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Asset Management Best Practice

Venture Capital Funds as an Alternative Class of Investment

by Michael D. McKenzie and Bill Janeway

Executive Summary

  • Venture capital funds became prominent during the boom period, which has distorted investors’ perceptions of this class of asset.

  • Venture funds are extremely risky and illiquid, and the evidence suggests that the average fund does not outperform public equity. Further, their supposed diversification benefits are most likely overstated.

  • The funds that do well are typically large, run by managers who are very experienced, and most of the alpha comes from only a handful of projects that generate large payoffs.

  • The future direction of the venture industry is toward funding large-scale projects, which are typically not a good fit of the venture capital funding model. Thus, potential investors need to be very cautious when considering this type of investment.

An Introduction to Venture Capital

The modern venture capital industry began after the Second World War, when the first venture funds were created to commercialize technology that had been developed during the war.1 A formal trade association was created in 1974 with the formation in the United States of the National Venture Capital Association (NVCA). However, venture capital was still a relatively small and esoteric investment sector, with fewer than 100 firms and less than US$500 million under management.

The mid-1990s, however, saw a remarkable change as an unprecedented volume of funds flowed into the venture capital industry on the back of the boom. This resulted in the industry becoming one of the largest asset categories in the alternative investments industry. Figure 1 presents the total capital under management for US venture funds, and the phenomenal growth rate of 45% in 1998, 58% in 1999, and 54% in 2000 is vividly illustrated. The bursting of the internet bubble, however, put an end to this meteoric rise, and the recent trend has been one of consolidation across the industry. In 2009, there were 794 venture capital firms in existence managing US$179.4 billion across 1,188 funds.

As professional venture capital evolved, it adopted the limited partnership form, which was designed (1) to protect passive sources of funds from losing more than the portion of their committed capital actually drawn down and invested, and (2) to reward the active venture managers with compensation contingent on investment success. The central character in a venture fund is the general partner (GP), who establishes a fund by seeking a financial commitment from various investors, who are referred to as limited partners (LPs). The GP’s compensation takes the form of a management fee, defined as a percentage (typically 2% of committed capital), and a “carried interest” in the profits of the fund (typically 20%). Note that, at this stage, LPs are only required to commit to the fund (typically for a period of 10 years) and no money is actually invested. The year in which the fund is established is referred to as the fund vintage year, and funds typically range in size from as little as US$10 million to more than US$1 billion.

Having established the fund, the GP will then set about identifying suitable investment opportunities. Venture opportunities may be as early in their process of generation as a sole entrepreneur with an idea, or they may be as mature as a well-established organization seeking growth capital. This process of identifying opportunities is the primary role of the GP and, anecdotally, for every 100 opportunities, only 10 will be given serious consideration, and then only one investment will be made.2

Historically, venture capital investing in the United States has been concentrated in the information and communications technology (ICT) and the life sciences/healthcare sectors. Nowadays, venture funds invest in a wide variety of industries: for example, in 2009 the sectors most favored were biotechnology (20% of venture capital investments), software (18%), medical devices and equipment (14%), industrial/energy (13%), media and entertainment (7%), and IT services (6%).3 A fund may choose to specialize in a particular sector, or, alternatively, it may be a general venture fund that has no restrictions on the scope of its investment activities. It is interesting to note that specialist venture funds have been found to outperform general venture funds, which is to be expected given that, unlike traditional fund managers, GPs typically engage in direct oversight of companies in which they invest. Consequently, industrial knowledge and relevant contacts are of paramount importance to successful venture investing.

Venture funds may also invest at various stages in the development of the company. For example, “seed funding” is provided to an entrepreneur to prove a concept (9% of venture capital investments in 2009 were to pure start-ups); “early-stage funding” is provided to companies which have products that are in testing or pilot production (26% of venture capital investments in 2009); “expansion funding” is where working capital is provided to a company, which may or may not be profitable, for the purposes of expansion (31% of investments in 2009); and “later-stage funding,” where capital is provided to a company that has established itself in the market, is typically cash-flow positive (but not necessarily profitable), and is growing at a consistent rate (33% of investments in 2009). As a general rule, the latter stages of investment are lower risk and so have lower expected returns. While some funds may choose to specialize in funding particular stages of financing, others may have no preference.

It is worth noting that, much like other segments of the fund management industry, venture capital funds-of-funds also exist. These funds-of-funds seek to lessen the risk from this type of investment by diversifying across a number of venture capital funds.

Venture capital funds typically have a stipulated “investment period”—usually four to five years—during which full management fees are paid, with these fees generally reducing after the investment period has elapsed. Whenever an investment decision is made, the GP will draw down the needed funds from the capital committed by the LPs. There is no requirement that all of the committed funds be called over the life of the fund—if suitable investments cannot be identified, the GP will not invest. However, a venture capitalist who is unable to find suitable investments is unlikely to raise a subsequent fund.

The return to the LPs from their investment in the venture fund comes in the form of periodic distributions. These distributions are the result of the GP creating liquidity in their investments either through outright sale of the investee company or through a successful initial public offering (IPO). In the former case, the distribution may take the form of either cash or liquid securities (if the acquiring company used such securities as the medium for the transaction). In the latter case, shares of the investee company are typically distributed to the limited partners, although the timing and number of distributions will necessarily reflect the liquidity and performance of the shares.

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Further reading


  • Gompers, Paul, and Josh Lerner. The Venture Capital Cycle. 2nd ed. Cambridge, MA: MIT Press, 2004.
  • Metrick, Andrew. Venture Capital and the Finance of Innovation. Hoboken, NJ: Wiley, 2007.
  • National Venture Capital Association (NVCA). 2010 NVCA Yearbook. Arlington, VA: NVCA, 2010. Online at:
  • Pisano, Gary P. Science Business: The Promise, the Reality, and the Future of Biotech. Cambridge, MA: Harvard Business School Press, 2006.



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