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Venture Capital Fund Mechanics

Those seeking to become limited partners in a venture capital fund may benefit from understanding the basic mechanics of venture capital, before going on to more advanced notions. This includes fund topics such as fees, commitments, carry, returns and structures. 

Important to note that these mechanics are often dependent on many factors such as region as well as the individual fund and what is outlined in the Limited Partnership Agreement.

Table of Contents

Structure

Venture capital funds are often structured as closed-end entities. This means that the fund has a predetermined period upon which it will dissolve and returns will be distributed to the LPs. Most VC fund periods are for 10 years as startups take time to mature and yield returns via exits / acquisitions or IPO’s. Usually, there are two years of extensions without fees. In sectors such as DeepTech, the fund duration maybe longer, as these sets of companies take much longer to mature

On the other hand, evergreen (open) fund structures have no termination date and are more liquid. However, they are very difficult to manage for small to medium funds and are usually adopted by large global multistage firms. 

Returns in both structures will be distributed to investors at the discretion of the fund manager and provided a portfolio company has yielded sufficient returns. For closed-end structures, this can also happen before the termination date of the fund. In open-end funds, the manager may choose to hold on to the asset even post IPO. 

Capital Commitments

Usually, limited partners will commit a certain amount of capital to the fund. However, important to note that the entire sum is not invested initially. Typically, a fund manager will ‘call capital’ several times throughout the fund’s lifetime; usually, this is between 20%-30%. You may also see that in some funds no single LP makes up more than 10% of the fund.

With this capital, managers will finance a portfolio of startups in exchange for equity. Consequently, though an LP is obligated to meet capital calls upon request by the fund manager, they will still be in possession of the capital up until each call. 

Partners of the fund are often expected to commit capital during calls as well. This ensures that there is an alignment of incentives for those managing the fund. Depending on the firm, this commitment on the part of the partners is around 1% of the fund.

Fees

VC funds will charge fees to run the management company. This capital is used to pay the salaries of the fund managers, the staff as well as other operational costs such as rent. 

Typically, this amount is between 1-3% per year depending on the fee structure. Over the life of the fund fees typically add up to 10-20%. At times, this number can be capped, especially in larger funds that manage vast sums of capital. 

Fees may be structured as a flat 2% per year for the duration of the fund, or, as a cascading structure that starts off higher but averages out to 2% over the fund’s lifetime.

The cascading structure is more appealing to new fund managers as the fund’s need for capital is not evenly distributed. Usually, new funds need more cash at the beginning to set up and prefer the cascading structure. Also, fund managers will construct their portfolio at the start of the fund and mostly make follow on investments in the latter half of the fund’s life, meaning they will not need as much money towards the end of the fund’s lifetime.

Carry

Limited Partners of the fund are usually entitled to their investment into the fund, after which the profits are split between the LPs and the GPs. Profit here is defined as any income after the initial fund is returned.

This split is usually a predetermined ratio of the fund’s profits, again, this is outlined in the ‘Limited Partnership Agreement’ which is signed by all parties. Typically this split is 80:20, between the investor and the fund manager, however is subject to change and negotiation depending on the track record of the manager.

Within the fund, you may observe a hierarchical structure upon which the Managing Partners sit at the top. Each partner’s level of carry and capital contributions depends on their seniority, where more senior partners are entitled to more carry but typically have to contribute more capital.

Returns

Venture capital is considered a very risky asset class as over 80% of startups fail. 3X returns are typically seen as the bar for funds, however, less than 10% of VC firms return this much capital. The funds that do outperform the market capture outsized returns. We dive deeper into this in our ‘Why invest in Venture Capital?’ article.

Though VC has outperformed every other asset class in the last 3 years, it is clear that the Pareto Principle is at work within VC funds. Limited Partners should be aware of the expected levels of returns from VC, as it differs across stage and sector of focus. It should be noted that new fund managers tend to outperform existing managers and small funds also tend to outperform very large funds.

Returns from VC funds are typically seen in 8 – 12 years. After raising a fund, managers will deploy some given percentage to construct the portfolio in 2-4 years. They will then keep the remainder of the funds capital in reserve, in order to back the winners in the portfolio. Typically VC funds will raise two funds before investors can get a good picture of how the initial portfolio is doing and so the third fund is crucial for new fund managers.

