Journal of Private Equity
March 22, 2003 No. 2, Vol. 6; Pg. 79; ISSN: 1096-5572
Venture capital and the university: the endowment's role
four strategies for increasing the flow of venture capital, attracted by endowment
Fried, Vance H. benefits are costing the endowment $ university intellectual property office, local
300,000 a year. These costs must be industrial authority, or research parks).
Research universities are a major factor in recognized and minimized, if not eliminated.
the economic growth of a region (Birch, LOCALLY FOCUSED PARTNERSHIPS
Haggerty, and Parsons ). Studies 3. Location is important. To generate local
show that the level of R&D expenditures at external benefits, investments need to be in These funds provide major external
a university leads to new business local ventures--those with a clear benefits because they invest locally. If
formations, which in turn lead to economic connection to the university or its region. locally focused funds are of the same
growth. While this argument has How capital reaches local ventures varies quality as core funds, they can be treated
traditionally been made with the by market sector. The market for small, as part of the core partnership portfolio.
expectation of a long lag time between early-stage investments is local with funds Subject to diversification limits, these funds
R&D spending and economic growth, a provided by locally based institutional are prime investments for an endowment.
recent study has shown that lag time is venture firms and angels. The market for Further, investments in proven-quality
actually quite short--as little as one year large, early-stage investments is national funds with a local focus might be
(BJK Associates ). with funds provided by institutional venture considered even if higher-quality
firms from throughout the nation. However, partnership investments are available
However, research spending by itself does early-stage venture funds from out of the outside the region.
not translate into local economic growth. geographic area are reluctant to invest
Two universities can have similar levels of without involvement of a local firm. For Unfortunately, many locally focused funds
research spending but significantly different small, late-stage investments, the market is are not of the highest quality. Many are
economic impacts upon their community. In local. For large late-stage investments, the first-time funds. In addition, small locally
addition to research spending, market is national. focused funds are unlikely to be able to
entrepreneurial activity is also influenced by attract and retain the same quality of
a variety of other factors, one of the most Due to the geographic nature of the private management as the larger, national firms.
important being access to venture capital equity markets, an endowment has two Further, the local pool of potential
(Roberts ; Gompers and Lerner basic ways it can generate local external investments may be too small to support a
). Not surprisingly, many among the benefits. First, invest locally. Second, freestanding venture capital firm.
university community and its supporters increase the university community's
are very interested in having their connectivity with the national market. Thus, investment in a local fund may pose
endowment invest in venture capital in a a real and substantial cost (in terms of
manner that increases the flow of capital to A strategy to generate external benefits lower expected risk-adjusted returns) to the
their university community and regional must get capital to local ventures without endowment. The quandary for the
economy. compromising endowment returns. There endowment is that it would like its
are four possible components to the community to have local funds because of
On the other side, most endowments are strategy: core partnership portfolio, locally the major external benefits, yet is not
strongly resistant to any type of investing focused partnerships, direct investments, interested in the local funds from purely an
done for economic development purposes. and student-oriented funds. investment viewpoint.
However, many university endowments
have been successful investors in venture CORE PARTNERSHIP PORTFOLIO If the supply of venture capital in the local
capital for strictly IRR reasons and remain market is already adequate, there is little
active in today's market. This article The bulk of the asset class should be reason for the endowment to invest in
presents a strategy for endowment invested in a diversified mix of the very weaker local funds since the external
investing that increases the flow of capital best private equity partnerships possible. benefits are provided to the community at
to the university community without External benefits should not be considered no cost to the endowment. However, if the
compromising the investment goals of the in developing the core partnership portfolio. endowment feels there is a need to
endowment. Three assumptions are central For many endowments, this will result in no stimulate the local market, it might consider
to this strategy. investments in locally focused funds them within the following guidelines:
because better investment opportunities
1. The primary purpose of the endowment are available elsewhere. 1. Severely limit the dollar amount of the
is to protect and grow the corpus. Private private equity asset class that can be
equity should be used as an asset class to However, there is potential to increase the invested in locally focused funds. A lot of
the extent it furthers this purpose. Any local community's connectivity with the external benefit can be generated from a
positive economic impacts on the university national market. Building a high-quality core relatively small investment.
