Venture capital funds are pooled investment funds that manage the money of investors who seek private equity stakes in startups and small- to medium-sized enterprises with strong growth potential. These investments are generally characterized as very high-risk/high-return opportunities.
In the past, venture capital (VC) investments were only accessible to professional venture capitalists, but now accredited investors have a greater ability to take part. Still, VC funds remain largely out of reach to ordinary investors.
Key Takeaways
- High-Growth Investments: Venture capital funds manage pooled investments in high-growth opportunities in startups and other early-stage firms.
- Exclusive to Sophisticated Investors: These funds target high-growth firms that are also quite risky. As a result, they are only available to sophisticated investors who can handle losses, along with illiquidity and long investment horizons.
- Accelerating Innovation: Venture capital funds are used as seed money or “venture capital” by new firms seeking rapid growth, often in high-tech or emerging industries.
- Exit Strategies: Investors in a VC fund earn a return when a portfolio company exits through an IPO, merger, or acquisition.
Understanding Venture Capital Funds
Venture capital (VC) is a type of equity financing that allows entrepreneurial or small companies to raise funding before they have started operations, or begun earning revenues or profits. Venture capital funds are private equity investment vehicles that seek to invest in firms with high-risk/high-return profiles based on the company’s size, assets, and stage of product development.
Substantial Involvement
Venture capital funds differ fundamentally from mutual funds and hedge funds. They focus on a very specific type of early-stage investment. All firms that receive venture capital investments have high-growth potential, are risky, and have a long investment horizon. Venture capital funds take a more active role in their investments by providing guidance and often holding a board seat. They play an active and hands-on role in the management and operations of the companies in their portfolio.
Investment Approach
Venture capital funds have portfolio returns that resemble a barbell approach to investing. Many of these funds make small bets on a wide variety of young startups, believing that at least one will achieve high growth and reward the fund with a comparatively large payout at the end. This strategy mitigates the risk that some investments will fold.
Operating a Venture Capital Fund
Venture capital investments are considered either seed capital, early-stage capital, or expansion-stage financing, depending on the maturity of the business at the time of the investment. However, regardless of the investment stage, all venture capital funds operate in much the same way.
Fundraising and Allocation
Like all pooled investment funds, venture capital funds must raise money from outside investors before making any investments. A prospectus is given to potential investors of the fund, who then commit money to that fund. Fund’s operators call all potential investors who make a commitment, finalizing individual investment amounts.
Seeking High-Growth Opportunities
The venture capital fund then seeks private equity investments that have the potential to generate large positive returns for its investors. This involves reviewing hundreds of business plans in search of high-growth companies. The fund managers make investment decisions based on the mandates of the prospectus and the expectations of the fund’s investors.
Management Fees and Operations
After an investment is made, the fund charges an annual management fee, usually around 2% of assets under management (AUM). Alternatively, some funds may charge fees based on returns earned. The management fees cover the salaries and expenses of the general partner. Large funds may have fees only on invested capital or declining after a specific number of years.
Venture Capital Fund Returns
Investors of a venture capital fund make returns when a portfolio company exits via an IPO or a merger and acquisition. The common fee arrangement is “two and twenty” (“2 and 20”). This means 2% of AUM, and a performance fee of 20% of profits made by the fund above a predefined benchmark. If a profit is made off the exit, the fund keeps a percentage of the profits—typically around 20%—in addition to the management fee.
Though the expected return varies based on industry and risk profile, venture capital funds typically aim for a gross internal rate of return around 30%.
Venture Capital Firms and Funds
Venture capitalists and venture capital firms fund various types of businesses, from dotcom companies to biotech and peer-to-peer finance companies. They generally create a fund, take in money from high-net-worth individuals, companies seeking alternative investments exposure, and other venture funds, and then invest that money into a number of smaller startups, known as the VC fund’s portfolio companies.
Growth Trends and Record Investments
Venture capital funds are raising more money than ever before. According to financial data, the venture capital industry invested a record $136.5 billion in American startups by the end of 2019. The total number of venture capital deals for the year reached nearly 11,000—an all-time high. Notable deals included a $1.3 billion investment round into Epic Games, as well as Instacart’s $871 million Series F. Fund sizes have also increased, with the median fund size at about $82 million, and some funds closing the year with $1 billion in commitments.
Related Terms: Equity financing, Venture capitalists, Investment funds, High-net-worth investors, Seed funding.