Reserves

As mentioned, VCs will keep a considerable amount of capital to back the fund’s winners. This is because of the inherent power law in VC where a majority of the returns are derived from a handful of companies. 

VCs want to keep capital in reserve in order to back their winners and keep the same percentage in ownership. These winners become abundantly clear as the fund matures and VCs usually have pro rata rights to invest in subsequent rounds. Interestingly, there is some debate among VCs about whether it is prudent to invest in new companies, rather than backing companies in flat and down rounds. 

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The Venture Industry Explained

The venture capital asset class makes up a tiny fraction of the total private investment in the economy. Still, it is un-proportionally responsible for a majority of the innovation and new job creation we see today. In our series exploring the intricacies of venture capital, we demystify the asset class and give a comprehensive breakdown into everything you need to know.

What is Venture Capital?

Venture capital is an asset class aimed explicitly at the sub-sect of private equity, which focuses on startups. To some companies, venture capital is a necessity as most financial institutions and lenders are inadequate in providing funding to startups due to their high-risk profile and failure rate.

Consequently, venture capitalists specialize in analyzing and investing in these technology-backed companies, in exchange for equity. These startups, to some degree, have comparable characteristics and approaches to disrupting traditional industries.

VC Startup Profiles

Venture capitalists back early-stage companies that utilize new technologies and business models. Since most of these companies run at a loss in the early stages, they are deemed undesirable and risky for most lenders. VC-backed companies dominate the news and garner a lot of attention, however, for every success story, there are countless failed companies in the same space. It is the role of venture capitalists to find these companies and nurture them for growth. 

It is costly to develop said technologies and software; however, once created, they are very scalable. Once a product is developed and gaining traction (product-market fit), the race for ‘blitz-scaling‘ and rapid expansion requires significant capital. 

These startups typically enter global winner-take-all markets and to gain a lead on their competitors, usually spend vast sums of money. Tech companies typically prefer growth over profitability in the short term, in an attempt to become market leaders. Therefore, in the venture capital model, investors are betting on the future value the company will attain once it becomes a market leader as it utilizes its competitive advantages. 

Does Venture Capital Work?

Most traditional businesses do not need venture capital funding, and the route of achieving steady growth with a positive balance sheet is the best strategy for these firms. So you might ask yourself, “does venture capital work?” and the short answer is yes, with a select subsect of tech-enabled companies.

There have been many studies aimed at answering this particular question. Ufuk Akcigit, a Professor of Economics at the University of Chicago, claims in a podcast with Freakonomics Radio that there is substantial evidence that shows VC-backed companies do indeed perform better. However, he points out the question, “would those companies have succeeded without venture capital ?”. 

In a recent paper named ‘Synergising Ventures’ where Ufuk is a co-author, the team of economists compares two sets of similar companies in an effort to answer this question. The research shows that VC-backed companies, when compared to alike businesses, do indeed perform better on multiple vectors, one being high-quality patent production, where the quality is measured by the citations it receives and the second being relative employment those companies produce.

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Evolution of average employment before and after initial venture capital fundingEvolution of average quality-adjusted patent stock before and after initial venture capital funding

Source: Synergising Ventures

How VCs Add Value

Venture capitalists, at least the best ones, add value to portfolio companies after investing in them. Most founders seek more than just capital from VCs and so investors which have a unique post-investment value add are at times the crux for the success of a startup. For founders, especially new ones, this is a crucial factor when deciding who to choose as an investor. 

The best venture capitalists are experts in a particular niche. This can be domain expertise, growth hacking, product development, operations, and so on. They will also have a vast network of people who can also provide value to portfolio companies. For example, this may be other investors or experts in hiring, marketing, and PR. Additional help to founders is what separates many venture capitalists and is a significant contributing factor for the success of portfolio companies.

The VC Strategy

In venture capital, fund managers will create a portfolio of companies around their thesis. Some funds are multistage generalist, while others are focused entirely on a particular stage with a strict focus on a domain

Portfolios are created to manage risk as venture capital is a highly risky asset class, which also has the potential to yield high returns. Since startups take time to mature, returns are typically seen far in the future. VC funds returns are not evenly distributed, and a few companies produce the majority of the returns; therefore, VC follows what is known as the ‘power law.’ 