community and region, as well as university portfolio requires significant exposure to the
image enhancement with potential donors, national marketplace. The endowment's 2. Any local fund must be professionally
are what economists refer to as "spillover" knowledge and exposure can provide managed and market return driven. This
or "external" benefits. These external valuable national market feedback and minimizes the cost (in lower returns) to the
benefits should not be the primary driver of relationships to local ventures. There will endowment. While the partnership's
endowment investment strategy. be additional administrative cost to the management may not be as good as
endowment. However, if properly established "A" investors, poor
2. Achieving external benefits can have real coordinated with management of the core, management is not acceptable.
costs to an endowment in terms of lower the additional administrative costs should
expected risk-adjusted returns. For not be great, and might be funded from 3. Only invest in funds that are able to
example, if an endowment expects a 3% outside sources (e.g., university public generate a significant amount of investment
lower risk-adjusted return on an investment service, state technology agencies, from other investors. For example, the
of $ 10 million, then the ensuing external endowment might have a rule that it will
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provide no more than 20% of a * It substantially increases the quality of
partnership's capital. Requiring significant Size in terms of amount invested is investments.
investment from others serves as a simple important to the extent it helps the
screen on the quality of the management. endowment attract and retain quality locally * It allows the fund to be very small--under
Further, the greater the investment from based management to run the direct $ 1 million--yet still be economically feasible
others relative to the endowment's portfolio. However, staffing does not need because it never leads investments.
investment, the greater the external to approach that of even the smallest of
benefits relative to the cost to the venture funds because the endowment is * It gives students contact with multiple
endowment. never acting in the role of lead investor. A venture capital firms.
well-qualified person can run a small
4. Take the role of a lead investor in the program on a part-time basis. * It allows the fund to avoid being the "bad
partnership: e.g., serve on the partnership's guy" when proposals are rejected, founders
advisory committee. In the core STUDENT-ORIENTED FUNDS fired, etc.
partnerships, many of the other investors
will be sophisticated and have a larger Student-oriented clinical education Co-investing by a student fund differs from
investment than the endowment. However, programs involving operation of a small direct co-investing by an endowment in that
for the locally focused funds the venture capital fund can also provide major the size of the co-investment is much
endowment will likely be one of the largest benefits to the university community. smaller and the criteria used for defining
investors, and the most knowledgeable Students directly involved receive potential co-investors are different. For
about private equity investing. advanced training in private equity example, a student fund might invest in a $
investing and business development. They 500,000 seed round where the lead
5. Don't be greedy. Because the also receive significant exposure to leaders investor is a small, local fund (perhaps
endowment is in a very strong bargaining in the venture capital and entrepreneurial even a sophisticated angel) because it
position relative to the general partners of communities. The result is a premier involves a university spinoff with an
the fund, it may be tempted to negotiate educational experience for participating opportunity for students to be very active in
very stiff terms. This is counterproductive if students interested in becoming venture developing a business plan. The same
it results in a partnership arrangement that capitalists, entrepreneurs, management of investment might be unacceptable for a
will not work in the long term for the general emerging growth companies, or service direct investment by an endowment
partners. providers to emerging growth companies. because the co-investor would not be
At the same time, the fund provides the viewed as "A" quality.
DIRECT INVESTMENTS university as a whole with a strong entree
into the entrepreneurial community, The co-investment approach solves some,
In addition to partnership investing, the resulting in valuable contacts for but not all, of the problems of the student-
endowment can also make direct placement, research access, and funding. run fund. Continuity remains a major
investments in ventures with a clear link to problem. Unlike students running a fund
the university community and region. This The concept of student-oriented funds is in that invests in public equities, students
will produce significant external benefits. its infancy. One current approach is to cannot create and liquidate a private equity
From an investment perspective, the issue create a fund that invests in ventures portfolio in a school semester. Further, the
is how can a direct investing program avoid owned and run by existing students. A co-investment model is based on venture
the problems of a locally focused fund. major problem with this approach is that the capitalists being willing to allow the student
number of quality, student-founded fund into their deals. Poorly supervised
The solution is to only make direct ventures is limited. Further, even those that students doing work they are not capable
investments as a co-investor. In this are high quality are usually too small in size of performing can seriously frustrate a busy
approach, the endowment identifies quality to warrant the professional level deal venture capitalist/co-investor. Even worse,
local investment opportunities and evaluation and monitoring that venture an overconfident student with weak
connects them to the national market. If a capital investing requires. By providing interpersonal skills can alienate even the
quality national private equity fund invests, them out-of-pocket expense money, this friendliest of co-investors.
