Many institutional investors such as investment banks, insurance companies, and pension funds have increased the volume of their direct investments in startups, after years in which the majority of their investments were made through "traditional" venture capital funds.
Investment banks have always filled several roles which are relevant to startups, the main ones of which are assistance in planning and executing public offerings and private placements, and assistance in monitoring and researching the fields of activity of public companies. In recent years, the volume of the investment banks' activity as managers of private equity funds which also invest in startups has increased. In their investment activities, banks operate similarly to venture capital funds. However, they can also actively assist the company in soliciting investments, either as the company's agents or within a relationship created with the company, in the hope of acting as lead underwriters when it goes public.
The capital invested by investment funds managed by investment banks often belongs to private or institutional investors which manage money with the bank, or to the bank's employees and managers. The investment is sometimes made directly from the portfolios of such investors, but is usually made through private equity funds established and managed by the bank, which also invest in startups.
Most of the investments of such funds focus on later stages and are accompanied by other services. For instance, the investment bank may structure a financing package for a company in the form of a bridge loan before an IPO, when the bank itself may act as the underwriter in the IPO, and after the bank invested in the company's second-stage financing round. Alternatively, the bank may render advisory services for a merger or an acquisition of a company in which it invested.
Holding Companies of Commercial Banks
Holding companies of banks are among the main investors in venture capital. These companies invest through outside venture capital funds or through venture capital funds established and managed by them. Similar to the case of investment banks, venture capital investments made through funds managed by the banks integrate well with other services provided by the banks, particularly providing loans and credit lines to the emerging companies, structuring financing for investments in equipment, and so forth. However, the manner in which banks examine venture capital investment opportunities and manage the funds are not materially different from that of other venture capital funds. Due to legal restrictions imposed on holdings by banks in companies, the investments are typically not made directly by the banks, but rather through the funds or through subsidiaries with independent management.
In recent years, returns on venture capital investments began having a considerable effect on the profits of commercial banks. In addition, massive profits started to accumulate on the balance sheets of the banks' holding companies through their investments. For instance, in the fourth quarter of 1999, profits from managing venture capital funds contributed about $1.3 billion to the profits of Chase Bank (and it should be kept in mind that this figure represents only the funds' share in the profits made by the investors in the funds they manage). While the funds afflicted the holding company with large losses in 2000 and 2001, in view of the remarkable past successes of the bank's funds, this fact did dissuade investors from investing in new funds created by the bank (which had meanwhile merged with J.P. Morgan) from raising new venture capital funds.
As mentioned in previous chapters, pension funds are also one of the major investors in venture capital, mainly through investments in venture capital funds managed by others. Since they are usually the main investors in the venture capital funds, they sometimes pay lower management fees to the fund managers. In terms of the investment horizon, pension funds of public U.S. entities have a higher tendency to invest in short-term investments and are more averse to high risk than other pension funds. They therefore tend to invest in funds which focus on companies in more advanced stages of development.
More than 60% of pension funds have investments in venture capital funds, with a high investment commitment of more than 7% of the value of the portfolio on average. The investments made by pension funds account for almost one-half of all venture capital investments, but the majority of this investment is conducted through investments in funds managed by others.
In recent years pension funds have been making more and more independent investments, usually through in-house venture capital funds. In most cases, these funds do not lead investment rounds. In keeping with their general profile of venture capital investments, direct investments in companies by pension funds of publicly traded companies are less frequent, and are made in the more advanced stages of the companies' lifespan. In addition, since investments by these funds are subject to lengthy decision-making processes, they are often unable to join investment rounds quickly. Venture capital funds of other pension funds invest in all investment rounds, in accordance with the investment profile defined for them by the pension fund. In light of poor returns in 2001 and 2002, numerous pension funds have decreased their involvement in the industry via their own funds, and return to the pattern of delegating money to external managers of other funds.
Insurance companies are active in the venture capital market both indirectly, though investments in venture capital funds, and directly, through direct investments in companies. They usually focus on investments in relatively advanced stages of the companies. Historically, insurance companies tended to invest in the debt market of emerging companies which carry relatively high interest rates (the "high-yield" market or "junk bonds" market). In the last decade, however, they have been increasing their investments in convertible debentures with substantial equity components (mezzanine loans). As for private startups, insurance companies usually focus on second-stage and bridge financing, with the majority of investments being made in portfolio companies of venture capital funds with whom such insurance companies had invested. In this manner, the insurance companies (or the funds they establish) gain a current deal flow after a screening process performed by investors whom the insurance companies trust. In recent years, many insurance companies have established branches for direct investments in venture capital, which are not materially different than venture capital funds in both the screening of the investments and the methods of investment. However, they are usually merely financial investors which are neither involved in managerial operations nor contribute any added value to the companies in which they invest.
Not-for-profit organizations have the optimal investment profile for venture capital investments they have no need for quick returns and can afford to be less anxious about market volatility than other entities, such as mutual funds or pension funds, which are appraised quarterly and from which investors often withdraw money quickly as a response to market declines. The main reason for this is that the endowments of such entities are usually meant to survive indefinitely, so their investment horizon is longer than that of venture capital funds, which almost always have a limited lifespan. In recent decades, such entities have been increasing their investments in venture capital funds and some, particularly the larger ones, established entities to examine companies and invest in them directly. Other entities resort to outside advisors to decide how to allocate their money among outside venture capital funds. A notable example of this type of investors are university investment funds which exist alongside almost every leading university in the United States, such as Harvard, Yale, and Columbia.
Mutual funds sometimes invest in private companies if they are likely to go public within 12-18 months. For instance, many findings indicate that in the years 1999-2000, the majority of the return of mutual funds focusing on the technology sector resulted from investments in shares during IPOs and, more conspicuously, from investing in the companies' final investment rounds before the IPO. In most cases, the mutual funds did not lead the investment round, but join rounds led by reputable venture funds. Since the volume of investments the funds can make in the private sector (i.e., unlisted companies) is usually limited by their own investment charter, many mutual funds have been established which focus on private placements before IPOs, often limiting the liquidity available to their investors.