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Source: The Unique Philosophy of Venture Capital – Michael Tan

A large percentage of the startups in the portfolio will go to 0, while several will return their initial investments or provide a moderate level of IRR. However, some of these companies will achieve outsized profits and will go on to return the entire fund and possibly more.

For this reason, venture capitalists only invest in startups and companies that can scale and return the entire fund or more. Often, VCs will look at the total addressable market (TAM) and work backward to see if said company has the potential to do so. The venture capitalists must categorically think that any of the companies within their portfolio can become a leader in that market for the foreseeable future.

Additional Resources: 

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Being a Limited Partner, with DocuSign’s Court Lorenzini

Watch the interview with Court Lorenzini, co-founder and former CEO of DocuSign, and LP in 15 funds with over 60 additional investments in early-stage companies across the world.

On the VC Asset Class

VC typically performs equally or better than other less risky assets

If you look at the asset class of private equity and sub-segment that down into startups you are looking across the ecosystem and saying “Where is this performing relative to other assets in my portfolio?”.

I’ve got many options to put capital to work and as an asset class even though this one is riskier it typically performs equally or better than what others would classify as less risky. To me, it’s a combination of asset allocation performance but also when you find managers who are outperforming they are generally radically outperforming. So you tend to pile up on those and that’s fun to watch and help those managers.

On VC Asset Allocation

I don’t have a specific number and I’m not aiming for a target amount with respect to my overall portfolio

This for me is a community with which I’m very comfortable. So as an asset class, I walk into this with my eyes wide open and I understand the risks, metrics and value. That being said, my portfolio to some might feel over-allocated to VC. I’ve probably got around 25% allocation in this class. 

But I’m not looking at the percentage. If I have a huge win in the portfolio I’m not really going to slow down my allocation to this asset class. I’m constantly looking at where my currently illiquid assets are and I have a bet that they’re going to become liquid at some point, or some portion of them will. So I’m not strict about that, to be honest.

On Evaluating New Fund Managers

I get very worried if I see a first-time manager saying they’re going to raise a giant sum of money

How much money I put into new fund managers really depends on many factors. I usually invest anywhere between $300k – $500k the first time out, depending on the extent of the manager’s track record. This gives me a feel of what this person will be like. Over the long term, I can put in around seven figures.

In evaluating a manager in the early stage, I firstly look at their deal warehouse, if they have any. I look at what those companies look like and talk with a few founders to see what really attracted them to this particular manager. I want to see if they have access to deal-flow that I want but am currently not exposed to. 

Importantly, I also look at the size of the fund they’re planning to raise and how they plan to allocate that. If a new fund manager says they’re raising a very large sum of money, that’s usually a red flag for me. To both raise and deploy large sums of capital is not a great thing for new managers. I also look at the size of the partnership, relative to the amount of capital being raised. I want to determine how many firms they can actually invest in or what they plan to invest in. Additionally, I look at how much time they’re willing to spend on each investment.

On Follow Up Investments

At this point, I can assess the fund’s performance

I have a couple of managers in the portfolio that have come back for second funds. I will say that in most cases I have re-upped with a bigger number in the second fund as generationally the funds get larger

I will put a certain amount of capital to work in the first fund and then wait to see how that performs. And then when they’re back in the fundraising mode I assess again and ask some questions. How do they pick? What are those companies looking like right now? Have they had any exits? Have they had any follow on investments? What do those look like? What are the things that they’re doing that make them stand out amongst fund managers?

On Sector Focus

I stick to markets in my experience base which is B2B Enterprise Software

One thing I check is if we are sector-aligned. I tend to know the sectors that I’m most comfortable in and can make a reasonable assessment. I tend to stick to my knitting in the sense that I’ll invest with folks that are going to build funds in areas that I probably have a deeper level of understanding.  

For example, there are some terrific pickers in the healthcare space and they’re successful as hell out there. However, because it’s not in my experience base it’s hard for me to initially judge whether they’re good or not. And so I tend to remain on the sidelines. 

There are lots of LPs who come from that space who are better suited. Flip that around and say enterprise software and consumer-facing companies, I know that space quite well. I’m very comfortable there and even climate, greentech as well as fintech, I can get comfortable with. So there’s a lot of spaces I’m okay with and there are a few sectors that I know I need to probably stay away from.

