As a result, many early-stage growth companies in America are now stranded in a financing no man’s land between the highest-risk seed capital stage funded by individual angel investors and the multibillion-dollar private equity sector that still looks for eight- and nine-figure deals featuring companies already making sales on their way to a stock exchange listing. The startups’ cash cliff has been cited as the cause of a “mass extinction event” — a dead cylinder in the U.S. economy’s growth engine.
That’s where the idea of an “innovation fund” partnering with a dozen or so midsize local government pension funds could fill the void in this still-risky growth stage. Pension trustees could harvest lush investment returns on a nationally diversified portfolio with lower fees than the venture capital industry typically exploits. As a bonus, they could collectively fuel the engines of economic growth nationwide. Emergent businesses based in a state where a pension fund participates would have a fair shot at some of that capital if they could pass stringent due diligence reviews and fiduciary governance oversight by angel investment experts in their industries.
It's a concept that originated years ago from the now-retired founder of one of the nation’s most prominent pension consulting firms. Today, the drawback on his original vision is that the larger public pension funds have outgrown the startup economy. As the chief investment officer of the California State Teachers' Retirement System, the nation’s second-largest public pension fund, recently noted in a TV interview, they manage so many billions in each asset class, and with so many rules, requirements and restrictions, that it’s difficult for them to effectively put money into the venture capital marketplace. And even then, it’s got to be the chunkier, later-stage money earning a lower return than angel investors are seeking. Accordingly, my proposals here are a second-generation revision for which I alone am accountable.
What’s missing today is early-stage Series A and B funding. Putting money into promising firms raising $5 million to $20 million of fresh capital in these transition stages following their angel funding round would never move the dial on the Goliath pension portfolios’ investment returns. For their trustees and staffs, it’s just not worth the effort and headaches of monitoring hundreds of pubescent companies that are too young for them.
What the big state funds are missing is the sweetest spot in the investment cycle. For example, the documented multidecade track record of my local angel group in southern California is a 25 percent annualized return on investment. That opportunity set could be the feedstock for an innovation fund if it’s organized properly.
Although this fund would invest at a later second-stage entry point, where share prices are often 25 percent to 35 percent higher than at the angel seed stage, capitalism’s Darwinian culling process will have wiped out almost half of the startups. This ex-post selection makes near-angel-level returns achievable for an innovation fund. That could translate into high-teens annualized returns on diversified portfolios over time, net of all fees and expenses — which makes this idea well worth the effort as a sliver in a pension’s diversified portfolio.
Flipping the Size Advantage
Where the city and county pension funds can come into play is that many of them commit less than $30 million to new venture capital funds each year. As such, they often pay the highest fees in the institutional marketplace and get only the hand-me-downs from the bigger pensions that snarf up the front-row seats on the venture capital bus. An innovation fund could flip this industry paradigm on its head by giving the smaller and midsize public plans a rare investment advantage by virtue of their size.
Nationwide, there are some 100 local pension systems in the ideal size range for launching this strategy, and an equal number of smaller plans that could tag along once it’s operational. They can champion and dominate this niche if they move fast enough: Success requires the initial organizing work to be accomplished this year, before a competing private consortium steps in.
To forge a durable strategic partnership, the nation’s two prominent angel investor networks, the Angel Capital Association and the Angel Syndication Network, could be invited to coordinate their various local chapters and affiliates to provide talent and the first filter for investment consideration. The innovation fund should also join the National Venture Capital Association to network with other VCs as deal-specific co-investors.
To screen out tadpoles, the innovation fund should invest only in companies that have already secured at least a million or two of angel-level capital. In most cases the fund would require material co-investment by another venture fund and could pick a director for their portfolio companies’ boards. Before the innovation fund wires its capital, its mandate should require that a minimum number of prior-round investors, including key angel funds, re-up into the company’s new capital infusion as co-investors. Such requirements will provide comfort to pension trustees that the fund won’t become sucker money bailing out zombie companies and lost causes.
