The Hidden Truth about Venture Capital Funds
In 2019 in the United States there were 1,300 Venture Capital fund managers with USD$445bn in assets under management. This amount has been invested in the development of startups in multiple industries.
Have you ever wondered how a Venture Capital fund works?
Venture Capital is an asset class that gives funding to new and innovative ideas. Startups disrupt industries by developing technology and new business models. Due to the level of risk that these investments have, they cannot be financed by traditional financial institutions like banks, since they usually require between five to ten years to reach maturity. Venture Capital’s investment is illiquid, has the expectation of high financial returns and assumes great risks.
Therefore, those players who want to enjoy the promising returns of VC investment and go in the quest for the next unicorn, must understand the main VC funds characteristics such as structure and operations, cash flows expectations.
1. How a fund is composed
Venture Capital funds are managed by the General Partner (GP), who usually has experience in making investments with a proven track record and a broad business network that allows him to originate investment opportunities. He defines the fund’s investment thesis and raises capital from investors, usually institutional, called Limited Partners. The average lifespan of a Venture Capital fund is ten years (five years of investment plus five years for exits, plus one or two optional years of extension).
The year in which the fund raises the capital will be the date to compare it against other funds of the same vintage.
2. Capital raising
During the capital raising process the fund manager sets a target fund size, which consists of two elements: a minimum amount of capital to be raised to start with the investments (first closing) and a maximum amount of the fund size that cannot be exceeded (hard cap).
First-time or unexperienced fund managers may raise parallel funds domiciled in different jurisdictions and sometimes with slightly different conditions, such as management fees, in the same capital raising process. This allows them to raise more funds and have more capital available to develop their investment thesis.
Usually the fund’s organizational expenses are paid off from the capital raised from Limited Partners.
3. Fund allocation
The Limited Partners make a capital commitment to the fund, amount that will be called in smaller portions from time to time by the General Partner through the investment period of the Fund, as the GP makes investments and coversexpenses. Also, the General Partners have a commitment, could be between 1–5% depending on the fund size.
Investments are usually made from the funds committed during the first five years of the fund’s life. Typically, 50% of the resources will be used to make initial investments in startups and build a portfolio of approximately 20 to 30 companies. The remaining 50% will be invested in follow-up contributions to the first investments (follow-on’s). Considering that 75% of the startups fail, fund managers will not invest additional money in 30–40% of their portfolio startups, will exercise their pro-rata rights in one third of the portfolio companies in order not to dilute their participationand will invest additional money on up to 20–30% of the portfolio companies.
Out of the funds committed, the fund manager will receive an annual management fee of between 1–3% of the capital raised (depending on the size of the fund) to pay salaries, office space and operating expenses.
Venture Capital fund managers are in the business of making multiple funds over time. Generally, they will not be able to go out and raise another fund until they have invested between 75–80% of the current fund, this is to align the interest of all LPs with the GP.
4. J Curve
Investment in Venture Capital reflects the performance of each fund’s portfolio in the form of a J-curve. The first 5 years will be solely to invest with no return on capital. As the startup grows and matures, there will be opportunities to realize the return on investment through an exit on the secondary market, a sale of the company or an initial public offering on the stock exchange.
Most Venture Capital funds invest during the first five years; however, some have more aggressive investment structures investing in three or four years.
Unlike private equity funds that use financial leverage to increase their returns, Venture Capital funds do not use leverage but just invest capital.
5. Waterfall
Venture Capital funds are governed by the Limited Partnership Agreement, which contains the distribution of payments (waterfall).
After the investment period, the VC funds expect to realize a financial return at exit. The distribution of returns is as follows:
- First, the total capital contributed by the Limited Partners will be returned.
- Then, profits are distributed (profit sharing, carry or performance fee) between the Limited Partners, who receive 80%, and the General Partner, who receives 20%.
Venture Capital funds consider the cash-on-cash return as an important measure of performance. In some funds, if this is greater than 2.5 times the amount of paid-in capital by LPs, the carry can rise to 25% for the General Partner.
Unlike Private Equity funds, typically Venture Capital funds do not consider providing a preferred return to Limited Partners, and neither does the catch-up for the GP.
6. Governance
Venture Capital funds have a pre-established investment process, have an investment committee that rejects or approves investment opportunities, and sometimes an advisory board conformed by Limited Partners.
General Partners are required to provide quarterly and annual performance information on the investment portfolio and the fund to the Limited Partners in order to update them on their investment.
Venture Capital funds are for the long run and act as portfolio managers. Either if you are an entrepreneur, an LP or a first time GP, you better know how VC funds work.
“The biggest secret in Venture Capital is that the best investment in a successful fund equals or outperforms the entire rest of the fund combined”. Peter Thiel, Entrepreneur and Venture Capitalist.
Hector Shibata. Director of Investments & Portfolio at ACV a global Corporate Venture Capital (CVC) fund and Adjunct Professor for Entrepreneurial Finance.
Ana Maury Aguilar. Investment analyst at ACV.
ACV is an international Corporate Venture Capital (CVC) fund investing globally in Startups & VC funds.
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