On Terms and Economics

Co-investment rights are very important to me

I have one other strong request that I make of all fund managers. I want to support the fund I want to be there and put a big chunk of money to work. But I also am very specific that when I make that investment, I also want co-investment rights when those opportunities present themselves. 

If the fund is looking for other people to jump in and add more money to the company it’s my expectation that I’m acting more like another venture investor than an adjunct to the fund in that context. So in such situations, I want no fees or carry on those co-investments as I’m in the fund already

On Being an LP

When they call I respond

I’m very active in the funds I’m an LP in. Again, part of my ethos is to operate in a way that not only provides capital but also my layers of experience to portfolio companies in the moments they need it. I’m always offering myself up to all the funds that I participate in as a resource and I’m extremely active in those funds.

As an LP, I want to economically grow the basket and put capital out where the entrepreneurs are, as opposed to pushing them into 5-10 economic centers. I think that model is tapped out. So as a significant backer of VC Lab, it’s important to me to back fund managers that are focused on undercapitalized and underserved markets. This is really important, however, these businesses must make economic sense. The deal still has to pencil out as that cannot be the only vector you judge.

One of our prime theses for myself and my wife is backing people from diverse backgrounds. We have a family foundation that my wife runs and we also have a for-profit entity that I run. In both of those, we look to deploy more than our fair share of capital to minorities and women investors, who themselves are investing in that sphere.

In Part 2 Court looks at the world of Venture Capital through the lens of an LP and shares his insights and advice for new fund managers.

Click here to continue reading.

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Why Invest In Venture Capital?

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.

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The Basics of VC Funds

The venture capital industry is the driving force behind technology companies that are changing the world. Many new investors are now rushing into the asset class to get exposure to the companies producing unprecedented levels of growth and returns. Find out what a venture capital fund is and how it really works. 

The Venture Capital Fund

A Venture Capital fund is a pooled investment fund by which the Venture Firm allocates capital to startups in exchange for equity. Typically, VCs are focused on technology startups with characteristics that enable them to scale and grow quickly. These companies are regarded as highly risky, however have the chance delivering high returns. Note that a VC firm may have more than one fund at any given time with varying areas of focus and strategy.

The Stakeholders

It’s important to note the distinction between a venture fund and a venture firm. While a venture fund is an entity upon which investments are made into startups, the venture firm is the overarching entity that encapsulates all of the funds and management company.

  1. Limited Partner

Limited Partners (LPs), are the investors in a venture fund and contribute most of the capital. They invest directly into the fund and receive earnings once / if the fund produces returns. Typically, once returns are actualized, LPs receive their entire investment into the fund after which the remainder of the profits is split 80:20 between the LPs and GPs respectively, depending on the fund.

LPs are often endowments, pension funds, institutional investors, family offices and HNWIs.

  1. Managing Partners

Managing Partners are in charge of the operations of the Venture Firm, and the particular fund’s long-term strategy. They make investment decisions and distribute the capital they’ve raised from LPs and typically put up 1-2% of the fund’s capital.

Fund managers are often VCs / investors with experience, entrepreneurs and domain experts.

To learn more on the other roles in venture capital click here.

The Structure

To invest in a startup in venture capital, several entities must be formed. The venture firm is a construct of all of these entities combined. These structures can become very complex, below is a representation of the most popular structure.

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Source: VCpreneur, Ahmad Takatkah
  1. The Limited Partnership

Investors into the fund will put money into a limited partnership entity, which will then distribute capital to portfolio companies. This entity is where the capital is held and distributed.  

  1. General Partnership

The General Partnership is made up of the partners in the fund and this entity receives carried interest.

  1. Management Company

The management company is used to manage the fund’s expenses such as salaries and rent. Managing Partners are owners of the management company and thus control the venture firm. 

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How to Invest in Venture Capital

1. Identify a fund with a compelling thesis

A thesis is a unique vision for the future of a market, technology or business model with a clear strategy to capture future value in the market. Investors and limited partners in venture capital have the option to invest in different funds with varying strategies

Research what type of technology companies you would like to have in your portfolio and listen to the views of fund managers with different areas of focus. For example, some VC funds exclusively invest in a certain sector at a certain stage of development, in certain geographies while others are global multistage generalists. 

