Why Institutional Investors Shy Away From Venture Capital

A decade of weak returns and poor transparency has driven asset owners to invest in only top quality funds.

(October 29, 2012) – The financial crisis hit venture capital funds especially hard, according to new research, for one particular reason: institutional investors. 

In the wake of 2008, pension, endowment, and sovereign funds have lost much of their appetite for high-risk investments with huge upside potential, two Tilburg University business law professors argue in their latest paper. 

The average length of time for a venture fund to reach its full fundraising goal has increased by more than 50% since 2007, Erik Vermeulen and Diogo Pereira Dias Nunes note. This “dramatic change in pre-financial crisis fundraising levels compared to post-financial crisis fundraising levels is mainly triggered by the fact that institutional investors started to massively shy away from investing in venture capital funds.” 

Why? According to Vermeulen and Pereira Dias Nunes, historically poor returns since the dot-com bust in 2000 to 2001 are a factor—payouts to venture capital fund investors dropped about 80% from 2000 to mid-2011. Additionally, venture capital funds tend to lack transparency regarding their actual performance, which is not an attractive quality for most people investing on behalf of institutions. 

The authors see this increasing wariness as, in many ways, a good thing for the industry: “Indeed, we have several observations to suggest that the fundraising process has undergone a ‘Darwinian’ evolution in the post-financial crisis era…. Only high quality funds seem to have a reasonable chance of receiving continuous funding for their activities. Indeed, institutional investors have largely chosen to invest only in the best performing and most highly reputed funds.” 

In the paper, titled “The Evolution and Regulation of Venture Capital Funds,” Vermeulen and Pereira Dias Nunes also observe that asset owners are taking an increasingly active approach to the management of funds, including negotiating more favorable terms in the investment agreements. 

With this increased investor advocacy and taste for quality, some chief investment officers are finding solid returns. Bruce Zimmerman, head of the University of Texas Investment Management Company, recently cited the asset class as a strong point of his nearly $20 billion portfolio. “Social media is a great place to invest right now, and we’re a desirable investor to a lot of venture capitalist firms. That part of our book is performing well,” he told aiCIO. Among those investments: Union Square and the Foundry Group, which are venture capitalist firms specializing in start-ups and technology companies. 

Read the whole paper here.