Current through Register Vol. 35, No. 18, September 24, 2024
A. PROGRAM STRUCTURE:
(1) The national venture capital investment
program of the state of New Mexico's severance tax permanent fund (STPF, or
fund) is intended to produce significant capital gains to the fund corpus and
additional diversification for the fund's assets. The venture capital
investment program is managed by the New Mexico state investment council (SIC,
or council) with the advice of the venture capital investment advisory
committee (VCIAC, or committee) and a fiduciary advisor. Currently, the advisor
is brinson partners inc. (BPI, or the advisor). The STPF is a permanent trust
fund, and all market-rate fund investments are subject to the prudent man rule.
Since the council is also required to retain investment discretion over all
fund assets, the advisor has been retained on a non-discretionary basis to
advise the committee and council on venture capital investments. Historically,
the average returns on well structured venture capital investment programs have
been 6 percent to 10 percent above that achievable in the traditional U.S.
equities market.
(2) The venture
capital asset class entails a high degree of risk, which must be managed very
carefully to avoid significant losses. Based on historical data, even the most
experienced and successful venture capitalists expect that 30 percent of their
direct investment portfolio companies will fail. This fact necessitates prudent
selection and proper diversification of venture capital fund
investments.
(3) Venture capital
has been accepted as a prudent asset class for investment both by the financial
markets and by the federal government. Most institutional investors limit their
exposure to venture capital to between 2 percent and 5 percent of their total
portfolios. Subsection A of
7-27-5.6 NMSA 1978, as
amended during the 1990 legislative session, specifies that the total
investment in the VCIP may not exceed one and one-half percent of the book
value of the STPF.
B.
DIVERSIFICATION:
(1) Due to the riskiness of
venture capital investments, prudent diversification is necessary to minimize
risk and maximize return. The VCIP initially committed to invest in a minimum
of fifteen venture partnerships (from $1.0 million to $2.0 million each) over a
three year period beginning in late 1988. Since each partnership will in turn
invest in 25 to 30 portfolio companies, the STPF should have approximately 400
small, rapidly-growing, potentially high yielding investments underlying its
venture capital portfolio from these initial phase fund investments. While many
of these companies will fail, historical experience indicates that many of the
successful companies will generate significant multiples on their original
investments, and will provide very attractive returns for the overall
portfolio.
(2) The VCIP portfolio
will be diversified with respect to time, geography, industry, and stage focus.
Of these four variables, time diversification is the most important. The
venture capital industry goes through cycles much like all the other investment
asset classes. Given the illiquid nature of venture capital investments,
attempting to "time the market" is not a realistic alternative. Most
sophisticated investors average into the market with new commitments on a
steady, annual basis. This insures that the investment of the majority of their
funds does not occur at a time when private company valuations are high, when
existing technologies are about to be superseded, or when specific industries
are in favor. Additionally, adequate time diversification insures that six to
seven years from the investment period, an investor is not vulnerable to a
depressed stock market when the majority of the portfolio investments might be
ready to go public.
(3) The initial
commitment process to venture capital partnerships for the severance tax
permanent fund required three years to complete (late 1988 - late 1991). Since
the fifteen partnerships selected during this time period will take an
additional three to five years to make all of their investments, the STPF
venture capital investment program has committed to investments that will be
made over about five to eight years, providing substantial time
diversification. In late 1992, (four years from the initial commitments),
distributions to the SIC from these venture capital fund investments have
become significant. These increasing distributions, and the growth of the STPF,
should allow investing in two to four new partnerships annually on a continuing
basis, which will further enhance time diversification. To provide adequate
diversification in geography, stage, and industry, the VCIAC and the advisor
have recommended the following weightings for the overall VCIP
portfolio:
(4) SEVERANCE TAX
PERMANENT FUND PARTNERSHIP GUIDELINES, revised December 1992.
