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Investing in Venture Capital

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10min read
TL;DR: Investing in venture capital (VC) funds can provide a compelling opportunity for investors who are willing to take on more risk and lock up capital. If you do decide to invest in VC, there are still a number of decisions to make, including whether you want to invest in a solo GP fund or a partnership, whether you agree with the manager’s strategy for sourcing and growing opportunities, and whether you’d like to invest in companies of a specific stage or sector. 

If you have excess cash from previous investments or recently experienced an exit or other form of financial windfall, you may want to start diversifying and investing in venture capital (VC) funds. When investing in VC funds, there may be a few factors to consider, including whether to invest in: 1) a sector-specific or generalist firm; 2) early- vs. late- stage; & 3 ) a solo GP vs. a firm.

What is a VC fund?

VC funds are investment vehicles that pool money from limited partners (LPs) to invest in startups with high growth potential. VC funds and private funds in general are different from public securities in that they call your capital over time and keep your money inaccessible (“locked up”) for longer. The typical period for calling capital is 3-4 years, and the typical life of a fund is ~10 years, but these details can vary depending on the fund. 

Why would you want to invest in a VC fund?

Investing in VC funds gives LPs a few advantages:

  • More exposure - Most companies have a minimum check size for investment. By pooling your money with other investors, you get more exposure to multiple early-stage companies than you would be able to invest in as an individual. Also, more and more companies are staying private for longer, meaning you can’t invest in them on the public markets. In order to get exposure to a company’s rapid period of growth, you often need to invest in the company via a VC fund before the company becomes public. 
  • More access - Presumably, the brand, reputation, and connections of the VC fund manager can get you into deals you wouldn’t get into otherwise. For example, a fund manager might have previous work experience at a major startup like Stripe or Airbnb and be able to source new startups from those networks.
  • Resources and staff - It’s the fulltime job of these fund managers to evaluate companies and to put resources into helping them grow (operating partners on staff, CEOs on call, etc.). These resources should increase the likelihood that the investments pay off.

What are the downsides of investing in VC funds?

Investing in VC funds carries many of the same risks that are inherent in investing in private funds:

  • Locking up capital - VC fund investments are longer-term investments, which means you have to be willing  to lock up your capital for a while. This lock-up period is necessary for fund managers to invest in private companies for the long-term. With this type of asset, you’re sacrificing liquidity for an increased magnitude of possible return. 
  • Giving up control - As a limited partner, you don’t have control over which investments the fund makes. The fund manager has discretion to choose the companies, so you have to trust they will pick good ones.
  • Higher Fees - Most funds will charge a performance fee for generating positive returns (usually 20%) and a management fee for covering fund administration costs (usually 2%), which is higher than most public securities. 
  • Vintage risk - Compared to other assets like real estate, there can be stark difference in the performance of a fund from one year to the next. Market cyclicality brings considerable risk. A fund raised when valuations are high is going to be more challenged to generate returns. The same is true to some extent for other investment vehicles, but even more so for VC funds because private company exits (IPOs and acquisitions) are so strongly tied to public markets and macroeconomic sensitivities. 
  • Binary outcomes - Unlike other alternative investments, VC investments either hit it big or go to zero. This structure makes it an especially risky asset class.

Should I invest in a sector specialist or a generalist fund?

While the evidence shows that sector specialists do not significantly outperform generalists, this question should fundamentally be guided by your investment objectives.

Most financial advisors suggest that an investor maximize their diversification. Therefore, the question is not “Should I invest in generalists versus specialists?” but rather, “Should I invest in many sector specialists, or a few generalist funds?” – in other words, are you outsourcing the diversification/sector allocation to your managers, or are you doing it yourself? The two guide rails here are:

  1. Risks of being too reliant on specialists: (a) Tunnel-vision and local optimization. The best-performing “tech” manager in a 1999 vintage fund might have underperformed the overall market (hence would have been better in just about any generalist fund). (b) Rigidity and overly sector-specific thinking/biases could leave a manager flat-footed in response to sweeping industry changes
  2. Benefits of relying on specialists: You can allocate and weigh sectors you find thematically attractive however you like.
  3. Risks of being too reliant on generalists: Can be subject to strategy “mission creep”, are ‘tourists’ in markets that they don’t know well, and can therefore be taken advantage of by specialists in those areas

Benefits of relying on generalists: You benefit from the ability of the generalist manager to compare returns across asset classes and make an informed decision on allocation 

Should I be investing in early-stage VC funds or late-stage VC companies?

The risk/return balance looks different for an early-stage vs. a late-stage VC investment. In general, VC is predicated on achieving an abnormal distribution of outcomes—that is, finding outperforming managers that can hit an above-average percentage of home runs per fund. This outcome is similar to how the top quartile or decile of VC funds are the most successful, while the median is mediocre. 

Early-stage investors often focus on “shots on goal”—the approach that says “9 out of 10 of my investments will return $0 but the 10th will generate 100x and I’ll therefore 10x my fund”. Therefore, early-stage investment success depends more on choosing based on the skills and track record of the founding team, and maybe looking at some data that suggests the company has a strong product-market-fit and large addressable market. 

