Why Emerging Managers Should Consider a Defined Benefit Plan with PBGC Over a Venture Fund

For emerging managers, the allure of managing a venture fund can be strong. It promises the chance to build a track record, generate returns for limited partners, and ultimately establish a name in the competitive world of venture capital. However, while launching a venture fund might seem like the ideal path, the reality is that it carries significant risks. Chief among those is the distinct and probable possibility of underperformance.

Even if your fund does hit the top 1% at a 5x, the full life cycle of a venture fund could end up giving your LPs a yawn-inspiring 10.4% return.

Given these challenges, an emerging manager may want to explore an alternative option, such as starting a defined benefit (DB) plan through the Pension Benefit Guaranty Corporation (PBGC) or partnering with one.

A Defined Benefit plan cannot directly "run" a venture fund, but it can still play a role in venture capital activities in the following ways:

1. Investing in a Venture Fund: A DB plan can invest its assets into a venture fund, which means the DB plan could become an investor in your fund. This could provide you with capital to invest in startups while ensuring that the DB plan benefits from potential returns on those investments.

2. Co-Investment: The DB plan could also co-invest alongside the venture fund, participating in the same deals. This could allow the plan to benefit from the returns of successful venture investments without being responsible for managing the fund itself.

3. Partnership with a Venture Fund: An emerging manager could establish a partnership between the DB plan and a venture fund, where the DB plan provides capital, but the manager continues to run the fund. The venture fund would maintain the typical investment strategy and operations, while the DB plan serves as a long-term capital provider, benefiting from the venture fund’s returns.

Let’s examine the benefits of this approach and why it may be a more strategic choice for those aiming to serve an investor community.

The Risk of Underperformance in Venture Funds

Starting a venture fund is an exciting yet highly speculative endeavor. Even the best managers can face years of underperformance before hitting a home run. In the early stages of a venture firm, it can take years to establish the right deal flow, refine your investment thesis, and build a portfolio of companies that have a high probability of succeeding. And at the end of it, 10% of emerging managers still end up losing 70% of the fund's capital.

Moreover, venture funds often require significant amounts of capital to operate, and the pressure to deliver returns quickly can be overwhelming. Navigating this pressure without a proven track record can be even more difficult. With venture fund performance being notoriously volatile and often driven by a few large wins, the risk of underperformance looms large. If a venture fund underperforms or fails to deliver the returns investors expect, it could tarnish an emerging manager’s reputation, making it near impossible to raise capital for future funds.

In addition to these performance risks, venture capital funds typically involve high fees, administrative costs, and a complicated fundraising process, which can and does take years.

Why a Defined Benefit Plan with PBGC Could Be a Better Option

Instead of going down the road of a high-risk venture fund, emerging managers could consider starting a defined benefit (DB) plan with the Pension Benefit Guaranty Corporation (PBGC). A DB plan offers several distinct advantages, particularly for those interested in building long-term financial security without the unpredictability of a venture fund.

1. Stability and Predictability

Unlike venture funds, which are influenced by market fluctuations and the unpredictable nature of startups, a DB plan offers guaranteed retirement benefits to employees based on a formula typically linked to salary and years of service. This structure provides emerging managers with a more stable and predictable path to financial security.

Additionally, DB plans are insured by the PBGC, meaning that if a plan sponsor fails to meet its obligations, the government steps in to ensure pension benefits are still paid. This level of security is not available in venture funds, where managers bear the full risk of underperformance.

2. Tax Advantages & How It Works

A DB plan offers significant tax advantages, as contributions are tax-deferred and can be deducted from the company’s taxable income, providing an immediate tax break. For example, a company could contribute up to $245,000 per participant per year, depending on age and the plan's design, reducing its taxable income by the same amount. This is especially beneficial for emerging managers who may not have substantial cash flow and need every dollar working for them. Additionally, the funds in a DB plan grow tax-deferred, allowing for compounding without the drag of annual taxes. This can accelerate wealth accumulation, as the deferred taxes allow more capital to remain invested and grow. For a new manager, this structure enables them to build resources for future investments while minimizing the financial volatility typically associated with venture capital.

To establish a Defined Benefit (DB) plan for a community like dentists, several forms need to be filed with the IRS and other regulatory bodies. First, you’ll need to file Form 5300 with the IRS to request approval for the plan’s qualification under the Internal Revenue Code. You may also need to file Form 5500 annually with the Department of Labor to report the plan’s financial condition and operations. Additionally, you'll need to complete Schedule SB (Form 5500) to report actuarial data and funding status, and if you have over 100 participants, you may need an independent audit. Depending on the plan design, other filings like Form 8955-SSA (for reporting separated participants) might be required. It’s essential to work with legal and actuarial professionals to ensure compliance with all regulatory requirements.

3. DB Plan: Start-up or Partner-up

For emerging managers who already have a fund, the idea of having a pension as a partner is an exciting opportunity. Not only does it provide the capital needed for investments, but it also offers the flexibility to double down on successful ventures and drive your fund’s performance further. This partnership creates financial stability, allowing you to focus on the most promising opportunities without the worry of underperforming assets holding you back.

It’s a win-win. With the stability that a pension brings, you secure both personal and professional peace of mind while maximizing your fund’s potential. This added layer of security gives you the confidence to pursue growth and performance, knowing you have the support to take calculated risks and make your impact.

4. Same Deals, Different Vehicle

In addition to the benefits of diversification, emerging managers who choose to start a Defined Benefit plan are not limited in their portfolio construction. This means they can invest in the same types of high-risk, high-reward assets they would target as venture capital managers—such as startups and growth companies—while also benefiting from the PBGC insurance coverage on the principal paid into the pension. This gives them the flexibility to pursue their preferred investment strategy without exposing their clients’ contributions to the same level of risk typical in a traditional venture fund.

Additionally, if the investments outperform expectations, emerging managers can distribute extra returns to pensioners, ensuring that those who supported the plan are also rewarded for its success. This structure aligns the interests of managers with those of their pensioners, offering a level of security and predictability that a venture fund can’t provide, while still delivering the potential rewards that venture capital aims to achieve.

By combining the opportunity to make high-reward investments with the safety net of PBGC insurance and the ability to share returns with pensioners, a DB plan offers a compelling alternative to the volatility of venture capital funds. This approach not only mitigates risk but also creates a win-win situation for both emerging managers and the individuals who entrust their assets to the plan.

5. Lower Barrier to Entry

Starting a DB plan with PBGC is less capital-intensive and complicated than launching a venture fund. While venture funds require significant financial backing and years of fundraising, a DB plan can be set up more quickly and with fewer upfront costs. This makes it a more accessible option for emerging managers who may not have a massive network of investors or a proven track record but still want to build long-term wealth and a sustainable business.

Conclusion

While the idea of managing a venture fund may seem like the ultimate career goal for an emerging manager, it’s important to weigh the potential risks, including the possibility of underperformance and the pressures of fund-raising. In contrast, a defined benefit plan with PBGC offers a more stable and predictable route to financial security, with tax advantages, diversified investments, and the ability to attract talent.

Ultimately, starting a venture fund or a DB plan isn’t an either/or decision—it depends on the emerging manager’s goals, risk tolerance, and financial circumstances. However, for those looking for long-term stability and a steady path toward wealth accumulation, the defined benefit plan offers a strong alternative to the high-risk venture capital route.