Shining a Light on Venture Capital’s Secrets Cost Public Investors Billions

Researching venture capital from the outside isn’t easy. “It’s a very difficult industry to study because it is a private industry; there isn’t much information about companies, investors, and so on,” says Ilya Strebulaev, a professor of finance at Stanford Graduate School of Business, where he directs the Venture Capital Initiative.

Venture capital firms do share copious amounts of data with their investors, or limited partners (LPs), who rely on information on portfolio companies and fund-level returns to make decisions. But venture capitalists consider such data confidential and require their investors to sign nondisclosure agreements. “For competitive reasons, there are costs to disclosing that information both for portfolio companies and for VCs,” Strebulaev says.

Conversations with major fund investors, however, reminded Strebulaev of an event that threatened to pierce the veil of secrecy surrounding venture capital more than 20 years ago, temporarily upending the relationship between VCs and investors — with lasting consequences for both.

The event in question involved a series of legal challenges to state-level Freedom of Information Acts (FOIAs) that require government bodies to disclose information to the public. These “sunshine laws” generally exclude trade secrets and other sensitive information from records requests. However, following the dot-com crash and Enron scandal of the early 2000s, journalists and public employees sued to gain access to more information about investments held by public investors such as state pension systems and public university endowments.

In 2002, the courts forced public investors to disclose their fund-level return data, raising the possibility that portfolio company data might eventually be released as well. The ensuing “FOIA shock” led some VCs to ban deals with public investors entirely.

To understand precisely what happened and its long-term ramifications, Strebulaev compared the impact of the FOIA shock on public and private investors and parsed the ensuing industry and regulatory backlash.

Using data from the financial services firm Preqin and the venture capital database VentureSource, Strebulaev and coauthors Will Gornall, PhD ’15, an associate professor at University of British Columbia Sauder School of Business, and Rustam Abuzov, an assistant professor at University of Virginia Darden School of Business, scrutinized commitments by private and public investors to VC funds before and after the FOIA shock.

Shutting Out Public Investors

Strebulaev and his colleagues discovered that public investors’ exposure to the top 20 VC firms was effectively cut in half following the FOIA shock. Had public investors done nothing in response, Strebulaev and his team calculated they would have lost an estimated $4.3 billion in returns. In fact, they compensated by moving into “funds of funds,” which buy shares in other funds, regaining indirect access to the top VC firms. Even so, Strebulaev and his team reckon that the FOIA shock still cost public LPs approximately $1.6 billion in potential returns.

The researchers found that only the top-performing VCs excluded public LPs from their funds. But they didn’t simply reduce the size of those funds; instead, they replaced their public LPs with private ones. “It wasn’t just a matter of cutting exposure, but of reallocating the type of LPs involved,” Strebulaev says.

Further analysis showed that top VCs engaged in this exclusionary behavior not because they were more concerned about privacy, but simply because other investors were eager to pour money into them. In other words, they could afford to be choosy. That privileged position also allowed the top VCs to modify their LP agreements, withholding valuable portfolio company information and fund-return data from public investors to keep them beyond the purview of sunshine laws. “If you don’t have the information, you can’t disclose it,” Strebulaev says.

As a result, forcing disclosure through regulatory channels had the unintended effect of limiting not only the investment opportunities available to public investors but also the amount of information they could get their hands on.

The top VCs were not the only ones to swing into action following the FOIA shock. Several state legislatures reacted by amending their freedom of information laws to limit disclosure requirements for public investors to help state pension funds and university endowments reenter the good graces of top VCs. Most of these amendments strengthened protections around portfolio company information, while some protected fund-level return data as well. These changes to state law and LP contracts led to a rebound in public investment among the top 20 VCs.

Strebulaev says the FOIA shock and its aftermath underscore how important privacy is to the venture capital industry, how difficult it can be to predict the effects of regulation, and just how stark the difference is between the top VC firms and everybody else. “Top VCs can dictate terms,” he says.