Venture capital (VC) is a critical catalyst for innovation and progress in various sectors, including healthcare, energy, financial services, artificial intelligence, and climate change. As an asset class, venture capital has consistently outperformed others over the past five years, making it an attractive investment option for those looking to diversify their portfolio and contribute to the advancement of groundbreaking technologies and solutions. This article will explore the reasons why investors should consider investing as a limited partner in venture capital funds and guide you through the process. It also includes a glossary of key venture capital terms for limited partners.
Venture Capital Performance
Over the last five years, venture capital has emerged as the top-performing asset class, outperforming stocks, bonds, private equity, real estate and even newer asset classes, like crypto. Investors seeking to diversify their portfolio allocate a percentage of their wealth to venture, typically ranging from 5% to 15%, depending on their risk appetite.
Venture Capital Economics
Venture capital funds typically charge management fees and carried interest. Management fees are usually set as a percentage of the fund’s committed capital, payable annually over ten years and commonly averaging 2% per year. Carried interest refers to the fund manager’s share of the profits after the principal is returned, commonly set at 20%.
For example, let’s consider a $10 million venture capital fund that achieves a 9x Total Value to Paid-In (TVPI) multiple. If an investor commits $250,000 to this fund, their total returns after all fees would amount to $2.25 million, representing a considerable return on investment.
Selecting a Venture Capital Fund
Finding the right venture capital fund to invest in requires a combination of introspection, networking, and research. The following step-by-step process can help you navigate this journey and identify a fund that aligns with your personal interests and investment goals:
Step 1: Define your Objectives
Before starting your search for a venture capital fund, it is essential to outline your investment interests, objectives, and criteria. Consider factors such as your risk tolerance, target return on investment, desired level of involvement, and the sectors or industries you are most passionate about.
Step 2: Network in Venture
Begin networking with industry professionals, fellow investors, and financial advisors to gather information about potential venture capital funds. Attend industry events, conferences, and webinars to expand your knowledge and connections in the venture capital ecosystem.
Step 3: Contact Managers
Contact target fund managers to express your interest and request more information about their investment strategy, fund structure, and terms. This interaction will also give you a sense of their communication style and how they value their limited partners, allowing you to create a shortlist of the most interesting fund candidates.
Step 4: Evaluate Fund Alignment
Dig deeper into each shortlisted fund by examining their portfolio companies, sector focus, and investment stage. Look for funds that have a strong track record in areas you are passionate about, whether it be healthcare, clean energy, or artificial intelligence.
By following this step-by-step process, you can confidently select a venture capital fund that not only meets your financial objectives but also allows you to contribute to the growth and development of innovative companies in sectors you are passionate about.
Performing Fund Due Diligence
Once you have a shortlist of interesting funds, you will want to complete due diligence. Depending on the size of the planned investment into a venture capital fund, there are differing levels of due diligence. For commitments at $250,000 and below, less due diligence is required, possibly doing one or two items below. For larger commitments, a full set of fund due diligence includes:
Manager Track Record
Investigate the fund manager’s experience and expertise in the target industry. Assess their track record as an angel investor, including their success in identifying and supporting early-stage companies. A strong background in the target industry and a history of successful angel investments indicate the manager’s ability to make informed decisions and generate attractive returns.
Reach out to the fund manager’s background references, such as former employers, colleagues, or limited partners in previous funds. Inquire about the manager’s character, work ethic, investment strategy, and communication style. These insights will help you understand the manager’s approach to managing the fund and working with limited partners.
Study the target industry’s trends, challenges, and growth potential to gauge the fund’s prospects. Estimate the total addressable market size and assess the fund’s ability to capitalize on the industry’s opportunities. This analysis will help you determine if the fund is well-positioned to generate substantial returns by investing in companies within the target industry.
If the fund has already made initial investments, analyze these portfolio companies independently. Evaluate their business models, competitive advantages, growth prospects, and management teams. This analysis will allow you to form your own opinion on the quality of the fund manager’s investment decisions and their ability to identify promising companies.
Review the fund’s Limited Partnership Agreement (LPA) and compare its terms and conditions, such as management fees, carried interest, and exit provisions, with industry benchmarks. This comparison will help you ensure that the fund’s terms are fair and in line with market standards.
Investing in a Venture Capital Fund
Joining a venture capital fund involves several key steps:
- Commitment Letter: Sign a commitment letter (PACT) to reserve a position
- Closing Package: Receive and review all agreements, including the LPA
- Sign LPA: Sign the LPA and Subscription Agreement, as needed
- First Capital Call: Receive wiring instructions and complete the funds transfer
As a limited partner, you commit to providing a specific amount of capital to the fund over its investment period. This committed capital is not typically contributed in a lump sum; instead, the fund manager makes capital calls, requesting portions of your committed capital as needed. The first capital call is normally between 20% and 35% of the total committed capital.
Capital calls can occur when the fund makes a new investment, incurs operational expenses, or requires additional capital for an existing portfolio company. You are legally obligated to fulfill these capital calls within the specified timeframe, as detailed in the LPA.