then the endowment makes a much smaller type of fund can be helpful to individual
direct investment on the same terms. The students trying to launch a business To be successful, a fund needs to be
quality of the direct investment is a function concurrently with their schooling. However, student-centric, not student run. Students
of the quality of the co-investor. If the co- "investments" by these funds are really must be top-quality, but also must be
investing partnership is part of the core, or more in the nature of a grant with the hope properly supervised. The fund will feel
similar in quality to the core, then the direct that some money may ultimately come "real" to the students, yet not expect
investments will be of the same quality as back. Perhaps more importantly, this students to perform activities beyond their
those made by the core partnerships. approach does not provide the broader capabilities. Student work assignments and
educational benefits gained by students their relationships with co-investors and
A small, well-run co-investment program investing in high-quality ventures. portfolio companies need to be structured
allows the endowment to get external so that students are helpful without getting
benefits at no cost. In fact, since the co- Another approach is to have students in the way.
investor is investing significantly more than actually run a fund with light supervision.
the endowment, the endowment is actually This model is ill suited to venture investing. (The appendix, "Running a Student-Centric
leveraging external benefits at 20 or 30 to Venture capital requires a consistent Fund," gives an example of how such a
1. Further, the co-investing program can investment strategy and a well-maintained program could be operated.)
increase returns to the core. Sometimes contact network. Thus, there must be
top private equity partnerships are continuity in management. In addition, An endowment's role in student-centric
oversubscribed, making it difficult for many of the activities that must be funds is important, but limited. Given its
investors to get in. Investors who can performed in managing a fund are heavily primary goal of educating students, it is
generate deal flow for the partnership are interpersonal, and generally not suitable for unreasonable to expect returns from a
more attractive as limited partners. Thus, a students. At times, students need to be student-centric fund to rival that of the core
co-investing program might help the observers, not doers. This is particularly partnership portfolio. Even if they did, the
endowment get into top partnerships, true when the venture capitalist must be a amount of money that can be invested
thereby boosting the performance of the "bad guy." The potential for major through student-centric funds is relatively
core portfolio. investment losses is quite high under this insignificant. As a result, investment from
model. the university general endowment into
While large venture investors have done student-centric funds should, at most, be
direct co-investing for several years, the Part of the problems with a student-run token in amount. Instead, capital for these
rationale here is somewhat different. The fund can be eliminated by running under a funds should come from alumni and other
focus is on increasing connectivity between strict co-investment model, only making interested friends of the university. It can
university community and venture capital investments as a small co-investor come either in the form of donations
market. As a result, the size of the direct alongside established, private sector lead earmarked to the clinical program,
portfolio in terms of number of deals is investors. There are numerous benefits to investment of "play money" by wealthy
much more important than size in terms of this approach: individuals, or program-related investments
amount invested by the endowment. (1) by foundations.
More deals means more external benefits.
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However, while the endowment's cash is The course and venture fund are managed Reporting. Students are responsible for the
not important to these programs, the by a permanent faculty director, with ample fund's reporting to investors. Regular
endowment's cooperation is. As previously room for involvement by other faculty, reports are made as per industry norms.
noted, through being an active investor in venture capitalists, entrepreneurs, and An annual partner's meeting is held in
venture capital partnerships, the service providers on a deal-by-deal or conjunction with a major college external
endowment gains a high level of knowledge issue-by-issue basis. As much as possible, event. In addition to external reporting,
and contacts in the venture capital the fund operates like a regular venture there is a strong internal reporting system.
community. Access to this knowledge and fund. However, there are some major It stresses written documentation more
network can significantly enhance the differences because of the heavy student than at most traditional funds. Due to the
performance of the student fund, both as involvement and co-investing requirement. annual turnover of students, multiple
an investment and, more importantly, as an classes are often involved over the life of
educational endeavor. Conversely, a Deal Origination an investment. Quality internal reporting
student-oriented fund may be a major tool makes it much easier for incoming classes
for an endowment to utilize in increasing The director is responsible for deal to quickly understand an existing
the university community's connectivity with origination. Many deals come through co- investment.
