisticated analysis than that. This is a very modest introduction to the topic. If you looked at the CalPERS and U of M results, one thing will jump out at you: The investment returns (IRRs) are all over the place. If watching your NASDAQ portfolio gives you alternate adrenalin highs and heartburn, you don't want to be investing in venture. From year to year (vintage), and between funds, and through the history of each fund, there's very high degree of variance in results. The up years of the Internet bubble, and the downs of the bust, have added a stronger cyclic element to that variance in the last decade, but VC has always been volatile and it always will be.

By definition, there is no ready market for the shares of the private companies in which venture funds invest. We hang onto them until the wished-for liquidity event (exit) of going public, or being bought out by another company. Setting a value on these assets in the meantime is more an art than a science, but you can be assured that the valuations are both related to the NASDAQ averages and even more volatile. The investors' shares in the fund itself are likewise illiquid. If they are saleable at all, it will be at a deep discount to another qualfiied investor. Once you are in a fund, all you can do is grit your teeth and hope it's one of the funds and vintage years that win.

You may also be assured that you will take losses the first few years. The annualized percentage returns for maturing funds (5+ years from inception), are a sort of polite fiction. This isn't a CD or T-bill that quietly and evenly accrues interest over time. In venture, bad news arrives first, hopefully followed by good news in the long run. Some call this the law of the J-curve, and the reasons for it are fairly simple:

Brand new startup companies are by definition risky, and some fraction of investments in them will turn out to be bad choices. The wise fund manager will kill and write off the bad ones as soon as the trouble is apparent. Meanwhile, the good companies take time to build their products, reach their markets, grow, and exit at a profit. Management fees, the largest part of the overhead costs of a fund, are charged evenly through its life based on its total size (committed capital), so that expense is also front loaded compared to the eventual profits as good investments mature. So not only do you get to grit your teeth, you're on a roller coaster ride that almost always starts out with a swoop toward the ground.

Why do public institutions invest in venture capital funds, if it's such a dodgy business? Simple: Over the long run, averaged over multiple funds and vintage years, venture capital has a higher rate of return than most other asset classes. This higher average return is the market's quid pro quo for the investors' acceptance of the drastic ups and downs in this high variance asset class. A prudent manager of a long term portfolio such as a pension fund or endowment won't put a high percentage of their value into venture capital, because the valuation and returns are too volatile year to year, and the asset is illiquid. But a good manager will have some fraction, often 10 - 15%, spread among multiple VC funds to enhance the long term return on their assets. They may drink their Maalox during the down years, but the institutional managers can console themselves that time and the law of averages are on their side.

A good investor in venture capital funds should understand this proposition and be ready to withstand bad years in order to participate in the good ones. As a negative example, corporate investors are notorious for their inability to invest through the whole cycle. They tend to enter the VC markets when they are already bouyant. Since dropping valuations and low returns can make things too hot politically for their in-house management sponsors, they often drop out at the bottom of a market, either ceasing investment or liquidating their portfolio entirely. This makes the average corporate less desirable as an investor to fund managers, and pretty much guarantees that they miss the rewards of market upturns, which are supposed to be their compensation for being in a volatile asset.

So here's the first unintended consequence of disclosure of VC returns by public entities: They will start to act more like the corporate investors. The newspapers are, after all, going to need to get a return on their investment of time by running more stories, and there is the public interest to be served:

We can now parse all of the data available to us -- a firm's results, the fees made by its managers, the donations the managers made to the political campaigns of CalPERS' elected officials (link mine) -- and decide whether we think CalPERS' investments are made fairly and based on merit alone. - San Jose Mercury News

The next unintended consequence is that public entities will have more trouble placing their money into venture capital funds. Venture capital management firms prize investors who are loyal when times are bad. They dislike investors who create extra burdens of reporting and entanglements with regulation and politics. Compared to private institutional investors, public entities will become a denigrated class. This is not speculation. Managers from firms such as Crescendo, Storm Ventures, Charles River and Sequoia have publicly stated that they will be less likely to take money from public entities, or will avoid them entirely. Sequoia has carried through on its statement, evicting the University of Michigan. The upshot is that public entities will end up in funds whose managers have had lower performance in the past, since these funds have less choice in investors. Another bias toward lower performance.

This is not the end of it. Some of the information requests to public entities have gone beyond quarterly total return numbers. For instance, the San Jose Mercury News also pushed to receive the specific valuations set on private companies by each fund in the CalPERS portfolio. This is anathema to venture fund managers. It is considered valuable proprietary information of both the fund and the invested company. Exposure of valuations can drastically affect the ability of a company to negotiate for further financing. Disclosure that its funders have written down the value since investing can weaken a company in the eyes of both new investors and prospective customers. Disclosure of a high valuation can also botch a deal, by indicating that a mutual agreement on investment terms is unlikely. For the infant start-up company, stealth as well as speed are often the only weapons against incumbent competitors.

A venture fund subject to this type of reporting will become the victim of understandable discrimination by entrepreneurs. The start-up executive with a good track record, who has a choice of investors, is not going to accept exposure to this risk and will simply avoid such funds. Since fund managers cannot accept the downward bias on performance this implies, at this point public entities will be kicked out of the venture asset class entirely. They then lose access to the greater returns over time that have been provided to their overall portfolios.

And the final unintended consequence is the loss of the portfolio yield that it was in the 'public interest' to protect against undue influence in the first place. The first order losers? The retirees, students and universities that are the beneficiaries of the public entity portfolios.

By Tim Oren


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