Academic institutions: The new players in venture capital?
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A less well-known event in the history of the respected Boston University is its not-so-successful entry into venture capital investing, decades ago. More recently, the University of Minnesota and others reportedly decided to move out of early-stage investing.
I was reminded of these examples when I read about a leading Indian academic institution launching a large early-stage investment fund. I began to wonder if managing venture capital was for all and sundry.
Conceptually, managing early-stage investments is straightforward financial intermediation.
Investment professionals, referred to in trade speak as general partners (GP for short), raise money from investors, known as limited partners (LPs for short) who have the capacity to wait for a long time to realize highly iffy returns.
GPs are paid a flat percentage of the funds they manage for their services. They are incentivized to maximize returns for the LPs through a share of the capital appreciation they generate.
The trouble of course lies in implementing this model. Notwithstanding the incentive compensation, fund managers can short-change their investors or simply perform poorly.
So what does it take for a venture fund to perform well?
First, the GP has to pull in a seriously large flow of quality investment opportunities. That is not as easy as one might think because savvy entrepreneurs are bound to ask themselves if they would like to have a public academic institution as an equity shareholder in their enterprise.
Second, the GP needs to bring in exceptional deal evaluation skills because entrepreneurs may not disclose credible information about their business, either out of sheer optimism or out of bad intent. The periodic stories in the Indian business press about investments that go up in smoke due to poor disclosure and deal evaluation are just the tip of the proverbial iceberg of failed investments.
Third, early-stage investment managers need to stay engaged with their portfolios for five to eight years, through the life of the investment fund. For that to happen, the fund management enterprise requires an organization that will find the best fund managers and keep them motivated to see those risky investments through to successful exits.
This last feature is as important as the other two, if not more so. Ironically, it is also the reason all forms of early-stage investment organizations, except the typical venture capital partnership firm, have often failed. Considerable evidence to this effect has been accumulated over five decades or more of the venture capital industry’s history.
That said, I wonder if any Indian academic institution will be able to create and sustain an organization of talented professionals who will stay with the fund management firm through the life of the fund.
That brings me to the main question: Should Indian academic institutions get into venture capital management?
At the end of the day, academic institutions are expected to produce academic excellence. Management schools have been handing down to generations of their students the wisdom that organizations and institutions should stick to their knitting in order for them to excel.
When it comes to managing money, academicians as well as their institutions have not exactly covered themselves in glory. In a typical academic understatement, professor Josh Lerner, Jacob H. Schiff Professor of Investment Banking at Harvard Business School, who has written extensively on venture capital, summed it up: “It’s very hard to marry these organizational forms.”
In spite of that warning, if Indian academic institutions plan to launch venture funds and do not heed their own wisdom, they could end up being the cause for much costly amusement in future.
G. Sabarinathan teaches at the Indian Institute of Management Bangalore. The views expressed are personal.