Fiduciary duty and venture capital

James Riley
Editorial Director

The last month has been interesting in investment markets. Global equity markets not only lost ground, but so with high correlation owing to their universal exposure to the lower-growth challenges of the old-world economy.

In the US, proponents of ESG (environmental, social and governance) considerations launched a campaign to argue that since these factors were now shown to have a positive correlation with longer-term returns, fiduciary duty requires pension fund trustees to undertake ESG supervision.

Locally, last week’s Australian Institute of Superannuation Trustees conference explored social impact investing, new asset allocation models, and the consequences of Australian funds out-growing the local market.

Superannuation trustees are fiduciaries and have a duty of care to act in the best interests of their members

Venture capital was also on the AIST conference agenda, but in the context that very few – in fact probably less than five – of our major superannuation funds currently commit capital to venture or innovation investment in Australia.

Typically, the set of ‘rational’ reasons given for this exclusion include permutations of the poor historic track record of VCs [in Australia], a lack of investment scale and illiquidity, leading to the opinion that Australian venture investment is not in the best interests of the members, or perhaps that it is simply too hard.

It is certainly true that superannuation trustees are fiduciaries and have a duty of care to act in the best interests of their members.

But increasingly, the exclusion of venture investment, or at the very least, serious research and assessment of local venture investment opportunities, can be considered as acting contrary to this fiduciary duty.

The Context – Building Retirement Savings – The 2 per cent Plus Gap

All would agree that the core duty of a superannuation Trustee Board is to invest the moneys under its care to provide its members with retirement savings. All would agree that the investment objective in this context is to maximise the value of that retirement benefit subject to constraining risks so that there is confidence in achieving a reasonable outcome.

In brief, Trustees seek to build portfolios of valuable assets; where an asset has value because it is expected to contribute to the target return and the drivers of this return differ from the return drivers of the other assets in the portfolio.

Venture capital can lay claim to being a valuable asset under this prescription. As a starting point, a number of studies have observed that the unlisted “entrepreneurial sector” outperforms the listed equity markets.

“We may intuitively think of stock returns as a result of the underlying real economy growth. However, we have observed that long-term real earnings growth fell behind long term GDP growth in many countries over the observed period.

“Several factors may explain this discrepancy. First, in today’s integrated world we need to look at global rather than local markets. Second, a significant part of economic growth comes from new enterprises and not the high growth of existing ones; this leads to a dilution of GDP growth before it reaches shareholders.”*

Arndt and Bernstein in a similar study observed this gap to be some 2 per cent, which is a non-trivial difference in any portfolio optimisation calculation.

More recently, venture observers have noted that the wealth accumulation from new technology companies is very highly skewed to the pre-listing investors.

And it is interesting that a leading advocate for social impact investing argues that the clear lack of correlation for such investments is in portfolio outcome terms, the equivalent of an additional 4 per cent yield.

If true for impact investing, the same conclusion would certainly apply to venture investment.

So on these observations, it is reasonable to conclude that the the duty of care for a superannuation trustee is to include Venture capital into its prospective asset mix.

The Qualifying Constraint – Another Proactive Duty

Of course, I acknowledge that the qualifying constraint to venture inclusion is confidence in the ability to capture the expected return. But this too is another area that is informed by the acceptance that fiduciary duty incorporates a proactive component, analogous to the accepted Trustee duty to actively exercise their shareholder governance entitlements.

Today’s Trustee practice is to assume that it is the responsibility of venture managers to set the investment mechanisms. Under this practice, the Trustee waits for the managers to come forward with their Investment Memorandum proposals, almost universally in the form of traditional 10-year venture capital fund proposals.

That in many cases these fail to pass the confidence-capture test does not absolve the Trustee of its duty. If the existing forms of entrepreneurial access are not satisfactory, the ultimate duty to devise an acceptable structure lies not with the managers but with the Trustee (though a consultative process is always available).

It is the Trustee that is charged with the duty to capture the available returns. If this requires a proactive, even innovative approach to the investment mechanisms, so be it; the members look for the Trustee to advance their interests.

The Investment Risk of Venture and Innovation Inaction

This risk is best summed up by a recent quote from Dave McClure of the US based 500 Startups, when he recently wrote (and I paraphrase slightly):

“I don’t know if all the startups will become unicorns or even gazelles, but for certain I know that all the dinosaurs are gonna die!”

Duty of Care is a proactive Duty

Today’s Trustees are not merely running portfolios but operating global investment businesses. The time has passed when Trustees could interpret their duty of care as a passive “gatekeeper” obligation, collecting the debt and equity coupons delivered by the market. Magnified by the age of technological revolution now upon us, but in reality also presence, their explicit duty to invest for their members’ best interests requires a proactive duty to engage in venture and innovation investment.

* Source: Is There a Link Between GDP Growth and Equity Returns? – MSCI Barra Research

Paul Cheever is Chief Executive Officer and Director of the Australian Institute for Innovation. The AII is a not-for-profit organisation whose mission is to bring practical experience to inform Australian policy and program discussions on the innovation system and innovation investment.

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