(a) Geography:
(i) Northeast......25-30 percent
(ii) Southeast.......05-10 percent
(iii) West Coast......35-40 percent
(iv) Midwest..........10-15 percent
(v) Southwest.......15-20 percent
(b) Stage:
(i) Seed Startup....10-25 percent
(ii) Growth............45-60
percent
(iii)
Late................20-35 percent
(c) Industry:
(i) Diversified.......85-95 percent
(ii) Specialized.......05-15
percent
(d) Notes:
(i) It is important to note that these are
only general guidelines, and deviations from these guidelines should be
expected as market conditions warrant. Deviations must be expected in order to
select the best venture capital funds when they are in the market. The best
indicator of risk and return is the performance of general partnership teams on
prior funds.
(ii) Since the SIC
began investing in venture capital in late 1988, the venture capital industry
has evolved. The geographical concentrations of venture capital have not
changed significantly, but the stage and industry focuses have. More funds are
moving to later stage investing, and fewer funds are specializing on one
specific industry. The weightings above have been amended to reflect these
evolutionary changes. In sum, the venture capital industry is continually
changing its focuses in order to reduce risk and enhance returns.
(iii) Many of the guidelines above have wide
ranges to allow taking advantage of opportunities that may occur within New
Mexico. The most significant example of this is the seed/startup stage
category.
(5)
The geographic guidelines above reflect where significant venture capital
opportunities currently occur on a national basis. Industry results indicate
that restricting the investing focus to one particular geographic area reduces
the return. With the exception of California, funds that focus entirely on one
state have typically not done well. A 15 percent to 20 percent focus on the
Southwest may seem small, but in fact is an overweighting in the region. Over
the last several years, only 10 percent of the dollars invested nationally have
gone into the southwest, which includes Arkansas, Arizona, Colorado, Louisiana,
New Mexico, Nevada, Oklahoma, Texas and Utah. This overweighting in the
southwest region is a conscious decision on the committee's part to encourage
venture capital investment in New Mexico.
(6) Subsection D of
7-27-5.6 NMSA 1978
states, "In making investments pursuant to this section, the council shall give
consideration to investments in venture capital funds whose investments enhance
the economic development objectives of the state, provided such investments
offer a rate of return and safety comparable to other venture capital
investments currently available." New Mexico is fortunate to have many
scientific, technical and academic resources. The VCIAC has tasked the advisor
to review for investment every venture capital organization with interests in
New Mexico that applies under the VCIP, and to not reject any such funds
without first consulting with the committee and SIC staff. The VCIAC and the
advisor will maintain open minds regarding all opportunities in New Mexico, and
will identify partnerships that have the early stage, seed, and startup skills
that are needed to succeed in the state without compromising expected
return.
(7) The committee and the
advisor do not advocate the use of venture capital investment programs solely
for economic development purposes, since historical data indicate that venture
capital programs focused on economic development have done poorly, and in many
cases, have been notable failures. The committee and the advisor will, however,
be sensitive to the needs of the state of New Mexico in this area. One
criterion used in selecting the advisor was the extensive data base it
maintains on groups outside the state with significantly successful investment
track records to use in evaluating all proposed investments for the VCIP. This
will insure that any New Mexico related fund selected by the committee and
council for investment will have a high probability of succeeding in the high
risk venture capital environment.
(8) In another effort to increase the
probability of attracting venture capital to the state, the VCIAC and the
advisor have recommended a mild overweighting with respect to stage focus on
the seed and startup category. Typically, only 5 percent to 10 percent of the
money raised by venture partnerships goes into this category due to its high
risk.
(9) The majority of the
selected partnerships will have an opportunistic or diversified industry focus,
since this approach has historically been the most successful. However, with
the continually increasing technological sophistication in today's more
competitive business environment, some specialized funds focusing on specific
industries may make sense. Industries of particular interest are biotechnology,
telecommunications, military and defense, health care, advanced materials, and
specialty retailing. The advisor's data base tracks numerous funds that have
been successful in each of these industries, and the committee will use this
information to select individual specialized funds with high probabilities for
success.
