Minority Firms Outperformed S&P 500 First Study Of Minority Venture Capital Industry

Kansas City, MO � The Kauffman Foundation recently released a pioneering report, Minorities And Venture Capital: A New Wave in American Business, the first profile of venture capital funds that make significant equity investments in minority business enterprises (MBEs). The report, based on a study by Dr. Timothy Bates of Wayne State University and Dr. William Bradford of the University of Washington, finds investments in MBEs resulted in healthy returns equal to, if not slightly higher than, traditional investments by mainstream venture capitalists. Recent studies, including the Kauffman Foundation�s The Entrepreneur Next Door, reveal that minorities, especially African Americans, are 50 percent more likely than any other demographic group to engage in business start-up activities.

�Access to capital is one of the biggest hurdles for any entrepreneur � and even more so for minority entrepreneurs,� said Carl J. Schramm, president and chief executive officer of the Kauffman Foundation of Kansas City, the nation�s largest supporter of entrepreneurship and the sponsor of the study. �We hope this report helps to lower those capital barriers.�

The report, which is an analysis of venture capital funds operated by members of the National Association of Investment Companies (NAIC) � a group of investment companies that share an interest in financing MBEs � is the first to explore the approaches to financing MBEs and calculate the rates of return of minority-oriented VC funds. �We set out to find out if minority-oriented venture capital investing was solid,� said study co-author Dr. Timothy Bates, distinguished professor at Wayne State University.

�We found strong, preliminary evidence of a robust minority venture capital industry.�

Key Findings

* Minority enterprise venture capital investing is quite profitable. The average investment per firm was $562,000; the average gross yield per firm was $1,623,900, generating an average net return of $1,061,500.

* Minority-oriented venture capital funds did not concentrate in high tech. Unlike the broader industry, which invested heavily in high-tech ventures, a more diverse portfolio kept funds focused on MBEs from their colleagues� steep slump.

* Public pension funds are the leading source of VC funds for minority businesses. However, these funders favor older, more established funds; therefore commercial banks and insurance companies as well as minor funding sources (under $5 million) such as government funds, foundations and individuals, play a key role in financing MBEs. In the early 1990s, only several million dollars in venture capital had been invested in MBEs. According to Bates and Bradford, the minority VC sector now has well over $1 billion in capital under management, with $2 billion within reach.

The authors found that minority-oriented venture capital funds grew enormously during the 1990s. The 24 funds that responded to the detailed questionnaire had raised $1.3 billion through year-end 2000. In 1998 alone, five of the surveyed minority-oriented VC funds had raised over $700 million in capital from institutional sources. Return On Investment Taken together, 117 investments tracked by Bates and Bradford from the 24 MBE-targeted venture capital funds surpassed a 20 percent rate of return. During that same time period, according to industry analysts, the S&P 500 Index had a 17 percent return. Furthermore, Venture Economics (VE) and the National Venture Capital Association derive a Private Equity Performance index.

VE tracks the performance of over 1,400 U.S. venture capital and buyout funds on a quarterly basis. As of early 2001, the ten-year trailing average annual return for the Private Equity Performance Index was 20.2 percent.

�This report dispels the most insidious myth about investing in minority-owned businesses,� said Amy Domini, founder and CEO of Domini Social Investments LLC, creator of the Domini Index. �It signals to investors, analysts and scholars, that if you overlooked this niche, fearing low returns, it�s time to take a second look.� The study used three approaches to measure profits: gross and net cash flows, internal rates of return (IRRs) and cash flow present values. IRRs are perhaps the most widely used measure of venture capital investment performance.

An IRR is the discount rate at which the investment’s cash flow returns equal the cost of the investment. It does not express the length of the investment’s life, its size or its gains and losses evenly.

Returns were not dominated by a few highly profitable deals. IRRs for the MBE-oriented funds ranged from minus 32 percent to +79 percent, with a median of 19.5 percent and a mean of 23.9 percent. Unlike many other surveys, rather than leave the IRR calculations to survey participants, which previously had resulted in spotty data, Bradford’s team calculated the IRRs.

In a regression analysis, higher IRRs were associated with large dollar size of investments (over $1 million), active involvement of VC partners in the portfolio companies and funds that were diversified. Lower IRRs were associated with smaller investments, receiving SBA funding and specialized investing that emphasized communications firms.

The authors concluded that larger investments earn higher yields and that communications focused funds (with 40 percent or more invested in communications) had lower IRRs than balanced funds. Investments by funds that are highly active in their firms had higher IRRs. The authors also found the nearly universal role of syndication among minority-oriented venture capitalists moderated risk while building value.

Where do minority-oriented funds get their money?

While public pension funds were the largest source of capital, corporations provided the fewest dollars. Of these major sources of capital, only banks and insurance companies, say Bates and Bradford, have been accessible to newcomers. Minor sources ($5 million or less) have therefore played a key role in the industry’s development. These include government, corporations, foundations and endowments, and individuals.

Overall, the funds tapped a median of three types of financial capital resources. Judging from the survey responses, a minority VC fund seeking to raise over $20 million from one funding source would be best off, concluded Bates and Bradford, approaching public pension funds, banks and insurance firms, funds of funds and corporate pension funds.

“At first, profit-oriented sources equated minority-oriented funds with social investing and shied away,” noted co-author Dr. William Bradford, endowed professor at the University of Washington, “but as word spreads that these are lucrative investments, this should change.”
Where and how do minority-oriented venture capital funds invest?

Minority-oriented venture capitalists don’t emphasize high tech. Twenty of the 24 funds surveyed that invested in communications firms were primarily in broadcast, not broadband. Sixteen invested in services (excluding medical), 15 in non-electronics, non computer-related fields. While 13 invested in wholesale and retail trade operations, 12 invested in manufacturing related to electronics and computers.

Because the niche had little exposure to the Internet bubble, the authors predict it will sustain profitability even as mainstream venture capital firms and funds generate losses.

“Picking ‘broadcast over broadband’ gave minority venture capitalists a healthier return than the industry as a whole,” noted Rhonda Holman, a Kauffman Foundation vice president. “No one would be surprised to hear that a minority-oriented VC’s last three investments were in broadcasting, especially radio stations, high tech electronics manufacturing and restaurant chains.”

Minority entrepreneurs Frank Washington and Amador Bustos both ran such firms. Washington, a 20-year telecom veteran, raised $4 million in venture capital for Systems Integrators, Inc. (Sii), which he restructured to help debug newspapers for Y2K. In 2000, Sii’s sale returned $18 million to equity investors. Today, Washington chairs MediaZing, an electronic multimedia advertising firm in Sacramento, CA.

In 1992, Michoacan Mexico native and University of California/Berkeley grad Amador Bustos launched Z-Spanish Radio Network. He turned it into the largest Hispanic-owned satellite radio network in the U.S., with 32 owned and operated stations and 42 affiliates. Bustos credits Syndicated Communications, a Maryland-based venture partners’ group, for his success. “It’s capital one can’t get anywhere else — dreams and start up business plans aren’t bankable,” Bustos observes. In 2002, he merged his $475 million firm with Entravision, Communications Corp, which has a market cap of $1.5 billion. •