June 12, 2020

Budding Trend: Institutional Investors Focusing Locally

Pandemic-induced economic instability and nationwide protests could spur investments in nearby businesses. Keeping politics out of the equation and ensuring proper diversification are musts.

Reported by Sarah Min

Last month, the Hawaii Employees’ Retirement System (ERS) told local venture capital fund managers that the pension fund will be increasing commitments to in-state investments—even doubling down in some cases—as the island deals with the pandemic.

The retirement system made the promise after adding $25 million to its Hawaii Targeted Investment Program (HiTIP) in a third round of funding that brought the total to $75 million. Thanks to its isolation, state residents have remained relatively unharmed by the coronavirus compared with the rest of the United States, but lost tourism revenue is a different matter.

“Anything we can do to support the state’s economic recovery while achieving our return expectations is beneficial not only to our members but to our fund as well,” Thom Williams, executive director of the pension fund, said in a statement.

For some institutional investors, the pandemic of the past several months and the recent George Floyd protests will likely boost an already strong interest in local investment solutions, particularly from philanthropies, according to John Austin, a nonresident senior fellow at the Brookings Institution.

“I think we’re going to see some strong interest in getting some more of the capital to be spent locally and particularly to help marginalized populations, minority businesses, and communities that haven’t had access to capital to grow their homegrown jobs and businesses,” Austin said.

But local commitments that promise a boost to the economy also have come with a history of controversy, and some have famously been mishandled. For example, Alabama’s retirement system has a decadeslong history of directly investing in the state’s golf courses and media companies, which has drawn criticism as well as litigation from those who felt the pension fund should find more profitable investments elsewhere.

In 2014, the Alabama Supreme Court ruled in favor of David Bronner, the head of the Retirement Systems of Alabama (RSA), after the 2011 lawsuit sought to restrict the retirement system’s in-state private placements.

In a 2016 newsletter, Alabama defended its in-state investments: “RSA investments have their good years and not-so-good years, and some of the RSA’s private placement investments have fared better than others. They are not all winners. But RSA has had more than its share of winners in the private placement sector, and those winners pay off in more ways than return on investment, Bronner and others say.”

Local Growth

Supporters of in-state investments eye the explosive returns in California, Massachusetts, and New York, particularly for tech and biotech. Massachusetts was the first to make an in-state venture capital (VC) fund in the 1980s.

But venture capital is historically a risky venture. And some local VC firms that do not have established names or the successful track records of some of the bigger coastal firms could lose out on their gamble ever coming to fruition. It’s an especially wary proposition for institutional investors such as pension funds that bear the responsibility for people’s retirements.

But for state funds that have the bandwidth to make riskier investments, supporters of venture capital in lesser-populated areas say there are benefits. For example, Canadian pension fund Caisse de dépôt et placement du Québec (CDPQ) has a double mandate: securing its employees’ retirements and local economic development. Meaning the pension fund manager believes it is also its duty to invest in its own backyard and to identify promising small and medium companies.

Certainly, CDPQ has broad-ranging investments throughout the world: As of last year, CDPQ held $340 billion in Canadian dollars ($251 billion US) in net assets and had invested a total of $219 billion in global markets. But among its many infrastructure projects worldwide, it also is paying to construct a new $6.2 billion light-rail system for Montreal.

In addition, the pension program is committing capital to seeding local startups. Its latest commitment is $50 million, overseen by a Montreal VC firm, Teralys Capital. Over the past five years, the pension fund has channeled millions in similar investments locally. Some were direct investments in Quebec businesses, such as Caisse’s $200 million equity infusion in 2018 to Plusgrade, a Montreal-based travel industry consultancy.

Meanwhile, investors and policymakers in the Midwest are hoping to shift the region away from its agriculture and manufacturing roots into a hub for technology, hoping to stem the tide of capital flowing to coastal venture fund managers, according to a Brookings report.

Indiana and Michigan have both created state innovation funds. Seeking to cast Illinois as a “Midwest Technology Hub,” the state treasurer’s office in 2018 boosted funding to roughly $1 billion invested over a decade. Grants for Illinois-based technology businesses are expected to create 60,000 jobs in the state, as well as attract more than $2 billion in additional private-sector money, the Illinois State Treasurer’s Office said.

Those states are hoping to capture just a bit of the venture capital magic, which has historically been a local venture anyway, given the challenges of managing and monitoring private companies from afar.

While that may change to some degree with the rise of teleconferencing during the coronavirus pandemic, there’s still something to be said for walking the hallways to gauge the temperature of what’s going on within the startup, according to David Wessels, an adjunct finance professor at the Wharton School at the University of Pennsylvania.

The Exception

But the majority of financial experts advise against local investments from pension funds, given that their sole fiduciary responsibility remains with the plan beneficiaries. Making investments to support local projects can also be a slippery slope. Investments made for reasons other than to generate pure investment returns, such as to appease a political agenda, can be detrimental to the portfolio.

But investments in infrastructure that bolster the local business climate in a way that directly supports the local tax base can pay off, according to Clive Lipshitz, managing partner of Tradewind Interstate Advisors and guest scholar at New York University.

For example, supporting a state’s air transit system can increase tourism, increase tax revenues, and bolster the local government’s ability to fund its pensions, which is crucial to a pension plan’s funded status.

But Lipshitz cautioned that any venture capital investment should first offer the same risk-return reward as any other investment in the portfolio, as well as adhere to strict governance principles. These investments also require a long time horizon, he said, and managers should be chosen with particular care.

“As long as there’s adequate proper governance and the investment stands on its own two legs, then making these in-state local investments can make sense because of the benefit they provide to the sponsor tax base,” Lipshitz said.

Illinois State Treasurer Pushes for Venture Capital Boost

Los Angeles Explores Direct Infrastructure Investment Strategy for Local Projects