The thesis and type of company also determine the risk, duration of the fund and other factors. For example, deep-tech companies are typically riskier and take longer to develop than most companies, but may result in above-average returns in some cases. You should predetermine the fund strategy that best fits you and what sectors you want exposure to.

Additional Resources: VC Investment ThesisSelecting a VC Firm Focus, Determining VC Fund Size 

2. Diligence the manager

Venture capital is often compared to marriage. However, while the average marriage in the US is 8 years, the most common closed-end fund duration is 10 years, so relationships between fund managers and the limited partners (investors in the fund) are really important. Speak with many managers and get a sense of their theses and the markets they’re focused on. 

When speaking with managers, find out the ticket and fund size. Larger funds can make more investments and have a diversified portfolio, though the ticket sizes are typically higher. 

You should dive deeper into the manager’s thesis and strategy and find out if you are both aligned. It’s also important to get a grasp on how the manager will get quality deal-flow and access to high-grade companies. Conducting diligence on this matter is prudent. Find out if entrepreneurs actively seek out the manager and if they have an amazing network of entrepreneurs and experts.

A manager’s track record and past performance are some of the best indicators of future performance in VC. The power law applies in venture capital funding too, and some exceptional managers vastly outperform the rest. For example, the average returns for VC over the last 10 years are 13.2%, however, in that time some fund managers achieve a considerably much higher IRR.

3. Review and understand the fund documents

Once you’ve found a fund manager with a compelling thesis, it is recommended you review the economic terms in the fund’s Limited Partnership Agreement (LPA) or equivalent governance document. The LPA sets forth the terms and conditions of the fund and serves as the operating manual for the venture fund and delineates your rights as an investor. Terms such as carried interest, fund duration, capital commitments, management fees …etc will be clearly defined here

For example, the Management Fee can be structured as a flat 2% fee per year or cascading down from 3.5% per year to average out to 2% overall. The Maximum Portfolio Investment Percentage will dictate how much can be invested into a single company as a percentage of the fund. Other terms such as GP Commitment Percentage will set forth how much capital the General Partners will put into the fund. LPs typically ask this to be set at 1%.

Brush up on all of these terms before subscribing to a fund. You can read more in VC Lab’s very own Cornerstone LPA which has simplified the legal jargon and complexity for fund managers and investors. 
Additional Resources: How to use the Cornerstone LPA

4. Sign the fund documents

The fund manager will communicate with you that they are planning to close the fundraising. You should be prepared to finalise the closing package, which typically depends on the firm, but will include documents such as the ‘accredited investor form’. If you are unsure of the terms at any point then ask a GP for further clarification

Once you are happy with the terms and conditions of the fund, consider using a fund lawyer when signing the agreement. Be prepared to submit said package in a timely manner, which is about a week. Beware that failure to produce said documents in an efficient manner may result in you missing the closing, especially if the fund is oversubscribed. 

Upon signing the documents you may not receive immediate confirmation. This is because the fund manager needs time to gather all the signatures from the LPs and finalize the closing.

Note that you are committing capital to the fund by signing this agreement and should have enough liquid capital on hand to remit funds when the fund calls capital from you. 

5. Contribute capital

To start investing in startups, GPs will typically ‘call capital’ from investors. Capital calls are legally binding requests for you to wire capital that has previously been committed to the fund

Capital calls usually do not happen immediately after signing the documents, but after the fund is ready to invest in startups. Typically, fund managers will not call your entire capital commitment at once but initially will call somewhere between 25% – 40% over a period of time depending on the fund.


They will use these funds to invest in companies during the fund’s investment period. Fund managers will then back the winners in the portfolio over time and call capital from yourself and other LPs when necessary.

6. Receive returns as portfolio exits occur

You will receive your portion of the returns as the companies in the portfolio mature and start exiting and being acquired. This can take longer than the lifetime of the fund, especially if the fund has considerably large winners. At times, the fund may be extended for a pre-defined period of time outlined in the LPA, to look for secondary sale opportunities and to maximise the returns on the assets held by the fund.

Some companies in the portfolio will break even and return modest earnings, though typically most of the returns will come from a few companies while a majority will fail. So it is important to note that your earnings will not be equally distributed.