(10) In summary, the VCIAC
and the advisor believe that these diversification guidelines will provide the
maximum return and safety of principal that are required by both Section
7-27-5.6 NMSA 1978 and
the prudent man rule.
C.
PARTNERSHIP SELECTION CRITERIA:
(1) The
committee seeks to prudently invest in individual partnerships with at least
the following characteristics:
(a) partners
that have significant venture capital experience;
(b) partners that are well known to each
other and have worked together as partners;
(c) partners that have demonstrated
successful investment performance records;
(d) partners that have appropriate experience
for the proposed industry focus of the fund;
(e) partners that have appropriate experience
for the proposed stage focus of the fund;
(f) partners that are raising a fund that has
a size consistent with their investment strategy and human resources
capabilities;
(g) partners that
have the abilities to source many of their own deals;
(h) partners that have the time, experience
and interpersonal skills to work effectively with their portfolio
companies;
(i) partnerships in
which the compensation plan for the general partners is fair, creates the
proper incentives, and rewards the general partners for superior long-term
performance;
(j) partnerships that
have as their primary business activity the investment of funds in return for
equity in businesses for the purpose of providing capital for start-up,
expansion, new product development, or similar business purposes;
(k) partnerships that hold out the prospects
for capital appreciation from such investments comparable to similar
investments made by other professionally managed venture capital
funds;
(l) partnerships with a
minimum committed capital of $5,000,000;
(m) partnerships that accept investments only
from accredited investors as that term is defined in Section 2 of the Federal
Securities Act of 1933, as amended, (
15 U.S.C.
Section 77(b)) and rules
and regulations promulgated pursuant to that section;
(n) partnerships that have full-time
management with at least five years of experience in managing venture capital
funds; and
(o) partnerships that
receive at least 40 percent of the fund's capital from institutional
investors.
(2) Many
institutional investors seek only to invest in the oldest, most well-known
partnerships. While this may be effective, the advisor has indicated several
concerns with this strategy if it is used as the sole approach. First, the
individual general partners who are responsible for the track record may be
retiring or spending less than full time with the partnership. Second, the
large size of the new funds may make duplicating the earlier track record
unlikely. Third, the growth in management fees may have tempered the general
partners' desire to work hard to generate capital gains. Fourth, the growth in
the general partners' organization and staff may cause communication and
investment decisions to be less consistent and less thorough than that
experienced on earlier partnerships. Finally, the wealth the general partners
have derived from their previous investment successes may dampen their
enthusiasm to work as diligently on the new partnerships.
(3) The advisor has recommended that the
committee consider younger venture organizations where the general partners
have the right combination of venture capital experience and youthful (mid 30's
to mid 40's) drive and ambition, which will often produce the best venture
capital performance. The committee and advisor will therefore select fewer
well-known megafunds (where the above mentioned problems may be significant)
and more smaller-sized ($40MM-$80MM) funds with experienced and still
aggressive general partners.
(4)
The committee and advisor will follow a balanced approach in selecting
partnerships. It is expected that the severance tax permanent fund portfolio
will ultimately contain some "first time" funds as well as some large,
well-known funds. The key ingredient throughout the selection process will be
the backing of experienced people. All "first time" fund investments will be
based on excellent managers with significant venture capital experience. It
should be emphasized again that the only significant data that may be evaluated
to indicate the probability of success on any proposed fund investment is the
performance of the general partners on previous funds. It is thus no accident
that the criteria listed above focus almost totally on the general partners,
their experience and their proposed strategies, and compare these factors to
the previous funds managed by the same general partners and the strategies that
were successful on those funds. The only collateral on venture capital
investments is the general partners themselves.
(5) Paragraph (2)of Subsection F of
7-27-5.6. NMSA 1978
provides the applicable definition of a venture capital fund for the venture
capital investment program. For the purpose of defining "five years of
experience in managing venture capital funds" the VCIAC and the advisor will
include prior experience in other venture capital fund organizations.