the venture capital marketplace. Further investors. Therefore, the director maintains
synergy could come from substantially regular contact with potential co-investors. ENDNOTES
overlapping management of a direct In some circumstances, the fund originates
investment portfolio and a student-centric the deal. They may be university spinoffs The author is grateful to numerous
fund. While their funding sources are coming directly from the University individuals over several years who have
different, deals in the direct portfolio will Intellectual Property Office. Also, since the provided insights that molded the concepts
likely also be in the student portfolio (but program is highly visible in the university presented here. In particular, Matt Burns,
not the other way around given a higher- community, local entrepreneurs may Rob Freer, Ron Moomaw, Georgeanne
quality co-investor requirement for the contact the fund first. Since the fund cannot Perkins, Tim Peterson, John Polonchek,
direct portfolio). lead an investment, the director needs to Jim Schrager, Dan Slater, and Mark Yusko
find a potential lead investor before provided comments and insights on earlier
ENDOWMENT INVESTING SHOULD proceeding further. Although students are drafts of this manuscript.
GENERATE EXTERNAL BENEFITS not responsible for deal origination, they
help make the fund visible by regularly (1) If an endowment is taking small pieces
Being in an entrepreneurial environment is attending networking events. of deals as a co-investor, the endowment's
a major plus for a research university. money is not really needed. It is just
Venture capital is an important ingredient in Deal Evaluation replacing a little of the money the other
creating this environment. Thus, major investors would have invested. However, if
external benefits flow to the university and Students are very helpful here. Working in the endowment had not actively fostered
the greater university community if its conjunction with potential co-investors, the connectivity, the investment may not have
endowment can increase the flow of director identifies tasks that students can been made.
venture capital to the university community. perform and assigns them to student
teams. When first looking at a deal, (2) This concept was developed by the
This article presents four strategies for normally only one team is involved. If the author with financial support from the
increasing the flow. Of these four, one-- deal heats up and the amount of work Coleman Foundation of Chicago. Many
investing in locally focused funds--may increases, additional teams can be added people were helpful in the development of
mean additional costs (in term of reduced as needed. the student-centric fund concept including
IRR) to the endowment beyond those James Bode, Garry Bruton, Clint Bybee,
inherent in the private equity asset class. Deal Making Barry Davis, John Frick, Charlie Heller,
An endowment should exercise caution in John Glynn, Dave Humphrey, Steve
pursuing this strategy. The other three-- The fund is a deal taker, not a deal maker. Lazarus, Greg Main, Bob Rees, Mike
utilizing the knowledge and contacts gained Deal making is the domain of the co- Tharp, and Carl Thoma. While similar, the
from investing in its core partnership investors. However, as a deal taker, the Wolverine Fund was developed
portfolio to increase the university fund has enough involvement for students independently at the University of
community's connectivity to the national to get a good look at the process. Michigan under the direction of Tim
venture capital market, making direct Peterson.
investments in local ventures as a co- Deal Approval
investor, and cooperating with student- REFERENCES
centric funds-provide external benefits Students make investment
without compromising the endowment's recommendations to the director and an Birch, David L., Anne Haggerty, and
investment goals. In fact, they may actually outside advisory board. The director is William Parsons. Entrepreneurial Hot
increase returns to the endowment. Given ultimately responsible for approving all Spots: The Best Places in America to Start
their win/win nature, an endowment should deals. As a practical matter, the fund and Grow a Company. Cambridge, MA:
pursue at least one, if not all, of these usually invests if the co-investor chooses to Cognetics, 2000.
BJK Associates. "The Influence of R&D
APPENDIX Post-Investment Expenditures on New Firm Formation and
Economic Growth." Research report for
RUNNING A STUDENT-CENTRIC FUND Monitoring. The fund asks for visitation U.S. Small Business Administration,
(2) rights to board meetings. Students attend National Commission on Entrepreneurship,
on a regular basis. Sometimes the director and Kauffman Center for Entrepreneurial
The program runs over the full school year may go, particularly if the meeting is Leadership, 2002.
as an elective business course that potentially acrimonious. Both students and
integrates classroom education with the director operate under a strict "only Gompers, Paul A., and Josh Lerner. The
operation of a small, co-investment venture speak when spoken to" policy. The fund Money of Invention: How Venture Capital
fund. As part of the management of the does not actively take sides in any conflict Creates New Wealth. Boston: Harvard
fund, students work on a variety of projects between investors, or investors and Business School Press, 2001.
