Put Government Pension Funds To Work

Small companies need capital, and state and local government pension funds can help if lawmakers will allow it.

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State and local government pension funds are an enormous source of capital in national financial markets. The 6,600 state and local government plans hold well over $210 billion in total assets, 31% of all pension-fund dollars. These assets are growing rapidly; a study conducted for the Department of Labor in 1980 estimated that public pension fund assets will reach well over $1 trillion by 1995. If recent trends continue, public and private pension funds then would hold 65% to 75% of all publicly traded equities issued by U.S. corporations. In effect, U.S. business financing, of large companies, at least, will be dependent on the portfolio choices of pension funds.

Clearly, it is critical that such a dominant source of capital be available to all sectors of the economy, including small businesses. Small or young companies are chronically short of equity capital and long-term debt -- or, as it is called in their case, venture capital. Only venture investors have the patience to wait for a return on their investment until the small business is long-term investments allow a small business to grow without the burden of fixed repayment plans.

Yet venture investing does not come easily to pension fund managers. These investments require risk-seeking and also patient money. Portfolio managers, however, mindful of their fiduciary obligations, have traditionally sought the relatively risk-free securities of blue-chip companies. Further, portfolio managers are not typically patient: Steady, positive, and immediate returns are their ideal. Few managers have been willing to face the upset of pensioners who see red ink on their annual reports.

Such attitudes have placed pension funds in a bind lately.Low risks result in low returns -- a situation that few funds can tolerate during high inflation. Managers have begun to realize that fiduciary responsibilities imply a requirement not for risk-free investment but for a trade-off between risk and return.

Private pension fund managers, as opposed to state and municipal fund managers, have been quick to grab venture capital investment opportunities. The rapid growth of pension fund assets, the relatively loose investment restrictions imposed by the Employee Retirement Income Security Act of 1974 (ERISA), and the need to keep up with record rates of inflation have contributed to this trend. From 1979 to 1981 private pension fund investments in venture capital reached $450 million -- a large commitment but less than 1% of the industry's total assets. Thus, while current levels are the highest in history, the untapped potential from the private sector alone is overwhelming.

State and local pension funds, however, have been hobbled by restrictive state investment regulations. In most state and local government units, pension fund investments are limited to a narrow list of investments such as blue-chip or government securities. Changes in these regulations typically require legislative action.

Such action would be well worth the effort. Venture capital investments, though representing a higher risk, can yield significantly higher returns than most other investments. The Ford Foundation realized a 32% average annual rate of return on its venture capital investments from 1976 to 1980. Research recently published by the California Department of Economic and Business Development showed that for all types of venture capital funds -- private partnerships, publicly held venture capital funds, and corporate venture capital funds -- the average return on investment was nearly 26% for 1960-80 and exceeded 32% for 1975-80. This finding is confirmed by a study recently released by the Commonwealth of Pennsylvania, which found that institutionally financed, professionally managed venture capital funds with assets of $5 million or more averaged returns of 20% to 45%. Analysts stated that they knew of no such venture capital fund that has not earned positive returns overall. Thus, investing a small portion of assets in venture capital makes good financial sense.

Progress is being made. Task forces organized in California, Wisconsin, Pennsylvania, and Illinois have all recommended that a small portion of public pension funds be invested in venture capital limited partnerships. Each of these states is currently working on legislation in this area. Michigan recently enacted legislation that would allow public pension funds to invest 2% of their assets in small businesses or venture capital firms.

Two public pension funds have direct experience in venture capital investment -- both with great success. The Washington State Investment Board has committed $26 million in five venture capital partnerships with such holdings as a temporary-help agency and a magazine. The State Teachers Retirement System of Ohio was granted authority in 1969 to invest up to 5% of its total assets in nontraditional investments. The STRS invested nearly 1% of its assets in seven venture capital limited partnerships.

Other public pension funds should follow the lead of these two. Legislative changes to allow venture capital investment should be pursued aggressively at the state level. The venture capital experience of the STRS and the many private pension funds provides assurance to risk-averse legislators and beneficiaries that "venture capital" and "fiduciary responsibilities" are not mutually exclusive terms. Venture capital and public pension funds are a good match.