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© Copyright 2000 Rogers Media. The following article first appeared in the November 2000 edition of
BENEFITS CANADA magazine.
Venturing forth
U.S. pension funds have jumped into the venture capital market, armed with strategies that enable
them to successfully navigate this potentially risky terrain. Once leery, more Canadian funds are following
their lead.
By Kirk Falconer
We've all heard about America's economic miracle. The seemingly endless boom cycle, near full-employment,
high rates of productivity growth and rising living standards. One of the vital but largely unsung
catalysts to this success story has been a dynamic venture capital industry. Once neglected and struggling,
venture financing in the U.S. was among the most muscular of capital markets in 1999, pouring an
unprecedented US$48.3 billion into a new generation of high-tech enterprises.
Another secret is the chief supplier of financial resources to the U.S. venture capital industry--pension
funds. For a long time now, the U.S. pension fund sector has been responsible for a major portion of the
billions flowing into this high-risk market. Last year, American pension funds invested an additional
US$10.6 billion in venture capital pools--almost double the rate two years previous.
While the pension fund share of total new capital in the U.S. dropped to 23% at the same time, from 59% in
1998, this was unrelated to fiduciary enthusiasm. From 1998 to 1999, U.S. pension funds plowed so much
money into venture investment that many hit their policy limits for the asset class. During the same
period, there was a veritable deluge of fresh cash injections from competing sources.
A similar tale can be told of pension funds in other economies. Steady growth in Australia's venture
capital industry over the past decade owes a debt to that country's pension fund sector, which presently
accounts for roughly 40% of total capital under management. In the United Kingdom, where private placement
markets have traditionally eschewed venture transactions in favour of leveraged buyouts, pension
funds--both British and non-resident--comprised 35% of new industry resources in 1999.
Canadian pension funds are another story. They are reticent about jumping into the domestic venture capital
market.
Over the course of the 1990s, about 5% of total annual new capital commitments to venture pools have come
from pension funds. Pension participation did make a sudden leap in 1997 to $237 million or 16.3% of total
inflows. But that event proved to be something of a false start.
Last year, pension funds contributed $134 million to pools or 5.6% of the $2.4 billion in new capital
overall, according to Mary Macdonald, president of Macdonald and Associates Ltd., a private equity analysis
firm in Toronto.
The Caisse de dépôt et placement du Québec, the Ontario Municipal Employees Retirement
System and Ontario Teachers Pension Plan Board have each recently attained a new in-house capacity for
venture investment, which provided a supplemental $410 million in 1999. This aside, the domestic rate of
pension participation in venture financing is still shy of the U.S. rate, even when disparities in economic
size are taken into account.
IDENTIFYING OBSTACLES
Members of the Pension Investment Association of Canada (PIAC) were polled on the topic of venture capital
in 1998. Senior managers representing 350 funds rated the significance of 14 barriers to pension
participation in venture capital. Survey results published in Prudence, Patience and Jobs: Pension
Investment in a Changing Canadian Economy (Canadian Labour and Business Centre, 1999) reveal that
fiduciaries see major impediments to entry or sustained involvement in this market. Above all, they
identify several obstacles to obtaining private equity's reputed superior returns (in the U.S., near 20% in
the long-term, but frequently above the 40% to 50% mark).
First on the list of barriers was cost. Venture investment generally involves considerable time and effort
to find high-growth business winners. Respondents say this expenditure is difficult to justify for a
marginal asset allocation. Pension managers also question whether the Canadian industry has enough seasoned
professionals for the task.
In addition, respondents expressed serious doubts about their own capacity to access useful market data, to
monitor venture deals once they were made, and to measure the performance of deals as they progressed. They
also wonder whether Canadian business opportunities are ever likely to deliver optimal risk-adjusted
returns. Indeed, only the regulatory strictures of government are viewed as inconsequential.
Many participants base their conclusions on direct experience from the late 1980s, when pension funds were
a sizable presence in what was a nascent period in Canada's venture capital industry. Most left, quite
abruptly, citing insuperable problems: excessive costs, conflicts with venture professionals, especially on
the matter of fees, and low returns. This unhappy history has shaped the outlook of many PIAC members.
"Our difficulty was essentially organizational. Pension managers were thrust into a role for which we
lacked experience, time and interest," says Donald Walcot, chief investment officer at BIMCOR (the internal
money manager of BCE pension funds) in Montreal and a survivor of the 1980s fiasco which he endured while
employed with the Ontario Hydro Pension Fund.
"Pension funds, venture capitalists and the entrepreneurs who were running investee firms were then new to
one another. There was a basic incongruence in our respective aims. When problems arose, all of the initial
goodwill quickly eroded." On top of this, Walcot adds that the returns just weren't there. "Had they been,
we might have lasted it out."
This brush with venture capital is representative of the majority of Canadian pension funds that abandoned
it as an asset class once the recession of the early 1990s was in full swing. Like Walcot, many believe the
short-term expectations of pension funds made them unprepared for illiquid investment.
These conditions coupled with the arrival of pension funds at the end of the market's cycle probably
spelled disaster.
COMFORT ZONE
Once again, there is a different picture in the U.S. At US $134.5 billion, America's stock of venture
capital is by far the biggest in the global economy, and its industry structure is highly advanced. But
this didn't transpire overnight.
American venture financing experienced many of the initial growing pains felt in Canada. U.S. pension funds
once met the same impediments and, as a consequence, developed a comparably rocky and volatile relationship
with members of the venture profession.
