The venture capital (VC) industry has seen tremendous growth over the past years. Most pension funds and government agencies have shied away from VC because of associated risks. However, more and more government agencies and pension funds are investing in VC due to high return opportunities. Pension funds and government find VC attractive because it is at the core of entrepreneurship; only a founder is closer to the start of a business than a VC.
By engaging in VC, an organization can scrutinize all the startup components to assess its potential. VC presents an opportunity for high returns that pension funds and government bodies want to be a part of. Moreover, VC capitals have had better returns than investments in the MSCI world index. Typically, pension funds and government agencies do not dedicate the entirety of their portfolio to VC; when they invest, it is usually a manageable proportion that will usually be profitable.
Another reason to invest in VC is the inflation offsetting potential relative to alternatives; fortune 500, MSCI index portfolios, or government bonds are not attractive options to offset inflation rates. Pension funds and government agencies are required to get into riskier ventures to offset inflation. It is not that these legacy investments, such as stocks, are not attractive, but pension funds will need to diversify their portfolios into riskier industries, such as startups or even cryptocurrencies.
Variants of VC deals exist, but the typical deal involves a VC firm injecting $3 million into a startup in exchange for 45% preferred equity. The VC would typically obtain a liquidation preference where the VC acquires a debt stimulation by getting 100% preference over management’s common shares; if the startup fails, the VC gets first claim over its assets, including technology. These deals usually also come with disproportional voting rights over critical decisions, such as the sale of the company or initial public offering (IPO). Typically, despite VC risks, they often know how to provide downside protection for themselves.
On the other side, if the startup ends up doing well, there usually are clauses giving VCs the right to invest more money into the company at a predetermined price. They can, therefore, obtain a larger share of the company below market value. There are risks, but as evidence shows, there are protections.
The big question is whether it is appropriate for pension funds and government agencies to invest in VCs. The answer is affirmative; venture pension funds and government bodies have a right to invest in VCs. High-risk investments are usually ignored in their infancy, but VC is not in its infancy; it has existed for a long time, and pension funds cannot simply wait as other industries and organizations continue to reap big profits. Take, for instance, the cryptocurrency industry, which can be aptly described to be in its infancy at just about a decade. Yet, even institutional investors have started investing in cryptocurrencies, which are riskier and worth less compared to VCs.
It is also important to note that there are waves for the hottest industries in specific periods. For instance, at the turn of the millennium, genetic engineering was the most popular industry, but it got overtaken by Internet companies. Another key is that pension funds and government agencies are not dedicating their entire portfolios to VC, only a fair amount to offset the low-risk, low-reward ones, such as government bonds.