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.
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 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.
Reduced risk by a portfolio approach
Portfolio Balance: Venture capital investments can add a layer of balance to an investment portfolio, complementing more traditional investments.
Risk Mitigation: By investing in a range of startups across various sectors and stages, VC can help mitigate the risks associated with more conventional investments.
Growth Potential: VC provides exposure to high-growth potential startups, offering a counterbalance to the slower growth of established markets.
Innovation Exposure: VC investments give investors a stake in innovative and disruptive companies, diversifying their exposure beyond traditional market sectors.
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.
Innovation & Economic Growth
Venture capital is a catalyst for innovation and economic development. Investing in VC can provide exposure to new fields of corporate development.
Driving Innovation: VC investments are crucial in fueling innovative startups, often leading to groundbreaking technologies and services.
Economic Contributions: These investments contribute significantly to economic growth, job creation, and advancing new industries.
Supporting Startups: VC provides essential capital for startups to develop their products, refine their business models, and scale operations.
Global Impact: By backing startups with global ambitions, VC investments can have a far-reaching impact, fostering worldwide economic development and innovation.
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 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.
Access to Emerging Markets
Emerging Markets are usually given earliest exposure to financial markets through private financing.
Market Exposure: VC investments offer exposure to emerging markets and sectors, including nascent industries with high growth potential.
Technological Advancements: Investors can tap into startups driving technological advancements, positioning themselves at the forefront of new trends.
Sector Diversification: This access allows for diversification into sectors that are underrepresented in traditional investment portfolios.
Early-Mover Advantage: Investing in emerging markets through VC can provide an early-mover advantage, capturing value from innovative companies before they become mainstream.
Active Involvement
In public markets, all you can provide until you are a majority shareholder is capital. With VC you contribute directional strategy to accelerate growth of an industry.
Strategic Influence: VC investors often have the opportunity to actively influence the strategy and direction of the startups in which they invest.
Hands-On Engagement: This involvement can range from mentorship to providing industry expertise and guidance.
Value Beyond Capital: Investors bring more than just capital; their experience and networks can be crucial to a startup’s success.
Personal Fulfillment: Being actively involved in a startup’s journey offers personal satisfaction, witnessing first-hand the impact of their investment.
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.
Risk Considerations
Above are all the reasons to invest in venture capital. However, the opportunity for massive returns is not without risk. Here are some key risk factors with venture capital investment.
Startup Volatility: VC investments carry the risk of startup failures, as a significant number of startups do not succeed.
Market Fluctuations: The success of VC investments is often tied to market dynamics, which can be unpredictable.
Illiquidity: Venture capital is typically a long-term, illiquid investment, with capital locked in for several years.
Due Diligence Importance: Thorough due diligence is essential to mitigate risks, requiring investors to assess startups comprehensively before investing.
Zander Buteux is Head of Growth for Decile Group, powering the next generation of venture capital firms worldwide with an integrated offering of training, tools, support, and funding. Decile Group is the parent of the VC Lab venture capital accelerator, which helped to launch nearly 50% of all new manager firms in 2022.
Prior to joining Decile Group, Zander was at Wilbur Labs, a San Francisco Based startup studio where he was a key operator in the founding of 21 startups across myriad industries. He is eager to optimize and improve the world around him by helping others realize their own opportunities and strengths.
