LP Venture Allocations

Venture capital is an asset class that epitomizes the high-reward and high-risk paradigm. When done well, venture capital can generate unparalleled returns. It offers Limited Partners the opportunity to partake in the growth stories of tomorrow’s leading companies, providing returns with the satisfaction of contributing to innovation and societal progress. 

Within the venture capital asset class, the smaller funds of emerging managers have the best overall returns. Emerging managers typically have something to prove and have untapped networks to leverage for success. This article provides an overview of investing in venture capital as a limited partner.

Why invest in venture capital?

If you are interested in long-term opportunities with large returns and are comfortable with risk, then venture capital is an attractive asset class. Whether you allocate or how much you allocate is based on self-reflection on your goals, risk tolerance, and other factors. We have a guide to explore the main questions below:

Clarifying Your Investment Goals

• Growth vs. Income: Are you primarily interested in seeing your capital grow over time, or are you looking for investments that could potentially generate income (e.g., through distributions once the startups begin generating profit)?
• Impact Investing: Do you want your investment to have a specific impact, such as supporting sustainable energy, technology innovation, or social entrepreneurship?
• Portfolio Diversification: How does investing in a VC firm fit into your overall investment portfolio? Is your goal to diversify away from traditional stocks and bonds, or are you looking to concentrate your investments in high-growth potential areas?
• Understanding Liquidity: Are you comfortable that your investment in a venture capital fund may be illiquid for 5 to 10 years, with no guarantee of a profitable return?

Assessing Your Risk Tolerance

• Loss Capacity: How much of your investment capital can you afford to lose without altering your standard of living or jeopardizing your financial goals? This helps determine the amount of money you should comfortably invest.
• Emotional Tolerance for Volatility: Venture investments can be highly volatile. Can you handle hearing about the ups and downs of the businesses you’ve invested in, knowing that failure rates can be high?
• Experience with Similar Investments: Have you invested in high-risk, high-reward assets before? How did you react to the performance of those investments, both good and bad?

Evaluating Your Investment Horizon

• Time Commitment: Given the long-term nature of venture capital investments, are you in a position where you will not need to access the invested capital for other purposes for a considerable period?
• Future Financial Needs: Have you considered upcoming financial obligations or goals (e.g., education expenses, purchasing a home, retirement) that may necessitate access to your investment sooner than the typical VC fund term?

Considering Your Role in the Investment

• Active vs. Passive Investment: Are you looking to simply provide capital, or are you interested in actively participating in the decision-making process or mentoring portfolio companies?
• Networking and Learning Opportunities: Are you interested in the networking and educational aspects of being an LP in a VC fund, such as gaining insights into emerging industries or meeting influential players in the startup ecosystem?

Why allocate to Emerging Managers?

Emerging managers in the venture capital asset class refer to those working on Fund I, II, or III. This segment of the asset class has historically delivered some of the highest returns, since they have smaller funds and something to prove. As an example, the $8.5 million Lowercase Capital Fund I is estimated to have returned over 250x.

Below are reasons why backing emerging managers can be particularly advantageous:

Diversification

Emerging manager funds typically invest in between 15 and 30 fast-growth companies. They typically have lower minimums that are similar in size to one direct investment, allowing limited partners to diversify in ways that were previously impossible. Emerging managers also typically have lower fees and overhead than established firms, allowing the manager to put more money to work.

Returns

Emerging managers have the historically highest returns within the venture capital asset class, which is often twice as good as the average. This is a result of the smaller average fund sizes, hands-on approach, drive for success, and noble strategies. Emerging managers also tend to invest in early stages, where the potential for exponential returns is significant.

Access

Emerging managers provide access to market insights and investment opportunities. They often focus on specific market segments in certain geographies, and the regular fund reports show where opportunities and pitfalls are. Emerging managers are often capital-constrained, so they normally send co-investment and follow-on investment opportunities to their LPs, which allows investors to act on the insights. 

