Table of content:
1. THE REASONS FOR INVESTORS TO PUT THEIR MONEY INTO VENTURE CAPITAL
2. THE TYPICAL INVESTORS’ REQUIREMENTS TO INVEST IN A VC FUND
3. THE STANDARD TERMS AND CONDITIONS IN THIS TYPE OF INVESTMENT
1. The reasons for investors to put their money into venture capital
Even though the reasoning to invest money into venture capital (VC) funds may vary according to the type of the investor, according to Bygrave et al. (1999), the main reasons include:
First, investors expect high returns on capital invested into VC funds. While a return of 30% p.a. was common, most investors nowadays are seeking for consistent 15-25% p.a., which is in line with comparing portfolio companies to quoted companies and adding a risk premium. Second, since VC target companies have a low correlation with quoted stocks, investors might aim for diversification effects for their overall portfolio. Third, as VC investments are highly illiquid, they provide a return premium. Moreover, the long-term horizon these investments especially fits investors, such as pension funds which have long-term liabilities. Fourth, beyond financial reasoning, investors might also consider VC due to relatively cheap access to the research and development of young companies, leading towards new ideas and products. However, since focus is shifting towards later-stage financing, this becomes less prevailing. Lastly, since young companies typically realise fast growth, they tend to create significant employment possibilities and thus represent a further investment objective of especially government-related bodies.
A further reason includes that many start-ups remain in the private market for many years, due to the large supply of private capital as well as the scrutiny of public markets (Economist, 2015; Erdogan, Kant, Miller, & Sprague, 2016). This phenomenon results in start-ups realising their high-growth phase while still being private. As a result, investors increasingly turn to the private VC market in order to benefit from these high-growth phases (Bender, Kupor, & Evans, 2015).
Besides, investors in the VC market may aim to escape the high volatility inherent in public markets due to its very liquid nature (Strumpf & Light, 2016).
2. The typical investors’ requirements to invest in a VC fund
As the VC market is growing in size and number of deals, reaching $49bn of total capital invested in Q1 2018 (KPMG, 2018), investors increasingly diversify their investments to obtain higher returns, with a larger range of VC funds to choose from compared to a decade ago. According to Bygrave et al. (1999), the decision depends on six main drivers:
Market analysis - Limited partners (LPs), the investors into VC funds that are structured as a limited partnership, are usually interested in investing in new sectors and industries with rapid growth and development potential. Thus, it is crucial for the general partners (GPs), the managers of the fund, to attract investors by demonstrating that several extraordinary investment opportunities are available. Moreover, the liquidity of the market plays an important role in the decision-making process for the investor, since liquidity is essential to exit investments at fair-market valuations. In fact, a good M&A and trade sales environment are essential, as such an environment provides the basis for most exit strategies.
Investment strategy - Investors are eager to assess the ‘unique selling points in terms of investment stage and sector, deal flow, decision-making, and management approach’ (Bygrave et al., 1999, p. 103) of the fund. First, VCs may be distinguished as specialists or generalists depending on the concentration of their investments in a particular industry or several sectors as well as in early- or late-stage companies. Second, it is important for investors to ensure that the fund is not too dependent on a single deal source or on different deals sourced through other VCs. Third, the managing approach of the investments is very decisive for investors. In fact, the number of investments that the fund is planning to make is linked to the approach applied. As the number of deals increases, a more passive approach is expected, due to a lower share in each portfolio company. In this case, GPs only act as financial ‘watchdogs’ in order to ensure that investments will meet expectations in terms of returns. On the contrary, funds that take a majority stake are likely to apply an active approach, meaning full and direct involvement in operational and strategic decision-making processes through board memberships, for instance.
Management team - The size of the management team and its previous VC experience are further detrimental aspects that investors evaluate before investing in a fund. In fact, there should be a correlation between the size of the fund in terms of assets under management (AUM) and the number of GPs in order to guarantee that the invested money is well-managed. While having a top-notch management team with experience is crucial, some investors might prefer to deal with a team with interdisciplinary and complementary skills in order to exploit trends in the market and to assist the company’s management with expertise in different areas, leading towards a successful strategy. Investors aim at investing their money in funds, in which the team of GPs is able to add value at every step, from the beginning of the investment up to the exit of the portfolio company. Finally, not only an alignment of financial interests between LPs and GPs is crucial, but also a low turnover of senior members within the team is important for gaining and maintaining investors’ confidence.
Track record - There are different criteria to evaluate the past performances of a fund that has a track record, including the historic returns, the amount of money repaid to investors and the spread of returns over a benchmark, if possible. Two common measures of historic return are the IRR (internal rate of return) and the realisation multiple. The most important measure of performance that investors look at is the IRR. Additionally, investors would like to evaluate the composition of the IRR, revealing whether the IRR stems from one extraordinary successful company or of a series of reasonable successes. Many investors prefer a fund with the second type to reduce return risk.
Structure of the fund - Investors are generally eager to obtain the highest possible return from their investments, thus the structure of the fund plays an important role to avoid additional costs related to tax and administrative charges. In terms of tax efficiency, there are two main structures, namely non-transparent and transparent structures. Among others, the first one is realised by having a fund based in a tax haven or in a country offering tax exemption, whereas the transparent structure is mainly represented by limited partnerships. In the former, tax charges only arise when profits are distributed to investors, while in the latter, tax liabilities arise when a disposal occurs independently of whether the profits associated are distributed. The attraction of international investors might represent a reason for funds to keep or abandon the status of limited partnership. For instance, after the Trump tax reform, KKR announced last week to drop the lucrative partnership structure to become a limited corporation and thus paying corporate taxes (Vandevelde and Espinoza, 2018). The reason behind this move lies in the executives’ belief that filing requirements attached to partnership status have deterred institutional investors from purchasing the firm’s shares.
Terms and conditions - Investors’ expectations must be in line with the terms and conditions of the fund. They can be different from fund to fund depending mainly on the investment strategy. The investor is generally in favour of a transparent fee structure and of terms that protect the investor against fraudulent GPs.