Category: Limited Partners

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
• Capital Commitments
• Fees
• Carry
• Returns
• Reserves

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. 

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?
• VC Startup Profiles
• Does Venture Capital Work?
• How VCs Add Value
• The VC Strategy

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.

Evolution of average employment before and after initial venture capital funding	Evolution 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.’ 

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: 

• Understanding VCs – Funders Club
• Venture Capital Primer – Data Driven Investor

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 Thesis,  Selecting 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.