The Venture Capital Bubble and Pension Fund Investment

Before discussing the projected Venture Capital bubble, let's first have a look at the relationship between private pension investment and VC. Venture capital is what the name suggests: it is a venture. It is invested capital that involves risk. It can pay big and lose big, and because of this it attracts certain types of investor.

Pension funds have traditionally accepted low returns and high fees in exchange for stability. However, the pension market is very competitive and many funds may be tempted to overstate their performance in order to attract investors.

In order to justify their claims of high returns on capital, funds require a means of justifying their claims. They could invest in safe low-cost index funds, but the return on investment would be too low for them. Informing retirees that they have insufficient funds to pay their pension is not on their agenda, so they seek ways out.

One of the things they can do is to search for hedge funds and venture capital investments. There is a risk involved with each of these but the rewards can be high. By including a percentage of VC in their investment portfolio, pension funds can maintain their optimistic outlook on returns from the fund on retirement. However, there are now questions being asked regarding the viability of such investments.

Is There a Venture Capital Bubble?

There may or may not be a bubble appearing in venture capital. Some, such as Marc Andreessen, claim that there is no such bubble, while others, including Bill Gurley of Benchmark, say there is. If there is such a bubble, and it happens to burst taking investment down with it, then the pensions sector is going to suffer. The question is, how much will they suffer? Perhaps not so much, although a lot depends upon how much they have invested in percentage terms.

It is a fact that the boom in venture capital over the past year or so has been partially funded by pension investments. This has come from taxation and state employee contributions. In fact, according to Dow Jones, the pensions sector has been the largest single source of VC funds for several years, contributing 20% of overall venture capital funds in 2014 and 25% in 2013.

If there is a bubble due to burst, then state employee pension funds will be hit. It might be true that such investments represent only a small percentage of pension funds' capital – under 2% - but this is still a significant dollar figure. Some large investors are becoming wary of risky investments.

Some pension funds will no longer invest in venture capital and hedge funds, or are at least cutting their VC exposure to minimal amounts. In September, 2014, CalPERS (Californian Public Employees' Retirement System) announced that it was withdrawing from hedge fund investment (valued at around $4 billion), and reducing its venture capital investment from 7% of its private equity portfolio to 1% over the next 10 years. Others are doing something similar.

Why Some VC Funds Refuse Public Pension Investment

In return, many of the top VC funds will refuse to accept public pension investments. This is because of the Freedom of Information Act which states that public pensions must be transparent in where their money is invested. This would conflict with the non-disclosure protocol of venture capitalists regarding the source of their investments.

This, in turn, results in many pension funds investing in smaller funds that are less particular about offering such information. These smaller funds may be performing less well than the larger funds. So pensions lose out both ways – not all venture capital funds perform well.

Venture Capital funds are the same as other forms of private equity in that they charge an annual management fee of 20% of profits plus 2% of the investment. Many pension funds will either pay this extra to prove they are managing the fund correctly or will draw away from venture capital funds as an investment.

In fact, some believe that many funds are not working as hard as they should to find the best investments. According to Diane Mulcahy, a Kaufmann Foundation senior fellow, the regular income they receive from fees might have reduced the incentive of VC fund managers to seek out profitable investments.

Venture capital is still a good investment, but there is fear of a bubble. This might result in a reduction in VC investment over the coming few years – in fact there are signs that this has already started. The third quarter of 2014 has performed slightly poorer than the first two, but not by much. However, there are still plenty of investors making venture capital funds available to invest in emerging technology, which is proving to be highly profitable if the right decisions are made.