In contrast, late-stage investment success becomes more dependent on the likelihood of raising larger rounds at higher valuations (hence less upside in some cases) and is more focused on underwriting progress and execution rather than technology promise and product-market fit. These companies have more available data, meaning investors can see how well the company is performing on metrics like customer retention, engagement, etc.

How this translates into risk profile and returns for LPs

In summary, early-stage funds might have a higher percentage of their companies fail—but the ones that succeed generate a higher return. Late-stage funds expect to have lower losses, but their biggest “wins” generate less upside as a result of having a higher entry-point valuation since they are investing in a company that already has a proven product. (See below for an illustration of how expected loss ratios decline in line with underwritten returns.) Often, which approach—early-stage or late-stage investing—brings higher overall returns depends largely on the skill and selection of the individual manager.

Pitchbook

While there is an early-stage rule of thumb regarding batting average expectations referred to as “1/3, 1/3, 1/3” (i.e. one-third of investments is completely written off, one-third returns principal or a slight gain, and one-third achieves a successful exit), data from PitchBook suggest there is more of a power law distribution, with only one in eight early-stage investments surpassing 5x returns, while more than 70% of deals were written off.

In contrast, late-stage investors seek a more balanced distribution of realized outcomes, e.g. “5 out of 10 investments will return 2x; maybe 1 or 2 go to zero; maybe 1 or 2 end up at 5x or 10x”.

As the table below reflects, the return on successful early-stage investments is higher than late-stage (translating into an annualized outperformance of nearly 20%). However, adjusting for the percentage of companies that fail, this relationship reverses and expected or average returns for early-stage investments are lower than for their late-stage counterparts. In other words, at the aggregate level, the effect of “more early-stage investments fail than later-stage” overwhelms the effect of “early-stage winners generate higher returns than late-stage wins”.

PitchBook Global Data Set as of August 8, 2019 (Note: Median returns across all portfolio companies are not necessary reflective of the performance of any specific investment fund)

How should I compare solo GP funds vs. firms with a team of investors?

Traditional VC firms follow the model of private equity firms, meaning they’re made up of a group of people (rather than a single leader). Being part of a firm gives the advantages of:

  1. Institutional brand/reputation: Partner XYZ moves on from the firm, but customers still have a relationship with his or her successor. “Brand” in this model typically accrues to the firm, which can persist for decades. (This arguably helps solve a principal/agent problem for founders: You know the firm cares about its long term reputation and doesn’t want to fleece you because they’re really in it for the long haul and will have to market themselves to many founders after your deal is done.)
  2. Specialization benefits: At a large firm, you can have an accounting/finance department that focuses on managing the funds’ capital; an IR team that gathers assets and talks to investors; an “acquisitions” team that works on buying companies and even an in-house “operations” team that manages companies after they have been bought. Everyone can focus on what they are best at (rather than relying on one person to do it all) 
  3. Scale benefits: Larger firms might have more potential to develop large alumni networks, manage multiple offices, raise larger amounts of money, and accrue more knowledge/expertise as a result of their wider reach

Disadvantages might include: 

  1. Inertia/bureaucracy - Firms are typically slower to action than individuals, partly by design
  2. Impersonality - They might be viewed as monolithic rather than human, which can influence the deals they complete 
  3. Fragmentation - If improperly managed, firms can give founders the feeling they are being “handed off” among different relationship managers

It’s important to note that competition among VC firms is particularly intense today—there has been a lot of “dry powder” raised to invest money in startups, and startups with great ideas are relatively scarce. This has historically led to a trend where “founders get to pick their investors” and often do so on the basis of personal relationships. However, this trend tends to reverse in bear markets.

This market circumstance sets the stage for the Solo GP Model, which prizes founder relationships, agility, and hands-on leadership as well as an emphasis on personal brand to generate new investment leads. Advantages of being a Solo GP might include:

  1. Personal brand/reputation: In this model, Solo GPs have the opportunity to build a great individual brand and accrue a level of star power and reputation that attracts founders who want to work with him/her. 
  2. Holistic involvement with outsourced specialization: The Solo GP can act as a combined acquisitions/operations team and devote his/her entire focus to helping her portfolio companies succeed—whether by lending her specific expertise in a certain area, or making introductions to others in her network. Advocates of the Solo GP model emphasize that the “operational expertise” angle of the major firms is overstated and outdated; having a cookie-cutter approach to “improving” companies is rarely effective and firms are better off with someone without legacy ties to a certain way of doing business. And with the advent of service providers to handle operational tasks (fund formation, legal, money movement, etc.), the Solo GP has become a viable alternative to a firm model
  3. Focus and alignment benefits: While a Solo GP may not have the scale or reach of a full organization, they tend to be more defined by the success of their portfolio (harder to write off a bad investment or fund as an anomaly). Solo GPs come from a variety of backgrounds but tend to have strong operational experience, which makes them more attractive to founders who might feel like they benefit from having specific company-building expertise and founder empathy.

Bottom Line

In short, if you're thinking of investing in a VC fund, think about it this way:

To read more about how to measure the performance of VC funds, check out our guide here.

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