One big difference, however, was the creation of a new market infrastructure that is adapted to fiduciary
needs. A notable advance was the establishement of best practices. This required venture professionals to
closely align their financial interests with those of pension funds.
Other pension-friendly vehicles also materialized, such as funds of funds or third party pools for
allocating assets cost effectively. Economically targeted investment vehicles also offer the security of
private-public partnerships.
To further accommodate pension funds, U.S. venture financing also developed a human resources component,
producing diverse investment specialists, intermediaries, market experts (known as gatekeepers) who act
solely on behalf of fiduciary interests, and deal-making agents.
Over time, private placement databases have also greatly improved, giving pension managers a better read of
market signals, especially on returns.
These innovations have provided U.S. pension funds with a comfort zone. Indeed, most innovations came at
the urging of pension managers and now form the essential terms and conditions for their regular selection
or renewal of partners and syndicates.
CALPERS CRITERIA
It is instructive to review the criteria established by the largest U.S. pension fund, the California
Public Employees Retirement System (CalPERS), under its Alternative Investment Management (AIM) program,
for the investment of about US$1.5 billion in venture capital via the fund of funds, California Emerging
Ventures. CalPERS-AIM criteria are replete with references to transparency, limited partner relations,
performance standards, professional quality assurance, provisions for cost containment, fair fee
structures, adequate consultative mechanisms and significant investment stakes.
CalPERS and other U.S. pension heavyweights, such as the New York State Common Retirement Fund, have found
a home in venture financing by adopting a take-charge attitude to knocking down hurdles. These and other
pension funds learned the ropes, developed an infrastructure to take pressure off their organizations and
set ground rules for venture professionals.
The big question is: can this be done in the much smaller Canadian industry ($12.1 billion under management
at the beginning of 2000) that is comparatively young?
DIVING IN
A pension-led movement is simmering in Canada. To compensate for our small market, several leading public
sector funds have elected to keep much of their venture decision-making in-house. This is the approach of
the Caisse. The Caisse flagship for this effort, Sofinov, and other subsidiaries meticulously hunt for new
technology-intensive company formations, such as the now indisputably successful Telesystem International
Wireless.
Other pension funds observe the American model of focusing on limited partnerships and alternative external
vehicles with solid track records, with the assistance of a growing domestic pool of knowledgeable advisers
and data products. Public sector funds on the West Coast, with assets aggregated under the British Columbia
Investment Management Corporation (BCIMC), weighed into venture investment in 1995 and are currently
involved in more than 60 limited partnerships at home and abroad, including Ventures West Management, known
for its role in launching Ballard Power Systems.
BCIMC began a thorough investigation of the private equity option in 1990 and studied the U.S. pension fund
experience before settling on a limited partnership strategy. "Venture professionals working with us must
also be prepared to adopt best practices like those advocated by CalPERS and other American pension funds
on such key topics as performance, fees and consultation," says chief investment officer Doug Pearce who is
based in Victoria.
Ontario Teachers has exhibited considerable confidence as a newcomer to venture financing. As part of its
1997 decision to commit $100 million, it struck a co-investment arrangement with Celtic House, the
Ottawa-based backer of spin-offs of Newbridge Networks (now Alcatel Networks) with benefit of the latter's
strategic patronage. Early in the game, the pension fund shrewdly chose a dedicated partner in one of the
country's hottest technology centres.
SIGN OF MATURITY
Another sign of maturity in Canada's venture capital industry is the recent attention given to the amassing
of data to profile financial returns. This year, with the encouragement of BCIMC's Pearce and other senior
pension managers, the Canadian Venture Capital Association, Réseau de capital de risque du Québec
and Macdonald & Associates Ltd. embarked on a survey of key market players that will generate the
first-ever estimate of long-term domestic returns in aggregate. These findings, and those of ongoing
surveys, should be of enormous value to pension funds given their concerns about performance and
benchmarking.
This kind of news may prompt some pension funds to re-evaluate private equity. After its protracted
absence, BIMCOR is contemplating a return to the venture capital industry. "Pretty much everyone is
rethinking the issue," notes Walcot.
It certainly would be good for Canadian economic growth and job creation if pension funds jumped into
venture financing. Without them, domestic venture capital supply is unlikely to soon match, in
proportionate terms, supply available in the U.S. Given their considerable assets, pension funds are simply
too influential to remain on the sidelines.
What is perhaps more pressing to pension fiduciaries, however, is the superior returns potentially offered
by venture capital, to say nothing of its use in modern portfolio diversification. U.S. pension
participants commonly allocate 3% to 5% of total assets to private equity, and with the right strategy,
their Canadian cousins may be well-positioned to take the plunge.
Kirk Falconer is the author of Prudence, Patience and Jobs: Pension Investment in a Changing
Canadian Economy(1999), and a senior economist with the Canadian Labour and Business Centre in Ottawa.
ckfalconer@clbc.ca.
*** ***
KEY BARRIERS TO CANADIAN PENSION FUND PARTICIPATION IN VENTURE CAPITAL
Rated as important or very important by senior fund managers who are members of the Pension Investment
Association of Canada
Investing is management-intensive, costly
78%
Too few qualified investment specialists
73%
Lack of critical market information
69%
Returns are inadequate, unreliable
66%
Potential high-profile failures, liabilities
64%
How to measure long-term performance
64%
Insufficient trustee support
61%
Source: Prudence, Patience and Jobs, CLBC, with the co-operation of the Pension Investment
Association of Canada, 1999
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