By Stefan Larsen
In the late 1970s and early 1980s there was a dramatic increase in private equity activity in the US when pension funds like CalPERS began to invest heavily in them following the clarification of the “prudent man” rule by the Department of Labor, declaring private equity a sufficiently safe investment. Most of this freed capital went into buyout funds which were capable of dealing with the volume and more interested in heavily endowed LPs. However, approaching the 90s, further investment into buyout funds became self-defeating as the top-tier funds were already saturated with pension fund money. The 90s also marked the beginning of the tech frenzy, with venture capital firms beginning to perform better than their buyout cousins. These above average returns were needed to keep pension plans solvent as the baby-boomers aged, and pension funds like CalPERS still had billions of dollars to invest in private equity. Investment into venture capital firms was an inevitable next step, but because of structural challenges, they were going to need help.
Pension Funds as LPs in the US
In investing in venture funds, pension funds struggle with several problems. Firstly, they usually have too much money to justify due-diligence on a venture fund which would take a relatively minute allocation compared to the capital needed to be deployed. If a pension fund had billions of dollars to allocate in alternative investment, deciding to invest 5 million in a venture firm would not be worth the time. This is exactly the problem CalPERS faced in 1998, where they had only allocated $1 billion out of the $15 billion that they had for alternative investments, and would have had to invest in many hundreds of venture firms, all of which they’d need to research, to allocate the rest. Conversely, many pension funds are also very small, and unable to meet the minimum investment limits at venture capital firms while maintaining any portfolio diversification.
Pension funds are also considered to be very bureaucratic and cumbersome to bring on as LPs. This is because they are usually directed by a board of people who are not all very financially savvy, and may not be comfortable with (or understand the benefits of) investing in private equity funds as an asset class. Many of the investment decisions also tend to be influenced by politics, since pension funds are government-run, and these political objectives may restrict the GPs they invest in. Additionally, to reduce the risk in making private equity investments, pension funds are required to make use of Gatekeepers, a type of intermediary, that will often require GP targets to fill out very burdensome paperwork. There’s usually a lot of internal bureaucracy as well, with all the decision-making power concentrated in the board and no discretionary powers to the investment professionals. This results in investment decisions that take almost a year to make. In most cases VC firms will not need to tolerate any restrictions or time-consuming bureaucracy, especially if top-tier, and will choose instead to raise funds from much more able parties on much shorter notice so that they can respond to the dynamism in the start-up world.
Another consequence of being government-run is that pension funds don’t pay their investment staff competitively when compared to institutions like private equity firms, VC firms and hedge funds. This means that expertise and connections are likely to be lacking among pension fund investment staff with regards to alternative investments, since the very able and connected professionals have probably already been poached by higher paying firms. Therefore pension funds typically have less capacity to do the necessary due-diligence for the many venture funds they’d have to investigate to deploy their capital, and they have less connections to insiders that would be willing to take them on as LPs.
Types and Utility of Intermediaries
Understanding the struggles of pension funds in the venture arena makes it no surprise that in the 90s many firms sprung up that were built to mitigate their structural problems and facilitate capital deployment. These intermediaries vary in function, each tackling the pension fund problem from different angles.
In the case of CalPERS, they employed Grove Street Advisors, a so-called fund-of-funds to deploy their massive capital store. Fund-of-funds have similar structures to private equity and VC firms, in that they take on LPs and invest their money into a portfolio of PE firms, trying to make a return on behalf of the pension fund for compensation through carried interest and management fees. They add value by providing the research expertise to be able to assess the performance of venture funds and the connections to get LP money into the best firms. From a bureaucracy standpoint, pension funds only need to be sure of the quality of the fund-of-funds which deploys their capital. The burden of dealing with the politics and paperwork falls squarely on the shoulders of the fund-of-funds, and once these menialities are settled, they can act with agility to deploy pension fund money.
While Grove Street Advisors helps scale down the massive capital stores of CalPERS into many venture funds, fund-of-funds can also act in a way similar to mutual funds and pool together small amounts of capital from many pension funds to be able to meet the minimum requirements for a venture allocation. This allows small holders to benefit from venture capital returns while also being diversified in other asset classes. There are a myriad of other types of fund-of-funds, including the targeted fund-of-funds that focuses on specific sectors to help LPs make more refined diversification decisions within the alternative assets class, and a customized fund-of-funds, that would build a strategy to invest in alternative investments commissioned by an LP. There are also fund-of-funds predicated on a classic blind-pool, attracting LP money based on a prospectus and then carrying out allocations to funds that meet the investment criteria outlined beforehand.
Beyond fund-of-funds there are also consulting services like Cambridge Associates, which do the due-diligence on venture funds and design a portfolio, but usually leave it up to the LPs to actually get the capital allocated. They don’t provide the agility necessary to have venture capital firms tolerate pension funds as LPs. Gatekeepers are similar to consulting firms, and pension funds are actually mandated to use them for an outside opinion to determine whether a fund is investable according to the “prudent man” rule. Specialized Rating Agencies provide venture fund ratings to LPs that subscribe to their services, selling a host of investment ideas and the due-diligence to justify them. Other intermediaries help broker transactions between LPs for illiquid private equity fund ownership stakes. This can help a pension fund get into a VC firm without having to get the timing right of the fund-raising, and without scaring off GPs with their cumbersome investment requirements at the fund-raising stage.
Probably the most exotic type of intermediary is that which securitizes the income streams from private equity portfolios in an effort to build a secondary market. This securitization could have lead to many different financial instruments for investors to take advantage of, but despite the possible utility, these products never became mainstays, primarily due to the difficulty in pricing them and only sporadic demand.
Intermediaries are essential for pension funds to become LPs to good funds, because they mitigate the issue of insufficient human capital to deal with the massive due-diligence requirements, and the lack of agility due to mandated use of gatekeepers, overly bureaucratic decision-making processes and politics. Fund-of-funds mitigate both structural problems, while most other types of intermediaries only help with the necessary due-diligence. Alternative asset classes are incredibly important and valuable to have access to. Even after the internet bubble burst, PE and VC firms were usually the only way that pension funds could achieve high enough returns to keep pension plans solvent with the unfavourable demographic trends. The initial proliferation of intermediaries was spurred by a combination of regulatory change and the improving performance of VC firms, but they provide essential value to encumbered LPs and are likely to continue to be important, especially as the unfavourable demographics develop in the age of quantitative easing, where pension funds can’t get the returns they need from bonds.
Authors: Stefan Larsen
Sources: Private Equity and Venture Capital: A Casebook – by Hardymon, Leamon, Lerner