A Risky Time for Venture Funds

Potential conflicts of interest, ties with China, and excessive leverage are among the challenges.

Originally published in the Wall Street Journal on February 2, 2022.

Venture and buyout funds are hugely popular—and also imperiled by ethical and other problems. I have a long history with such funds. As an adviser to Yale in the 1970s, I recommended that it make its first venture-capital investment. I gave similar advice to Harvard and other universities.

In 1985, David Swensen began his 36-year career as Yale’s chief investment officer and became the most successful institutional investor of his era. He greatly increased Yale’s allocation to venture funds and buyout funds. He also expressed to me his view that venture funds and buyout funds generally raised too much money and charged excessive fees.

In recent months, investors around the world have asked me how to get into the top American venture funds. I tell them they are unlikely to be able to do so because of the volume of money wanting in, and that they should be wary of consultants or advisers who claim otherwise. I also say that they should disregard self-serving comments that it doesn’t matter when one starts a venture or buyout investment program so long as one invests for the long run. It always matters when you start.

This isn’t the moment to begin investing in these funds. Why? There is a tsunami of money pouring in from institutional investors because of recent sizzling returns, deal quality is lower, and funds are paying much higher prices for the deals. Additional red flags include still sky-high fees for investors and returns that are calculated by fund managers. Add to that some funds’ ersatz claims that their operations have a low correlation with public markets, when the opposite is true. Another concern is excessive leverage in buyouts. The use of leverage in today’s buyout funds reminds me of the holding companies that flourished before the crash of 1929. At Yale, Mr. Swensen was averse to the use of leverage in buyouts—preferring no leverage—but didn’t find that an option.

I have two more concerns about venture funds and buyout funds. One is that some members of endowment investment committees at universities and other institutions are themselves hedge-fund, venture-fund or private-equity managers. The high fees they earned have in many cases enabled them to become major donors to the institution. Their investment expertise is valued, as it should be. But they’re unlikely to recommend allocating less money to those very worlds.

A more serious concern is the conflict of putting money into the fund of a friend, who is expected to reciprocate by directing money to your fund. This is hard to avoid, given the interlocking relationships of fund managers and boards. The chairman of an institutional fund’s investment committee may even signal to a consultant that he expects other consultant clients to be directed to his venture firm. The world of investing is still enough of a club that it isn’t easy to speak openly of such serious ethical lapses.

Early in my career, I didn’t see that these conflicts would emerge. Nor did I see that building large investor staffs at institutions dedicated to hedge, venture and private-equity investment might also create a subtle conflict because staff members are unlikely to recommend directing less money to their own area, much less cutting it off altogether. Consultants and advisers who earn their living recommending “alternative” investments are subject to the same pressures to keep clients in “alternatives.”

Another ethical challenge for U.S. venture funds arises from their growing and profitable ties to China. The Journal has reported that the industry is funding Chinese semiconductor and other high-tech industries that support the Chinese military at a time when China is testing hypersonic missiles designed to thwart U.S. missile defenses. Some U.S. tech companies, including semiconductor companies, appear to be doing the same.

Adam Smith pointed out in the 18th century that sustainable business success requires ethics. Let’s hope the venture industry rediscovers this insight.

WRITTEN BY:
Equity Edge | CHIEF INVESTMENT OFFICER