Capital flows into venture capital funds from pension funds, university endowments, foundations, finance companies, and high-net-worth individuals. Such investors in venture funds are called limited partners (LPs). The word "limited" asserts their passive role with 'limited' say in a fund's operational activities.
LPs include institutional investors (e.g., pension funds, foundations, endowments, banks and insurance companies) and family offices and high-net-worth individuals (HNWIs). The bulk of capital for venture funds comes from pension funds. While considering an investment in a venture capital fund, each LP assesses the fund based upon:
- Institution's asset allocation strategy: Any investment institution will establish an asset allocation strategy - this is a fancy term of how they invest their capital. Such a strategy includes a set of investment principles and portfolio construction guidelines designed to generate an overall target rate of return for the LPs. Venture capital is treated as a sub-asset class of private equity that falls under "Alternative Assets."
- Investment criteria: The factors that help LPs choose target investments within each of the asset classes. In venture capital, this may translate to fund stage (seed /early, late stage or multi-stage), fund sector (technology, health care) and geography (US, Europe, Japan, Global).
- Investment process: Time lines and steps each LP needs to follow to make an investment decision within each asset class
All LPs aim to minimize risk and aim for a target financial return. For any venture fund, targeting the right mix of LPs is a bit like matchmaking; understanding the array of potential investors and their decision-making process is the first step to raising the fund in an efficient manner.
For example, a first-time fund launched by first-time managers is more likely to raise capital from individuals and family offices and will seldom get the attention of institutional investors. In future posts, we'll look at why this occurs, and understand the allocation strategies of the various LPs. This may help develop a framework for targeting suitable LPs. While pension funds are the largest contributor to VC funds, these are also conservative with respect to VC allocations. Endowments and foundations are comparatively more aggressive and allocate larger portions to VC asset classes. Finance companies function as specialized intermediaries and follow the guidelines established by their sponsors. A fund-of-funds (FoF) is established as an intermediary to allow larger institutional investors to research, access, and manage VC investments. Within all these players, some have a stronger penchant for PE and VC and will often deviate from the aggregate.
For any venture fund, it is prudent to know that your competition does not come necessarily from other venture funds, but from other asset classes that offer a better risk-adjusted return to the LPs.