In part 1 of this series, we examined what is venture capital and why people invest in it. In this post, I’ll explain how venture capital (VC) funds are structured, what are the target returns, costs, and holding periods.
Like other managed asset classes, venture capital funds pool money together from third-party investors. These investors – called Limited Partners (LPs) – are usually institutions with high capital reserves. As illustrated below they tend to be pension funds, university endowments, corporate treasuries, etc. seeking to maximize portfolio performance by diversifying their investments. With the demonstrated high return potential of venture capital and the growing comfort with VC investing, LPs have recently expanded to include family offices, high net-worth individuals, and angel investors. In my next post, I’ll cover the current and future profile of venture investors.
How is a VC fund structured?
A venture capital company creates a fund around an investment thesis. This investment thesis is built on perceived high-growth areas where traditional capital is unwilling to invest at R&D or early growth stages of a company. These are the riskiest times when companies don’t have revenues, customers, or tangible assets.
The venture capital company defines why certain markets are ripe for high-growth and then builds an investing strategy behind that thesis. The investing strategy outlines the number of investments to be made, the amount per investment, and the holding periods needed to reach the fund’s target rate of return. Most funds deploy capital in the first three years and the capital is locked in for a period of seven to ten years. Like other asset classes with a holding period (i.e. bonds), investors are unable to access the capital until the fund reaches its maturity. This makes VC investing an illiquid asset; one that you can not cash out of or trade on a secondary market to another buyer.
Unlike bonds, which are usually the lowest risk investment vehicles, VC investing has a high-risk profile. There is a fair probability that investors will not see a return of any kind thereby risking all the capital invested.
To offset the inherent risks of investing in VC (illiquidity, high probability of unreturned capital, etc.) the target rates of return are purposely set to be high. Usually, targeted rates of return are between 15% to 20% per year across the fund’s life. The allure of VC though is that it could have much greater returns – even higher than 100% return year on year. Imagine turning a $10M fund into a few billion dollars. Few asset classes have such massive growth potential. This is a big reason why sophisticated institutional investors allocate 0.5% to 2% of their capital to VC. When the funds are big like US state pension funds, that allocation equals hundreds of millions to billions of dollars invested per pension fund.
How does the funding and liquidation work?
When a VC is fundraising, they receive capital commitments from LPs for the fund. Essentially, they’ve agreed to the fund’s investment thesis, strategy, commercial terms, and management team. The LP’s commitment to the fund is for a portion of the total fund amount (i.e. $10M commitment on a $100M fund) for the duration of the fund (usually 10 years).
The Limited Partners own 100% of the fund. The VC manages the fund via their managing entity and its General Partners (GPs).
Upon closing their fundraising and during the investment period (normally the first 3 years), the GPs make capital calls to invest in qualified companies they sourced. LPs are required to meet their capital commitments, including the management fees to retain the right to disbursements.
After investments are made, fund managers work with their portfolio companies to grow their enterprise value. This is done by developing strategy, identifying partnerships and customers, recruiting, etc. Additionally, VCs ensure their portfolio companies perform well and manage their finances responsibly by serving on a board of directors or an advisory board. This too is different than other asset class managers like mutual fund and hedge fund managers who are passive investors.
After the investment period, the fund has a holding period where invested funds await a liquidity event for disbursements to investors. The liquidity event or “exit” comes in the form of an IPO or acquisition of that portfolio company. Unlike private equity, VC-backed companies rarely return cash to investors via dividends because free flow cash is reinvested in the business to rapidly grow its enterprise value. Upon exit, the GPs distribute funds back to investors. In the case of a company’s IPO, after the standard lock-up periods, the GPs usually are responsible for identifying the right market timing to return funds.
What is the fee structure?
Like some hedge funds, venture capital funds charge on a “2 and 20” model. A 2% annual management fee for the life of the fund and a 20% carried interest “carry” for the success of the fund. The management fee covers all the personnel costs involved in sourcing, evaluating, governing, and growing these investments. It also covers the back office costs (legal, audit, etc.) involved in creating and managing all the investments.
The carried interest is a profit share with LPs. After a fund returns the capital invested, the LPs receive 80% of the profits and the VC receives 20% of the profits.
- Assume a VC raises $100M fund that earns $700M after ten years.
- The 2% management fee would be $20M. ($100M x 2% x 10 years).
- After all investment capital and 80% of profits are returned to LPs, the carried interest for GPs is $120M. ($700M returned – $100M invested x 20% carry)
- Investors will have earned $580M after accounting for fees.
- That’s a 34% IRR assuming even capital calls the first 3 years, $2M management fees all 10 years, and even capital disbursements in the final 3 years.
The venture capital industry was created to provide investors with an outsized return on investment. Venture capitalists have backed some of the largest established technology companies including four of the top 5 publicly listed companies Alphabet/ Google, Apple, Microsoft, and Amazon.
VCs identify and invest in trends as early as 7-10 years before widespread market adoption. VC funds exist to diversify risk by spreading investments across several portfolio companies.
How do I invest?
In my next post, I cover the various ways investors of all sizes get access to VC investments.
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