Venture Capital Returns
Venture capital fund distributions are the returns on investment that limited partners receive from the fund’s profitable exits, such as through initial public offerings (IPOs), mergers, or acquisitions. It is important for investors to recognize that venture capital investments have a long-term horizon, and receiving the first distributions often takes between three to five years. This timeframe reflects the period required for portfolio companies to mature and achieve successful exit events. Additionally, it may take up to seven years or more for a venture capital fund to become profitable, as early-stage investments carry a higher degree of risk and some portfolio companies may not yield positive returns.
Venture capital funds typically provide their limited partners with quarterly and annual reports to keep them informed about the fund’s performance, investment activities, and portfolio companies. These reports offer insights into the fund’s financial status, including the net asset value, capital account balances, and any changes in the portfolio’s composition. Additionally, the reports may include updates on individual portfolio companies’ progress, milestones achieved, and any significant events or industry trends that may impact their performance. By maintaining regular communication through quarterly and annual reporting, venture capital funds ensure that their limited partners stay informed and engaged, fostering a transparent and collaborative relationship between the fund manager and investors.
Benefits of Venture Capital
Investing in venture capital funds as a limited partner offers numerous benefits, including:
- Attractive Returns: Venture capital investments have the potential to yield substantial returns compared to other asset classes.
- Exclusive Networking Opportunities: Limited partners gain access to private events, connecting them with industry leaders and fellow investors.
- Supporting Innovation: Venture capital investments fuel the growth of innovative companies that can transform industries and improve the world.
- Portfolio Diversification: Adding venture capital investments can reduce portfolio risk by providing exposure to a different asset class.
- Learning Opportunities: Limited partners can deepen their understanding of various sectors and investment strategies through their involvement in venture capital funds.
Venture capital: A form of private equity financing provided by investors to startups and early-stage companies with high growth potential.
General Partner (GP): In the context of venture capital funds, the general partner is the fund manager responsible for making investment decisions, managing portfolio companies, and overseeing the fund’s operations. GPs typically receive management fees and a share of the fund’s profits (carried interest) as compensation for their services.
Limited Partner (LP): An investor in a venture capital fund who contributes capital but does not participate in the fund’s management or investment decision-making process. Limited partners have limited liability, meaning their financial exposure is restricted to the amount of capital they have committed to the fund. They share in the fund’s profits in proportion to their investment, after the deduction of management fees and carried interest.
Committed capital: The total amount of money that limited partners agree to contribute to a venture capital fund, as outlined in their commitment letters and the fund’s Limited Partnership Agreement (LPA). Committed capital serves as the fund’s financial resource for making investments, covering operational expenses, and supporting portfolio companies. The fund manager typically calls for this capital in installments through capital calls over the fund’s investment period.
Capital call: A request made by a venture capital fund for its limited partners to contribute a specified portion of their committed capital. Capital calls typically occur when the fund makes a new investment, incurs operational expenses, or requires additional capital for an existing portfolio company. Limited partners are legally obligated to fulfill capital calls within a certain timeframe, as specified in the fund’s Limited Partnership Agreement (LPA).
Capital account: An account maintained by a limited partner in a venture capital fund, representing their share of the fund’s investments, profits, and losses. The capital account balance fluctuates based on the limited partner’s capital contributions, capital distributions, and their allocated share of the fund’s realized and unrealized gains or losses. The capital account serves as a record of the limited partner’s financial interest in the fund.
Management fees: Fees paid by limited partners to the venture capital fund manager, typically calculated as a percentage of the fund’s committed capital, to cover operational expenses.
Carried interest: The share of a venture capital fund’s profits allocated to the fund manager, often around 20%, as compensation for managing the investments.
Limited Partnership Agreement (LPA): A legal document outlining the structure, terms, and conditions of a venture capital fund and the relationship between the general partner (fund manager) and limited partners (investors).
TVPI (Total Value to Paid-In): A performance metric that calculates the multiple of money returned to investors relative to the amount invested.
Internal Rate of Return (IRR): A financial metric used to measure the profitability of an investment, expressed as an annualized percentage rate. IRR represents the discount rate at which the net present value of an investment’s cash flows equals zero. In venture capital, IRR is commonly used to assess the performance of a fund and compare it to other investment opportunities.
Data room: A secure online repository containing a venture capital fund’s financial statements, legal documents, and other critical information for potential investors to review during the due diligence process.
Commitment letter (PACT): A document signed by a limited partner, stating their intention to invest a specified amount of capital in a venture capital fund.
Distribution: The process through which limited partners receive their share of a venture capital fund’s profits, typically in the form of cash or stock.
Portfolio company: A company in which a venture capital fund has invested. The collection of all such companies in which a fund has stakes is referred to as its portfolio.
Early-stage investment: Venture capital investments made in startups or young companies that are in the initial stages of development and have not yet generated significant revenue.
Growth-stage investment: Venture capital investments made in companies that have demonstrated market traction and are experiencing rapid growth but may not yet be profitable.
Late-stage investment: Venture capital investments made in mature companies that are profitable and have a proven business model, often on the verge of going public or being acquired.
Exit strategy: The method by which a venture capital fund realizes a return on its investments, such as through an initial public offering (IPO), merger, or acquisition.
Due diligence: The process of researching and evaluating a potential investment opportunity, such as a venture capital fund, to assess its viability, risks, and potential returns before making an investment decision.