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The characteristics of US institutional investors

US institutional investors are increasingly looking to invest in European venture capital partnerships. This edited extract from SITRA's ‘Attracting foreign investment into early-stage Finnish technology companies' examines the characteristics of US investors, their criteria for placing commitments with VC funds and the opportunities for VC firms in Finland to raise capital from the US.

American institutional investors have immense amounts of capital they have to invest to produce high returns. These investments are handled by a very small group of intermediaries. The only kind of non-bond market that has produced consistently high returns over the past eight years is private equity, in other words venture capital. Hence investments (into private equity funds) will remain stable or maybe even go up.

Consistent with the above statement, we expect that there will be an increasing interest among US institutional investors to place funds into European venture capital partnerships. 50 per cent of respondents to a survey believed that international private equity was the most attractive asset class, with 33 per cent saying that specifically developed markets are preferred.

Adding the visibility of Finnish technology firms, it is reasonable to believe that Finland will be one of the preferred targets of some of these institutions. Thus, one of the key future considerations for Finnish venture capital funds is to develop an approach to soliciting US institutional investors as limited partners. Otherwise, only foreign groups will have access to that capital, leaving the Finnish investors at a disadvantage when competing with those foreign groups.
 
Each type of institutional investor has its own set of criteria for placing commitments with venture capital funds, and as we will see, some make more practical targets for Finnish venture capital funds seeking to raise new capital abroad. Fortunately, information on institutional investments flows relatively freely in the USA.

By analysing the characteristics and preferences of US investors, we hope that we can help Finnish venture capitalists achieve over time a high level of integration with the US technology markets that will ultimately lead many early-stage technology-based companies to become global leaders. In addition, we believe that understanding the preferences and needs of US investors will allow Finnish venture capitalists to become leaders in the emerging European venture capital community, and will in fact improve the quality of Finnish investors portfolios. Finally, we believe that taking a proactive approach toward attracting foreign investment will ultimately help lead Finnish investors to offer higher value-added internationalisation services to Finnish companies, creating more valuable Finnish companies and more wealth for Finnish investors than if Finnish venture capitalists choose to ignore these opportunities.

Who are the US institutional investors?

Types of US institutional investors

The first step in understanding foreign institutional investors is to identify and classify them. Within this paper we will primarily concentrate on three types of investor: corporate pension funds, endowments and foundations, and public pension funds. Each of these types of institution has a different fundamental mission that leads it to execute unique investment policies, and the groups seeking to attract investment from each type of institution need to be aware of the parameters of these investment policies before contacting them. In addition, we also comment on another key actor in the institutional investment process, the pension consultant, or gatekeeper.

First, the typical public pension fund is much larger in investable assets, amount committed, and amount invested in alternative assets than either of the other two categories. However, the endowments and foundations have a significantly higher ratio of assets committed to alternatives than the two types of pension funds - on average 13 per cent of their assets are committed to alternatives, as opposed to about five per cent for the pension funds. In general, the percentage of the commitments that are actually invested by the investment managers is similar across institutions, at around 70 per cent.

Each institution must acknowledge that its status is one of the following: (1) a recently established program, (2) actively building portfolio, (3) selectively making new investments, (4) making mature, recycling investments or (5) making few, if any, commitments. If we only consider the institutions that are actively building their portfolio we find an even larger relative appetite among the endowments - on average 20 per cent of their commitments are to alternative investments.

This information is quite consistent with the information we obtained from our interviews with several venture capital fund managers when they were asked to compare the types of institutions they preferred to solicit for their funds. For example, an Israeli early-stage venture fund manager, raising his first venture capital fund, stated that he was able to raise much of the money for his fund from university endowments in a matter of two months. An American mezzanine fund manager also stated that endowments were the best limited partners, from the standpoint of ease of service and loyalty - endowments tend to be the most patient form of institutional investment.

Alternative assets of interest

In this report we are particularly interested in venture capital and international private equity investments, so we will examine these categories in this section.

Over time, the preferences of institutional investors within the alternative investment category have been changing. Since 1992 portfolios have been increasingly weighted toward leveraged buyouts and international private equity, while venture capital has decreased. Western Europe is the most preferred of the international private equity alternatives, and its leadership appears to be increasing.

The potential to solicit private investment to Western European funds is both high and growing. Therefore a primary motivation for Finnish private equity managers must be to differentiate Finland from the rest of Western Europe.

What are the key factors an institution looks at when choosing a private equity manager?

In the above sections, we identify the key constraints and expectations of different types of US institutional investors. However, we know that in practice those investors are looking at a number of other, generally more qualitative factors when making their investment decisions. Institutions look beyond the top manager to the full management team. A premium is put on showing that the management team has history together, and that their reputation in the investment community is good. The terms of the fund general partner's participation in the fund is also important. The investors take a close look at the hurdle rate the managers set and the period over which the carried interest over this hurdle rate vests, as well as the degree of ownership the management team has in the fund.

Investors main concerns are related to the current investment climate in which large increases in investable capital into private equity investments inflate valuations and leave too much money chasing too few deals, ultimately reducing returns. The track record of the general partner is in the end the key factor in the investment decision, with the recommendation of the gatekeeper and the fit with the funds strategy being key factors as well.

Opportunities and threats facing Finnish venture capital firms

The key issues Finnish venture capitalists must deal with in raising institutional capital in the US relate to differentiating the fund from the rest of Europe, establishing credibility based on their track record, and making the institutions feel comfortable with the terms of the offering. There are barriers and potential solutions for each of these issues.

The Finnish venture capital community does not appear to have a clear image in the US. While certain players are known among venture capital circles, this does not translate to name recognition at the institutional level. Even the relative buzz about Finnish technology companies will likely take several years to manifest itself at the institutional level. Before the venture capitalist makes his road show, there is little reason for investors to believe that a given manager can generate superior returns, in contrast to countries like Israel, Taiwan, and the UK that have a much higher profile.

Thus the Finnish venture capitalist must establish both the macro-level argument for Finnish investment opportunities (which some other countries can de-emphasise), and the micro-level argument for his own fund's uniqueness. The macro section can focus on factors such as the economy of Finland, status as an EU founder, and the technology drivers that make Finland different from the other European countries. The micro argument can be crafted by emphasising the existing track record of the management team, and the unique investment strategy of the fund.

Firms with no formal track record are clearly not a good candidate for raising funds in the US. In terms of structural issues in the fund, a key issue may be the existence of the investment committee in most Finnish funds. US investors will likely not agree to sit on investment committees, since industry practice in the US strictly separates the institutional fund manager from any involvement in the operations of its investments for tax reasons.

In addition, they will not want to participate in a fund where other institutional investors are sitting on the investment board for two reasons. First, it will create two tiers of investor, one with operating control and one without which can be perceived as an opportunity to favour one investor over another. Second, they will not perceive other institutional fund managers as being good judges of high-risk investments, leading in their view to a lower potential return on investment. The Finnish industry practice of the investment board will need to be re-examined as US and domestic investors begin to co-mingle as limited partners in Finnish private equity funds.

Copyright © 2002 SITRA

Sitra, the Finnish national fund for research and development, is an independent public foundation under the supervision of the Finnish parliament. The fund aims to promote Finland's economic prosperity by encouraging research, backing innovative projects, organising training programmes and providing venture capital.
 
The fund was set up in conjunction with the Bank of Finland in 1967 in honour of the 50th anniversary of Finnish independence. The fund was transferred to the Finnish parliament in 1991. For more information please visit www.sitra.fi