related to private equity investments. Using management.
a clinical seminar format, students report Roberts, Edward B. Entrepreneurs in High
regularly on their projects. As a class they Special Projects. Student teams do special Technology: Lessons from MIT and
discuss the issues they are facing, and projects for portfolio companies as needed. Beyond. New York: Oxford University
receive guidance as to how problems may Often these projects relate to securing Press, 1991.
be resolved. Throughout the course, additional financing or exploring new
supplemental readings and mini-lectures business opportunities. Students are To order reprints of this article, please
are given on topics relevant to the investing particularly helpful to seed investments by contact Ajani Malik at
activities of the fund. In addition, students helping develop formal business plans for email@example.com or 212-224-3205.
look at major issues in the venture capital use in securing early round financing.
industry. The University of North Carolina at Chapel
Hill has 8% of their $ 1 billion endowment
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allocated to private equity. The endowment The Community Technology Fund at student-centric model. It invests $ 100,000
invests both as a limited partner and a Boston University wears multiple hats-- to $ 200,000 per deal alongside venture
direct co-investor alongside well-known venture capital, technology transfer, and capital firms. To date, the fund has invested
private equity funds. The endowment only new business formation. Technology $ 1.5 million in nine deals. The total amount
invests locally if it feels that the local transfer includes patenting and licensing of co-investment in these deals is
investment opportunity is of high enough responsibility for all the university's approximately $ 150 million.
quality to be included in its core portfolio. intellectual property. New business
As a result, investments in North Carolina formation develops and incubates spinouts The fund only invests in deals with a formal
are limited. However, it is now leading in based on university technology. In addition or informal "Michigan affiliation" An example
the creation of a seed fund to focus on to hands-on management, the Community is HandyLab, a company founded by two
deals with a "University of North Carolina Technology Fund provides these spinouts chemical engineering Ph.D. students.
affiliation." The primary purpose is not to up to $ 100,000 in seed capital. HandyLab is developing an integrated DNA
increase the follow of venture capital to analysis device based upon cutting edge
North Carolina, but rather to generate The Community Technology Fund also technology in nanoliter microfluidics. The
superior returns by investing in what the manages the university endowment's Wolverine Fund invested in HandyLab's
endowment sees as a market where the private equity portfolio. The endowment initial $ 2.5 million round in 2000. Since that
supply of quality investment opportunities is has a $ 100 million commitment to private time the University of Michigan has
greater than the supply of capital. equity. Partnerships are selected without maintained close ties with HandyLab--
regard to location; however, given the large licensing technology, performing sponsored
The fund will be a $ 20 million fund with $ number of established venture funds in research, providing interns in both business
10 million provided by the endowment. A Boston, many of the endowment's and technology, and making available
subsidiary of the endowment's investments are in national funds with university facilities. The Wolverine Fund
management company will manage the Boston offices. has been an active investor. Students
fund, charging market level fees and carry. regularly attend board meetings as
The fund's strategy for dealing with the In addition, the Community Technology observers and help on a variety of
problems associated with being a new, Fund makes direct investments using a co- business issues, including raising a $ 2.5
small fund includes: investment approach in deals led by top-tier million second round in 2002.
venture capital firms. It is an early stage
* Recruiting a highly experienced, focused, lifecycle investor in both life VANCE H. FRIED is a
successful venture capitalist as managing sciences and information technology.
partner Investment size is $ .5 to $ 2 million per professor of
round, and $ 3 to $ 4 million per company. management in the
* Maintaining a close, but totally informal,
relationship with the university's technology While partnership investments are made College of Business
transfer units with endowment funds, direct investments Administration at
and new business formation seed capital
* Investing in only a few deals a year comes from an evergreen fund unrelated to Oklahoma State
the endowment. This fund was created 27 University, and an
* Utilizing the endowment's global network years ago with an initial investment of $ 2
of private equity relationships to help locate million from university surplus operating advisor on private
large co-investors for follow-on financing funds. The fund has grown to $ 50 million equity and start-up
rounds today--$ 9 million from additional
investment by the university and $ 39 issues to both the
* Using experienced local entrepreneurs as million in retained profits from venture private and public
advisors and interim management for investments.
portfolio companies during the early sectors.
development stage The Wolverine Fund at the University of firstname.lastname@example.org
Michigan is a $ 3 million fund run under a
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