Fifth in a series of weekly posts by myself and Nicholas Lovell of Gamesbrief which answer the fifty questions you should ask before raising venture capital. We expect the series to run for a year after which we will collate the posts into a book. You can find the rationale behind the series here, and the list of questions here. We welcome your comments on any and every aspect of what we are doing.
In the first four posts in this series Nicholas and I have addressed big meaty questions – what is venture capital?, what exactly is an investor? and so on, which has been fun, but has been a bit like building a house before the foundations are down. This week I want to look at those foundations – asking the question ‘where do VCs get their money from?’
The quintessential answer to this question is ‘institutional investors’ or ‘pension funds, insurance companies and endowments’. These are all examples of companies that manage huge pools of money which they invest for maximum risk weighted return. Generally speaking, they have a high level ‘asset allocation’ policy which splits their money across different types of investment with the major groups being equities (i.e. shares traded on public exchanges like NASDAQ or the LSE), fixed income (i.e. government and corporate debt), cash, and ‘alternative assets’ (which includes venture capital). The idea is that if you have a large pool of money under management you should have a mix of low risk-low return, medium risk-medium return and high risk-high return investments and alternative assets/venture capital is one of a small number of high risk-high return options. The allocation to alternative assets is typically 1-5% of the total, and the good news is that modern portfolio theory is pushing fund managers to increase their exposure to alternative assets and so this percentage is slowly rising.
Venture capital is a part of the alternative assets allocation, usually alongside private equity and property. The bad news is that the portion of alternative assets earmarked for venture capital is highly volatile both between fund managers and within individual fund managers over time, and has been trending markedly down over the last couple of years.
Raising a venture capital fund is similar in many ways to raising money for a startup. The VC writes a pitch deck giving the background of the team and explaining how they will make money, and then they call up potential investors to try and get a meeting and then go and pitch. Institutional investors, or Limited Partners (LPs) in industry parlance get pitched all the time and many are poor at returning emails and phone calls. A typical VC fund has at least 10-20 different LPs so you can imagine that the fund raising process is often long and hard. Many prospective VCs fail to raise a fund entirely, and for most others the process takes 1-2 years. It isn’t that bad for everyone though – as with startups there are some hot funds at hot periods in the market who get their fund raising completed in a matter of weeks.
Alan Patricof, one of the founders of Apax and considered by many to be one of the fathers of venture capital, wrote a brilliant post describing the challenges he faced raising his latest fund. He titled the post You Think It’s Hard To Raise Money For A Company? Try Raising It For A VC Firm.
Institutional investors are the most desirable LPs in a VC fund because they typically understand the asset class well and will invest in subsequent funds (assuming good fund performance).
Other investors in VC funds are corporates who want a window into the startup world, often because they like to acquire venture backed companies, and governments who want to stimulate the startup ecosystem in their country, believing that it will lead to job creation and faster economic growth.
Since the credit crunch of 2008 government money has become an increasingly important part of the venture capital landscape as institutional investors have pulled back in a flight from risk.