D. INVESTMENT DECISION PROCESS:
(1) The investment decision process will
begin with a thorough review and analysis of each proposal by the advisor.
Those proposals recommended by the advisor for investment, and/or those related
to New Mexico, will be forwarded to the committee to evaluate. Those proposals
recommended by the committee for investment will be presented to the council
for approval. The council may then authorize the state investment officer to
make specific investments.
(2) The
first eight steps in the evaluation process below are internal procedures
followed by the advisor's staff. These steps are presented below in order to
fully describe the thorough and prudent process required to select any venture
capital fund proposal for investment. While the SIC staff may be advised of
proposals currently under consideration by the advisor and informed of progress
on specific proposals, active involvement by the SIC staff and the VCIAC will
not begin until step 9 below [now Subparagraph (i) of Paragraph 5 of Subsection
D of 2.60.20.8 NMAC].
(3) The
advisor's venture division is organized in a manner that will facilitate
efficient and informed investment decisions. Several individuals currently
share the primary responsibility for handling partnership investment
opportunities. Although these specific individuals shepherd each partnership
through the decision process, all of the professionals in the division are
actively involved in each investment decision.
(4) The advisor will keep the council's
venture capital portfolio manager (VCPM) fully informed during the following
process, particularly during steps1 through 8 [now Subparagraphs (a) through
(h) of Paragraph 5 of Subsection D of 2.60.20.8 NMAC], and especially on those
proposals that are related to New Mexico. The actual procedure used will be as
follows:
(5) ADVISOR'S INTERNAL
INVESTMENT DECISION PROCESS:
(a) The advisor
receives/solicits an offering/investment proposal from a partnership raising
money. Should the state investment council receive any proposals directly, they
will be forwarded to the advisor for the initial review.
(b) The advisor's professionals will review
the proposal. Careful attention is paid to each opportunity, particularly
groups organized, operating, or focusing in New Mexico.
(c) Should the decision be to not recommend
investment, a letter will be sent or a phone call made to inform the
partnership of the decision. If the opportunity is one which was referred by
the committee or council, or one which is related to the state of New Mexico,
the advisor will discuss the decision with the state investment officer and the
VCPM prior to any notification of the partnership; if the opportunity merits
further evaluation, rigorous due diligence is performed. Reference checks are
made, the track record is analyzed, and meetings are held with the general
partners. Numerous internal discussions are held and issues are raised and
addressed.
(d) The advisor's
venture division reaches a consensus on whether to pursue the investment
further or to reject it. If the decision is negative at this point, the
notification procedures in paragraph 3 [now subparagraph (c)] above will be
followed.
(e) If the decision is to
continue, an Investment memorandum is written by the advisor's venture
partnership investment professionals. This memo summarizes the opportunity and
the factors leading to the decision to pursue the investment.
(f) The investment memorandum is sent to the
advisor's venture capital subcommittee (not related to the VCIAC). The
subcommittee is comprised of the advisor's chief investment officer, all of the
advisor's venture investment professionals, and senior management from the
advisor's legal, equity, and account management divisions.
(g) If a majority (which must include the
chief investment officer) of the advisor's subcommittee approves the
investment, a commitment is made to the partnership. The advisor will then
notify the VCPM of the amount that will be recommended to the committee for
investment under the VCIP. All recommendations are still subject to successful
negotiation of the partnership documents.
(h) At this point, a copy of the investment
memorandum, as well as the offering/investment proposal will be mailed to the
VCPM. The time frame in which an investment decision is needed will be
indicated in the cover letter, as well as in a follow-up phone call.
