What most people do not understand about Venture Capital

Venture Capital (VC). These words are commonly used among entrepreneurs almost on a daily basis. However, not many entrepreneurs know that venture capital investors have to fundraise as well and have to go through the same hard and lengthy times when fundraising for their new funds. This article aims to take you a step closer to the world of VC explaining basic relationships that take place behind the curtains.

 

Relationships

As you might assume from the paragraph above, VC investors have their investors as well which we call Limited Partners or LPs. LPs can basically be companies or individuals that look for return on their capital through a partnership or a so-called fund. Fund is then managed by fund managers who we also call General Partners or GPs. Therefore, fund is the limited partnership formed for the purpose of investing money managed by general partners who are responsible for all management and investment decisions.

LPs can have many forms. From public pension funds, funds of funds, insurance companies, corporations to wealthy families (family offices), or business angels (high net worth individuals). First LPs in venture capital started to appear in the 60s – 70s when first venture funds were formed by tech executives who were seeking to get involved with startups that were from their domain. As soon as other LPs,  professional asset managers such as pension funds or funds of funds, realized that these executives have a good taste and instinct when investing in early stage/ high risk tech companies. The industry put Venture Capital under a newly emerging asset class – Alternative Asset Class. This class also includes other investment areas such as art, hedge funds, or wine which do not represent the traditional classes such as fixed income or real estate.

On the other hand, GPs are responsible for all investment decisions in order to get a return on the fund in a timespan of 7-10 years depending on agreements with their LPs. GPs live off management fees (in many cases disliked by LPs) usually balancing around 2% p.a. Back in the days this number was agreed to cover fund managers’ costs (fund sizes used to be much lower) and then GPs would profit from a 20% carried interest on the overall return.

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Olu Eletu – unsplash.com

How do LPs decide where to invest?

Okay, so what if you were to establish a new VC fund? How would LPs evaluate your potential to manage their money to bring them a nice return/ multiple? According to Oxford University’s professor Tim Jenkinson (2014) VC fund performance persists across funds of the same partnerships. In reality this means that LPs would invest into partnerships (funds) that have already performed well in the past making it harder for newcomers to raise a fund at their first attempt. This nicely reflects a current situation of the taste of more institutional investors to not invest into new VC funds. We can observe this especially in the CEE where majority of VC funds’ LPs come from a private sector or less institutionalized investors such as business angels.

Interesting finding is that this is not the situation in private equity (PE) where fund performance does not persist across the same funds. This could perhaps be explained due to the fact that PE invests in functional business models that actually can generate money and value, thus risk assessment is less complicated as opposed to the VC.

Another supporting argument when looking at the VC asset class is that between years 2002-2009 a total of $205b was invested in VC but only $220b was returned which, as you may assume, is not the best return overall. As a result, LPs started to be more concerned how they build up their portfolios. They either allocate a lower percentage to the VC class and focus on more secure classes or only work with partnerships that performed well in the past. For example the Swedish National Pension Fund (AP) invested only 3% to the alternative assets class which clearly shows that the current institutional LPs’ mood is rather risk averse for the venture capital class.

What are the implications for Slovak VC investors?

Currently, none of the Slovak VC funds have reached the time of returning capital to their LPs. Therefore, it is hard to make any conclusions for the Slovak market yet. Good point is that some of the local investments are showing a potential and managed to fundraise follow up rounds outside of Slovakia. In the long run, it is important to show some early wins (good exits) to attract more interesting LPs to the country which can open up a bit more the Slovak capital market. This would also create a possibility to fundraise larger funds which are able to fill in a later stage funding gap which currently exists in the whole region.


Cover photo: Fabian Blank – unsplash.com

 

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