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How does a Venture Capital Fund work?

By 22 November 2022 No Comments

Investment in technology startups, previously reserved for a few Business Angels and specialist investors, is gaining prominence in the portfolios of an increasingly large number and type of investors, from individuals to corporations and institutional investors. Most of this investment is channelled through Venture Capital funds which, given their characteristics, are managed by experienced professionals and supervised by regulatory bodies such as the national stock market commission or, the Comisión Nacional del Mercado de Valores (CNMV) in Spain. To shed light on these vehicles, which are new to many investors, and often capable of providing higher than average uncorrelated returns, I wanted to write this brief article summarising how they work.

Let us start with a practical and almost obvious definition: they are investment vehicles in which one or more investors (“Shareholders” or “Limited Partners”) commit part of their savings to be invested by specialised professional managers (“Managers” or “General Partners”) in unlisted innovative tech companies, with the objective of obtaining a medium/long-term return in line with their strategy.

Some of a fund’s main characteristics are already apparent from this definition:

  • Strategy: Traditionally Venture Capital funds invest moderate amounts in the early stages of these tech companies (which usually have a life of 2-3 years so far) and then “build their position” by acquiring more stakes in subsequent capital increases or buyouts with larger investments in the most promising companies of their diversified portfolio (usually 20-30 companies). This model has inspired a wide variety of strategies, with funds investing in a single sector or technology, or identical amounts in all portfolio companies at very early stages or, even focus only on established startups (>5-10 years old), for example. What the vast majority of strategies have in common is the objective of selling the holdings with strong capital gains, normally in so-called “Exits” (sale of the startup to a larger company), and they can also be sold to other specialised funds at subsequent stages of the company’s life or through a stock market listing. Again, what almost all agree on is that these strong capital gains are derived from strong and rapid value creation through the growth of the invested startups during the period in which the fund is a Partner/Shareholder of the Startup.
  • General Partners (GP): Due to the underlying characteristics of a fund, it is normally required that its management team has experience, not only in identifying opportunities and negotiating investments and divestments, but also in supporting Startup founders during the various facets of creating an innovative and high-risk company. This depends on the Fund’s strategy, of course…
  • Limited Partners (LP): It is these risks, together with the illiquidity associated with Venture Capital Funds, which means that these funds are normally reserved for professional investors, although well-advised retail investors of a certain size are also allowed to participate. The stakes acquired by the Funds in unlisted Startups are often difficult to sell in the short term and the Venture Capital Funds themselves are not traded on any organised market either. However, Funds with strategies specialising in this “secondary market” have flourished in different parts of Europe recently.
  • Commitment: Shareholders or LPs of such Funds do not normally pay out their investment all at once but make a commitment to pay out a total amount in several disbursements (“Capital Calls”) at the request of the GP. In this way, the aim is to maximise the final return of the Fund by matching the inflows of capital with the identified investment opportunities. Similarly, it will seek to return the capital obtained through Exits as soon as possible to LPs, minimising the time of money left idle in the Fund and thus its opportunity cost.

With all this knowledge, we can now better specify how a Fund works: LPs will formalise their commitments during the Fund’s subscription period (1-2 years), during which the Fund is marketed. During the investment period (3-6 years, depending on the strategy) the GP will request the disbursement of the commitments to invest the money in different Startups. Typically, small amounts in many (20-40) at the beginning (20-45% of the fund) and larger amounts in the 5-10 best performing Startups towards the end of the investment period. Finally, during the divestment period (5-7 years after the investment period), the GP will try to sell the acquired shares with the aforementioned strong capital gains and pass them on to the LPs by redeeming the fund units. It is as easy as that. However, a picture (or diagram) is worth a thousand words:

The new era of European Venture Capital

The arrows have been drawn up on the scale of cash flows, as a rough guide. In terms of fees, Venture Capital Funds usually charge an annual management fee on the amount committed during the investment period (1.5 – 2.5% per year) and on the amount actually invested and still managed (i.e. not divested) during the divestment period (0.5%-1.5%). In addition, the GP charge a success fee (10 – 30%, called “Carry”) on capital gains exceeding a minimum return threshold (IRR) for LPs (6 – 10% per annum, or “Hurdle”).

Remember, there are many variations of this model. These Funds aim to achieve annual net returns in excess of 15-20% per year (with a view of 7-10 years, and don’t forget the annoying illiquidity of the asset) for their LPs. To a large extent this has been achieved globally in the last decade, arguably the second most significant decade in the history of Venture Capital in Europe. Moreover, these investments tend to be uncorrelated and therefore provide a great complement that balances out a more traditional investment portfolio. They also encourage business innovation, technological entrepreneurship, value creation and positive impact in society… it is therefore great news that more and more investors are integrating Venture Capital into their portfolios for these many reasons. However, as always, you have to understand what you are investing in. All that glitters is not gold, and any commitment to any asset, Fund or GM must be evaluated with intelligence and caution.

Media sources: Revista Gestores, 8th edition, pages 31-32 (Spanish only!)