As pension funds rush to invest in venture capital, hedge funds and other alternative investment vehicles, they should be mindful that they're sailing into unfamiliar waters. In short, these investments offer none of the protections of traditional asset classes.
Pension funds must verify uncertain performance reports, weigh varied and unconventional fee structures, and understand the timing for putting money to work and the lack of liquidity of these investments. Few pensions have the internal staffing to undertake the special due diligence these investments require. Some big pension funds, such as the Chicago Teachers Retirement System, are significantly increasing their venture capital, private equity and other alternative allocations, whereas others, such as the Missouri Public Employees Retirement System, have chosen to avoid these risks altogether.
Enticed by spectacular returns, pension funds increasingly are allocating a larger percentage of their assets, now typically 3% to 7%, to venture capital, hedge funds and other alternative strategies. The number of firms offering these products is exploding, attracted by fees higher than those for traditional asset management.
If a pension sponsor doesn't known what it is getting into, it will be in for some unpleasant surprises. There are no disclosure or reporting requirements that apply to the alternatives. The securities the fund holds rarely are publicly traded and often are subject to collateral agreements containing terms that must be considered in establishing their values.
As a result of these factors, valuation of venture funds' securities holdings is far less clear than valuation of real estate. Valuation of real estate holdings in recent history has been problematic for pension funds. Because of the attendant vagaries, venture managers have tremendous leeway in valuing portfolio securities. After all, no one, including consultants and pension investors, has access to all the information that must be considered in establishing values.
Given the fat fees in this business and the lack of regulation, it is not surprising that many institutional and mutual fund managers with mediocre performance in traditional asset classes are getting in the act. Venture funds are virtually immune to the criticisms, such as underperforming a benchmark, investors level against traditional asset managers.
In general there is no place for weak portfolio managers to hide in today's world -- but venture funds are the perfect hiding place. Because there is no uniformity mandated by law and no required disclosures, investors can be kept in the dark. Venture managers get paid a fee at least twice that of traditional portfolio managers; and the investor has no right to redeem for years. Finally -- and this is the best part, from the manager's perspective -- the investor won't even know if the performance is good until it's all over. Unfortunately, as in the case of hedge funds, I've observed that it's often the weakest portfolio managers that are attracted to unregulated investment vehicles, although it well may be only the best managers survive and prosper over time.
Investors can't get performance numbers for comparisons and any numbers they get aren't sure to be accurate. Furthermore, even if the performance results disseminated are provable, remember that because there is no general disclosure obligation, a venture capitalist is free to disclose selectively the performance of only his best-performing funds.
Few venture capital firms, if any, would survive the same level of scrutiny that activist pension funds require of the public companies in which they invest.
Pension funds that invest in venture capital funds should begin asking the same difficult questions of these funds that they would ask of a public company or registered investment adviser with which they invest.
Edward A.H. "Ted" Siedle is president of benchmarkalert.com and Benchmark Financial Services Inc., Lighthouse Point, Fla. The following is adapted from a lengthier commentary.