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Journal of Private Equity


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  • 1. 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 funds 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 [2000]). 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 [2002]). 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 [1991]; Gompers and Lerner basic ways it can generate local external investments may be too small to support a [2001]). 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 CompetitivEdge 1-888-881-EDGE Electronic Clipping
  • 2. 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. CompetitivEdge 1-888-881-EDGE Electronic Clipping
  • 3. 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. strategies. invest. 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 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 CompetitivEdge 1-888-881-EDGE Electronic Clipping
  • 4. 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 Michigan is a $ 3 million fund run under a CompetitivEdge 1-888-881-EDGE Electronic Clipping