7 Things LPs Should Know Before Investing in VC Funds:
- The definition of venture capital (VC) has evolved from being artisanal, early-stage financing to a broad spectrum ranging from inception to pre-IPO. Essentially, VC now represents minority investing in private technology and life science companies.
- The VC landscape has become as fragmented as the buyout space, now encompassing small, mid, and large-cap segments. Each of these has distinct risk/return characteristics. Smaller funds offer substantial cash-on-cash upside but come with significant volatility. In contrast, large, reputable brands are increasingly akin to private equity (PE) risk/return. Small funds represent the potential for venture alpha (with associated risk), and large funds offer venture beta. Both can play a role in a diversified portfolio.
-Track records are helpful but should be seen as a guide rather than an absolute indicator. VC funds typically take 5-7 years to settle into their ultimate performance quartile. Therefore, funds launched in 2019 or later are generally too early for a conclusive assessment, and overemphasis on them can lead to false positives or negatives. Similarly, funds older than 6-7 years are challenging to evaluate accurately, as macro and micro variables (such as fund size and team composition) may have changed over time.
-There's considerable debate on platforms like LinkedIn comparing public equity performance to private equity/VC, with some claiming that public equities perform better. Statistically, this is not true, particularly when focusing on above-median performance. While a 9% buy-and-hold return in public markets might yield over 2x in a decade, comparing this directly to private funds is misleading due to differences in drawdown and distribution periods (capital typically drawn over 4-5 years, with distributions starting in years 4-8, depending on strategy). This is why the Public Market Equivalent (PME) was developed as a more accurate comparative tool.
-Managers often hold similar shares of stock at varying valuations. Therefore, it’s essential to inquire about their valuation methodologies and the holding prices of their most significant positions. Managers who aggressively mark down may appear weak compared to benchmarks, while those who haven't look better than they are.
-Using General Partner (GP) commitment as a percentage of the fund to measure motivation can be a weaker signal than expected. It’s more insightful to assess the GP's commitment as a percentage of their personal balance sheet or understand what drives them by spending time with the manager, which will yield a more accurate signal.
- Every decade sees the emergence of new firms that become dominant players (e.g., in the 2000s, it was firms like First Round, A16z, and USV; in the 2010s, Ribbit and Felicis are a couple of examples). Today, discovering and spotting talent is as crucial as having access when aiming for consistent performance.