(i) When the advisor's investment memorandum
and the fund offering / investment proposal are received by the VCPM, the SIC
staff will decide, based on the time available until an investment decision is
required, whether to schedule consideration by the committee and the SIC by:
(i) including the proposal for consideration
at the next regularly scheduled VCIAC and SIC meetings if this procedure will
produce a timely investment decision; or by
(ii) distributing the materials to the VCIAC
members by regular or express mail as necessary, and scheduling a special
committee meeting. In either case, if the committee's recommendation is
favorable and time then permits, the proposal will be included on the agenda
for the next regularly scheduled SIC meeting (normally the last Wednesday of
each month). If an investment decision is required prior to the next regularly
scheduled council meeting, the state investment officer will make a decision,
based on the committee's evaluation of the relative attractiveness of the
proposal, on whether to request a special meeting of the SIC in order to meet
the decision deadline, or to notify the advisor that the proposal will be held
until the next regular SIC meeting and that additional time is required to
reach a decision. If the necessary additional time is not available, the
proposal will not be considered further, and the advisor will be notified of a
negative decision. Special meetings of the SIC may be called upon a minimum of
72 hours notice.
(j) If
a negative investment decision is reached at any point during the VCIAC/SIC
consideration process, the advisor will be immediately notified by telephone.
If the outcome is a favorable decision, the advisor will be notified of the
approval and the amount of the SIC commitment; and
(k) After the council reaches a decision and
the advisor has been notified, the advisor will then be responsible for
notifying the partnership of the decision and the firm commitment amount, if
any, pending agreement on document terms.
E. PARTNERSHIP DOCUMENTATION PROCEDURES:
(1) Each venture capital limited partnership
is created and governed by a partnership agreement. Each partnership agreement
covers and defines all relevant terms for the affected partnership, including
fees, distribution policies, purposes of the partnership, limited partners'
rights and duties, and a myriad of other matters.
(2) The advisor will begin reviewing the
major terms of the partnership early in the decision process. Review of the
actual documents begins after an investment decision has been made. The advisor
will act as the council's agent in assuring that the partnership documents are
complete and meet all of the SIC's legal requirements. The process for review
of the legal documents is as follows:
(a) the
partnership legal agreement is received by the advisor;
(b) a copy of the agreement, as well as any
other documentation (e.g. management agreement, subscription agreement, side
letters), are sent to the advisor's legal counsel;
(c) both the advisor's legal counsel and
venture partnership investment professionals will review the
documents;
(d) the advisor will
negotiate the most favorable terms possible with the partnership;
(e) after final documents are drafted by the
partnership's counsel and approved by the advisor, the initial closing will
occur;
(f) the advisor's legal
counsel or the applicable general partners' legal representative, as
appropriate, will include a cover letter on all partnership agreement documents
sent to the SIC stating that the agreement conforms to Section
7-27-5.6 NMSA 1978 as
well as to prudent management and normal business practices prevailing in the
venture capital industry. This will allow execution of the documents without
further review by the New Mexico attorney general's office or by any other
state agencies. If there are unknown factors at the time the cover letter is
issued, they will be clearly stated; and
(g) each partnership will provide a side
letter indicating their views on investing in New Mexico and on assisting the
venture capital industry in the state when opportunities occur and/or if so
requested by the SIC staff.
F. CLOSING PROCEDURES:
(1) After a commitment has been made and
acceptable documents are submitted by the partnership, the first closing will
occur. A closing requires execution of the necessary partnership documents and,
usually, a transfer of funds. All appropriate documents (and any subsequent
amendments) will be sent by the advisor to the VCPM f or execution. The
advisor's legal counsel or the applicable general partners' legal
representative, as appropriate, will include a cover letter as described under
Partnership document procedures [now Subsection E of 2.60.20 NMAC] above. The
SIC will execute the partnership documents, and provide wiring instructions and
all other information necessary for the STPF's fiscal agent bank to deliver the
amount of the initial drawdown if /as required. After the closing, all executed
documents will be sent to the VCPM for review and transmittal to
safekeeping.
(2) The advisor will
notify the VCPM of all subsequent drawdowns and provide wiring instructions a
minimum of five business days prior to each drawdown date. Using the procedures
described above, the SIC will instruct the fiscal agent bank to wire funds to
the partnership in accordance with the STPF's investment obligation.