Where the Innovators Are
For starters and focus, candidate portfolio companies should ideally be located in states, counties or metropolitan areas with multiple local public pension plans in this size range, unless the member investors vote otherwise. There are about 15 states where multiple local pension plans in this size range are located. Collectively and coincidentally, they also happen to form the backbone of the innovation economy where most of America’s breakthrough technologies take root, and geographically they overlap nicely with the Angel Syndicate Network. Eligibility can also include other states if their consolidated pension system invests or metropolitan areas elsewhere if the local public pension plan becomes a fund investor. No venture fund today can rival this geographically targeted job-creation feature.
Angel groups can become local advocates whose members could personally help represent the innovation fund to pension fund staff and trustees, including follow-up reports when one of the fund’s portfolio companies is located in their proximity. This network structure and its deep pool of experts can trim fund costs and fees and enable participating pension plans to demonstrate their efforts to support local economic development.
To qualify, a candidate company would need to have the upside potential to be acquired or go public with an IPO valued above a specified amount, perhaps $100 million. To be deemed innovative, it must feature novel info-, med-, bio-, ag-, energy- or fintech products. This is strategic and purposeful breakthrough investing for public funds, not Shark Tank entertainment.
To secure an innovation fund investment, a candidate company would have to be approved by local angels and the innovation fund’s central portfolio investment committee and its deal-specific expert industry advisory members. Participating angel groups would be expected to share their data rooms, prior diligence reports and company investment updates, providing unprecedented and unvarnished access to the company’s full history and even dirty laundry that most VCs cannot secure. The result is what savvy investors call “information advantage.”
Companies with insider connections to participating pension fund trustees or staff would be disqualified. Those that previously failed to update investors regularly and deliver on their prior promises, milestones and projections at and after the angel funding stage would also be filtered out. The fund will avoid drowning swimmers. By investing selectively this way nationally, with two layers of independent decision-making, the fund would forestall fears of crony capitalism whereby local politicians and pension trustees might be tempted to funnel taxpayer money to their golfing buddies, campaign contributors or a brother-in-law’s flailing company.
Unlike a typical private equity fund that pays placement agents and enriches the venture capital management partners, the innovation fund would be able to charge lower fees for most pension funds because it would have a lower cost structure at scale. Most angels involved in this show have already made their millions, so they don’t need to be compensated from management fees just for contributing their expertise. Fees should be somewhere between the industry’s standard fee structure and the discounted rates negotiated by the largest pension plans. The calibration of those fees would depend on the size of the fund overall as well as the amounts each pension fund invests.
Big Dogs and Unicorns
Once this fund is operational, a follow-on “Innovation-C” fund, with no geographical preferences, could be launched to provide the Series C round of major-league growth capital to the successful portfolio companies that would then be attractive to the larger public pension funds and VCs. That would fill out the ecosystem with a lower risk/return investment option in a fund large enough for the big dogs’ portfolios. By virtue of their original investments in the innovation fund, the smaller plans would gain access to the pre-IPO deals and other potential unicorns identified by the angels, as well as the “pro-rata rights” that inure to the earlier investors. Smaller pension plans invested in the original innovation fund could also enjoy special rights to invest in the larger C fund.
Putting this all together is not child’s play, and it will require cooperation of multiple groups that have never worked together. The legal and regulatory hurdles will be formidable, and time is the enemy. Some pension consultants won’t like it because it’s completely outside of their databases, their experience and their analytical expertise. To them it’s a pig in a poke, so for oversight let’s include an independent advisory “board of visitors” consisting of respected pension consultants who can be joined by pension and angel association representatives to help guide the ship.
To get off the ground, this idea will need prompt, strong and decisive institutional support from major national and state public pension associations, followed by active involvement from angel-land leaders. That’s a tall order, but there is a clear upside to this strategy — and a void to fill — if it’s done properly without undue fence-sitting. With the COVID-19 lockdowns, aggressive Fed tightening and the SVB collapse all behind us, and given the Series A and B capital drought today, the timing couldn’t be better.
Governing's opinion columns reflect the views of their authors and not necessarily those of Governing's editors or management. Nothing herein should be construed as investment advice.
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