Few agree as to whether there’s a bubble in venture capital. Bill Gurley says there is one, Marc Andreesen says there isn’t, and so forth. Either way, some journalists have been quick to note that if there is a bubble, it is different this time. Because venture capital is funded by private, wealthy investors, the thinking goes, at least mom-and-pop investors aren’t at risk.
That’s not entirely true. Public pension funds—the state-run investment pools responsible for the retirement benefits of nearly 20 million Americans—have quietly been funding the recent boom in venture capital. The investment pools are made up of tax dollars and contributions from state employees. For the last few years, they have made up the biggest single source of funds flowing to venture capital, according to the most recent Dow Jones Private Equity Analyst Sources of Capital survey. In 2014, they contributed 20 percent of the sector’s overall haul, down slightly from a 25 percent contribution in 2013.
To be sure, the amount that pensions allocate to venture capital isn’t that big, relative to the pension funds themselves. Indiana’s Public Retirement System allocates (PDF) 1.6 percent ($363 million) to venture capital, which is on the higher end as a percentage of assets; the California Public Employees’ Retirement System (CalPERS) allocates a more typical half percent of assets, although the fund is so big that this meager fraction totaled $1.8 billion in 2013. The amounts are small enough that if pension funds’ entire venture capital investments were to evaporate, pensioners would still be all right. In most states, pension obligations are guaranteed by state constitutions. If the investments—in venture capital or anything else—don’t pay off, taxpayers are on the hook for the shortfall.
Some venture capital funds earn above-market returns and invest in successful startups. But these aren’t the funds in which pensions typically tend to invest. Public pensions must be transparent about their investments; they are subject to the Freedom of Information Act. Many of the top-performing venture capital funds won’t accept pension money because they don’t want to publicly disclose their portfolio. That leaves public pensions to pick from other, often lesser, funds.
Like hedge funds and other kinds of private equity, venture capital funds charge an annual management fee of 2 percent, plus 20 percent of profits. Performance is an open question. Many funds under-perform an S&P 500-stock index fund. Diane Mulcahy, senior fellow at the Kaufmann Foundation, claims many funds aren’t profitable and says the steady fee income diminishes the incentive to find profitable investments.
Pension funds are notorious for putting up with low returns and high fees. In order to justify their assumptions about how well its pension investments will perform, states need the potential for big payoffs. Investing in a simple, low-cost index fund might provide more reliability at a lower cost, but its projected return would also be lower—and that might force them to acknowledge they don’t really have enough money to pay future retirees. This creates an incentive to seek out expensive, risky investments, like venture capital and hedge funds.
Last week, CalPERS announced it would no longer invest in hedge funds, and is aiming to cut its venture capital exposure from to 1 percent from 7 percent of its private equity portfolio over the next 10 years. The state of Arizona claims it’s reducing its $90 million venture capital investment. Despite the mixed incentives, some pension boards apparently have their limits.