Impact

Conviction-based investing in early stages has the highest likelihood of having a large impact. The early investors in Google, Tesla, Space X, OpenAI, and similar success stories have all helped to change the world while also creating fortunes. Backing passionate emerging managers in future growth markets can help foster advancements with far-reaching societal impacts.

Investing in emerging managers not only diversifies an LP’s portfolio but also aligns it with potential high-return investments, drives societal progress through innovation, and unlocks access to untapped markets.

What are some common circumstances to be an LP?

Limited Partners join the venture capital asset class from various backgrounds and for various reasons. Here, we explore some common situations:

Angel Investor – Diversification

Angel investors typically engage in direct investments in startups, yet face limitations on the number of deals they can execute annually. To augment deal flow and achieve diversification, angels allocate a portion of their investment capital to venture funds annually. This strategy not only broadens their investment base but also mitigates risk by spreading exposure across multiple ventures.

Family Office – Long-Term Vision

Family offices manage the wealth and investments of affluent families, focusing on preserving wealth for future generations and supporting targeted initiatives. Investing in thesis-driven, sector-focused funds aligns with their long-term vision, offering returns that contribute to the family’s legacy while advancing causes they are passionate about.

Corporate – Strategy & Returns

Corporations invest in venture capital through their strategic investment arms to gain insight into emerging trends and technologies that could influence their core business. For these entities, emerging managers represent a dual opportunity: they promise attractive financial returns and provide a strategic window into potentially disruptive innovations.

Development Bank – Economic Growth

Development banks are motivated by investments that promise to stimulate economic growth and development. Allocating resources to emerging managers focused on impactful ventures allows these banks to contribute to innovation, job creation, and the strengthening of economic resilience in their focus areas.

Fund of Funds – Strategic Returns

Funds of funds diversify their investments by allocating capital across a portfolio of venture capital funds. They seek out emerging managers for the potential of differentiated returns and the opportunity to benefit from the unique strategies and market insights these managers bring to the table. This approach enhances the overall performance of their investment portfolio through strategic diversification.

How much do I allocate to venture?

Making the decision to invest in venture capital requires self-reflection, individually or as an organization. Once the decision is made, it is important to allocate enough capital to take advantage of the best and most strategic opportunities. 

Traditional conservative allocators recommend 2% to 10%, depending on various factors. A larger allocation, such as 15% to 20%, allows investors to secure the necessary diversification to ensure an average (3x to 5x) or above average return (5x to 10x). It also allows the LP to capitalize on special opportunities that arise, such as follow-on investments and IPO shares.

Here are a few benefits of having a larger capital allocation to venture:

Diversify Across Funds & Firms

Investing across a range of emerging funds and firms allows LPs to mitigate risk by not putting all their eggs in one basket, ensuring exposure to various sectors, geographies, and investment stages. This strategic diversification maximizes the chances of participating in outlier successes, which are often responsible for the majority of returns in venture capital portfolios.

Back Top Portfolio Companies

Investing in emerging managers gives LPs the chance to back top portfolio companies directly, allowing for deeper engagement and potentially higher returns from these investments. This direct support can accelerate the growth of high-potential startups, contributing to the LP’s overall return on investment.

Support Rising Star Managers

Emerging managers often represent the next generation of venture capital talent, bringing fresh strategies and perspectives to the industry. By allocating capital to these rising stars, LPs can participate in their growth journey, benefiting from their success as they become leading figures in venture capital.

Leverage Secondary Liquidity

Investing in venture allows LPs to leverage opportunities for secondary liquidity, such as selling their stakes in funds or companies before the typical exit events. This can provide early returns and enhance liquidity, making the venture allocation more flexible and potentially more lucrative.

Conclusion

Allocating to emerging managers represents a strategic move for LPs to enhance returns, diversify risk, and contribute to the broader economic and societal good. By carefully selecting and backing emerging managers, LPs can tap into the full potential of the venture capital ecosystem, benefiting from the innovation, agility, and unique market access these managers provide.

About The Author