G. DISTRIBUTION MANAGEMENT
PROCEDURES:
(1) The successful outcome of a
venture capital investment program will be the distribution of cash and
securities to the limited partners. The advisor will be responsible for
returning, or directing the return of, all distributions, both cash and
securities, to the STPF. As the partnership interests mature and distributions,
or notices of distributions, are received, the advisor will notify the VCPM and
the STPF's fiscal agent bank. For cash distributions, the advisor will insure
that the proceeds are delivered directly by wire or check to the fiscal agent
bank. The advisor will provide information as to the components of the cash
distributions (i.e., return of principal, realized gains, and interest/dividend
income). Securities will be delivered directly to the STPF's custodian bank. In
some cases, partnerships will manage distributions through brokerage firms. In
those cases, arrangements will be made by the advisor to transfer custody of
the securities to the custodian bank. The advisor will contact the VCPM as
necessary to obtain current delivery instructions.
(2) When stock distributions are received,
the advisor's post-venture public stock managers will analyze the public
companies and determine the optimal time to sell the stock. The advisor will
advise the VCPM of the hold/sell recommendations, and act only as authorized by
the VCPM. If stock under the advisor's control is sold, sales proceeds will be
delivered to the fiscal agent bank as directed by the VCPM.
(3) Stocks distributed by venture capital
partnerships may be restricted under the SEC's Rule 144 or under an
underwriting lockup provision. The council will rely on the advisor, who has
had significant experience in dealing with these issues and has personnel on
its staff dedicated to the evaluation of these securities, to advise the SIC on
the most prudent disposition in each case.
H. MONITORING PROCEDURES: The advisor will be
responsible for monitoring the activities of all venture capital partnerships
in the SIC portfolio. Specifically, the advisor will:
(1) attend annual meetings. As notices of
meetings are received, the advisor will notify the VCPM in writing. The VCPM or
other SIC representative(s) will attend these meetings when possible;
(2) review all amendments to the partnership
agreements and forward to the SIC with recommendations for approval or
disapproval;
(3) evaluate all
partnership activities for compliance with partnership documents;
(4) serve on advisory boards on behalf of the
council as appropriate;
(5)
consolidate the partnership reports into uniform statements on a quarterly
basis;
(6) measure and evaluate
partnership return data;
(7)
evaluate and manage the distributions of public stocks; and
(8) conduct periodic meetings with the
general partners on an individual basis.
I. REPORTING PROCEDURES: The advisor's
portfolio status and performance reports will be provided to the council staff
on a quarterly basis. These reports will be sent within six weeks following
each calendar quarter end. Verbal reports of valuations only are available on
the fifth business day following the quarter end. The advisor's reports will be
compiled from data in the quarterly statements received from the individual
partnerships, which normally are received by the advisor from one to three
months following the end of each partnership's fiscal quarter (which may also
vary). Due to these delays, the performance reports received by the council
staff will be dated four to five months following the end of the period the
data covers. Since venture capital valuations are very imprecise and uncertain,
this delay is not considered significant. These reports will summarize the
status of the portfolio and each individual partnership with respect to total
commitment, drawdowns, cost, valuations, distributions, total value and
internal rate of return. A separate performance page will illustrate the
returns of the partnerships listed in chronological order to provide a better
perspective on the returns. The following regularly updated facts will then be
reported for each partnership: client capital account information, ownership
percentage, internal rate of return, a summary of terms, the names of the
general partners, a listing of all investments (including those written off),
and a distribution table. All return information will be calculated on a
quarterly basis by the advisor. The returns are based on cash on cash [sic]
plus adjusted residual value to the limited partner. This requires an accurate
record of all distributions, a review of the portfolio company valuations for
accuracy, an adjustment for the net unrealized gains on the general partners'
carry, and an update on the public stocks, if any, for the quarter end value
less appropriate discounts for trading (i.e. Rule 144) restrictions.