An Odd Proposal

Later this week, the Teacher Retirement System of Texas will take up a gubernatorial request that it allocate up to $600 million for direct venture capital investments into Texas-based companies and related technology endeavors. It is an odd proposal, to be sure, but not necessarily one to be dismissed out of hand.

TRS currently makes all of its venture capital investments as a limited partner in unaffiliated venture capital funds, as do most public pension systems. For example, its upcoming alternative assets committee meeting will consider fund commitments to both Leonard Green & Associates and Providence Equity Partners. Also like most public pensions, TRS buttresses a fairly meager alternatives staff with third-party consultants (Hamilton Lane, in this case). As of August 2005, approximately 3.3% of the $93.32 billion system was invested in alternatives.

But this new proposal from Gov. Perry is an attempt to shake up the TRS model, in order to promote local economic growth. Specifically, Perry is concerned that the local venture capital community has all but dissipated in the post-bubble years, and that the result is an unfair disadvantage for Texas-based startups. And he’s right.

Texas receives the third-most venture capital of any state, but this year will receive less than 25% from in-state investors. Compare that to #2 Massachusetts with over 36% from in-state. Sure outsiders are coming in, but it’s always difficult to attract VCs from outside the 50-mile radius. The result often is that entrepreneurs are either trying to bootstrap themselves or picking up and moving to the Coasts.

“I think what we’ve seen is an over-correction since the bubble,” says Stephen Straus, a former Austin Ventures pro who currently is forming a new early-stage fund in Texas. “We’ve had almost no new funds begun since the bubble because lots of angels or would-be fund managers only got into the market in 1998 or 1999, so their only experience with the asset class is of being burned… People aren’t necessarily aware of the problem because so many bubble-era companies are kind of masking the lack of new VC-backed companies.”

The first governmental attempt to tackle the problem came two years ago, when Perry and legislators formed the Texas Emerging Technology Fund. The $200 million vehicle makes investments in three ways: Direct early-stage plays in Texas-based technology companies; Matching funds for federal grants; and an attempt to attract top academics and others with a strong history of commercialization.

So where does the new proposal come in? Perry wants TRS to allocate up to $600 million for follow-on investments for existing TETF portfolio companies/efforts. TRS would not be required to participate in any particular deal, while the portfolio company would likewise be permitted to secure funding elsewhere. Consider TRS to have “introductory rights” instead of “right of first refusal.” If TRS says yes, Perry also plans to ask other state system like UTIMCO to participate.

A legal staff memo for TRS suggests that it would have two ways to enact such a program: Either it could hire some in-house staffers to evaluate and manage the portfolio, or it could retain a third-party manager. The attorneys recommended the latter option.

As I wrote above, it is certainly an odd proposal. Critics – including newspaper editorial boards — already have said that TRS has no business doing anything beyond generating the highest possible returns. Indeed, I can’t find anything in the TRS investment mission that discusses economic development.

Others have argued that this smacks of throwing good money after bad. After all, if a company can’t get traditional VC funding in rounds B or C, maybe it doesn’t deserve the money. Moreover, might the TRS program feel pressured to do certain deals, in order to make the Governor’s original TETF program look better?

I wholeheartedly agree with both of these points, and this proposal is something I normally would take to the woodshed. And I really do want to. The problem is that the state really does have a venture capital shortage, and it would be irresponsible for the Governor to not address it.

So where does that leave my conclusion (which we really need to get to, as this is way too long)?

Truth is, I’m not certain. I don’t believe that TRS should set up this program as currently defined – in part because TRS does not have direct investing competency, and in part because local investment programs tend to have lower returns than geographically-diversified programs.

I’m kind of partial to an idea of Stephen Straus, whereby the state would form a fund-of-funds dedicated to in-state managers. This might look like corporate welfare in the short-term, but could help rebuild what would become a self-sustaining VC ecosystem. Such a fund-of-funds would have to be backed by the state – not by TRS – because the state is responsible for economic development, whereas TRS is not.

Anyway, we’ll see what TRS says later this week. In the meantime, take a look at some recent papers on the Texas VC situation from Straus and Bob Boldt/Trey Thompson.