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Why Invest In Venture Capital?

Top 4 Reasons to Become a Limited Partner in a Venture Capital Fund

Today, venture capital is the global driving force of technological innovation and change.

Venture capital has long been considered as an ‘alternative investment’, due to the perceived high risk by investors and the inherent nature of the power-law that is within VC. However, historic backers of VC such as university endowments are enjoying unprecedented levels of returns thanks to the growth of technology, which is encompassing every facet of a companies operations and the economy.

We will explore some of the reasons why now is the perfect time to invest in the VC asset class and why becoming a limited partner in a VC fund is a very compelling and prudent choice, especially for angel investors. 

1. Historically High Returns

Venture capital is seeing incredible levels of growth accompanied by historic levels of liquidity and the asset class is performing well compared to public market indices. This year, Harvard Endowment recorded a 34% gain and swelled to its AUM to $53.2bn, while MIT’s endowment grew to $27.4 bn after a 56% return so far in this year and VC outperformed every major asset class over the last several years.  

Early-stage funds, particularly new fund managers in the pre-seed to seed stage, are enjoying high returns as the VC market is thriving. Exits in US VC-backed startups have already doubled in 2021, compared to levels seen in the previous two years and there is more liquidity in venture capital than ever before. We are seeing the atomization of venture firms, where founders are opting for either elite firms or specialist small fund managers. 

Historically, new fund managers typically outperform more experienced managers across the board. Recently the upper quartile of new fund managers attained 27.1% IRR on average while non-first time managers in the same bracket have achieved 19.6% IRR. New fund managers on average also attained a Total Value to Paid-In (TVPI) ratio of 1.85 while more experienced managers scored 1.75 in the upper quartile.

2. Reduced risk by a portfolio approach

Angel investors, in particular, should note that the diversified portfolio approach taken by VC funds reduces risk. However, due to the inherent power law in VC, a portfolio of startups also has the potential to generate very high returns. New fund managers typically outperform new angel investors in the long run and the tried and tested VC model offers LPs more time to engage in other activities.

Angel investors who are looking to make below 30 investments should be wary of the risks associated with an undiversified portfolio. Angels often need to manage their own portfolios and implement their own strategies. To make around 30 investments, an angel investor can usually meet with anywhere from hundreds to thousands of startup teams and conduct lengthy due diligence.

Below you can find an example of a venture capital portfolio. This example below is for demonstration purposes only. Please note that investing in a VC fund still has risks of a total loss, however, the probability is much lower.  Under a low scenario, a portfolio still has the potential to generate a positive return despite the fact that the majority of investments failed. Also, in the high scenario, one unicorn-level company can help the portfolio generate a massive return depending on the stage.

VC diversification for Angels

3. Focus on a thesis through a professional manager / expert

Early-stage fund managers are typically highly qualified specialists in a domain of expertise and have theses for achieving outsized returns. A fund manager is typically is a well-connected expert in a particular market, meaning that they have a well-thought-out strategy to capture value and have access to high-quality deals through their vast networks. 

The majority of high-quality deals rarely become public knowledge. Such deals are typically accessible via a large private network of entrepreneurs and venture capitalists and are often oversubscribed. It’s also important to note that the inbound deal volume of a VC firm is often an order of magnitude greater than that of the typical angel investor. Funds typically diligence 1,000s of companies per year and usually have systems in place for analyzing such opportunities at scale. They tend to also have larger teams with a broader set of domain expertise to help with diligence.

4. Opportunities to invest directly in portfolio companies

Becoming an LP in a VC fund does not necessarily mean the end of one’s angel investing career. In fact, being an LP in a VC fund will at times offer investors co-investing opportunities, giving LPs exclusive access to high growth opportunities at later stages which are often reserved to large growth funds. As Court Lorenzini, co-founder of DocuSign, LP in 15 funds and investor in over 60 companies, shared in an interview with VC Lab, at times he invests alongside the funds of which he is a LP.

Additionally, becoming an LP will give you more deal-flow opportunities in other areas as well. Since most new managers have small fund sizes, they often will need to syndicate their pro-rata stake to their LPs. Since funds usually have more deal-flow than individuals, your fund manager may often refer high-quality deals that do not fit the fund’s thesis, but you may be interested in. This will consequently lead to you expanding your inner VC network and building an array of founders and entrepreneurs who will also refer deals to you.