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Where do VCs get their money from?

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.

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ScreenShot051 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.

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  • http://azeemazhar.com/ azeemazhar

    Nick

    Thanks for this.

    Patricof is right — it’s a nightmare raising money for a VC firm, in particular for first time firms, as conversations with many entrepreneurial VCs will attest.

    Let’s be clear about the alt allocation – it includes property, timber, art, farmland, private equity. VC ends up being a small subset of privet equity which is a subset of alts. So it ends up being truly a tiny slice. And when you dog down VC to early stage technology (rather than lifesciences or later stage), the pie gets smaller and smaller.

    My sense is that the alternative investments industry is still in its emerging phase. The fact that David Swenson with his timber and the British Rail pension fund in the 80s are still held up as important case studies, highlights the relative opacity around the use of alts by LP investors.

    Europe is clearly ‘behind’ than the US. My data is old, but I remember seeing that European funds overwhelming preferred traditional investments relative to US pension funds; and that they were heavily burnt by the performance of alternatives (in particular VC) during the late 90s and noughties, as they caught the tailend of dot com mania.

    It is a pity because we do know have some battle hardened VC who are now ready to invest based on ten years or more in the business–something we didn’t really have in 2000.

    However, I can’t see — given the dire performance of European VCs — LPs jumping into this market in anything like the numbers they do in the US. So I do think that goverment is going to have to do some keynseian pump-priming in this market — for example, backing funds and agreeing to take the first losses. One model might be for govt LPs to agree to take first losses, in return for not paying carry or management feeds on their funds. Traditional LPs would invest on normal terms, but have a lower downside risk. VCs get funds of the right size to correctly capitalise their portfolio and increase the chance of winners. Next cycle of funds, government steps out of the way.

  • http://www.theequitykicker.com brisbourne

    Hi Azeem – couldn’t agree more. It is up to the current crop of VCs with funds to prove that we can make money in Europe, then the money should start to flow. That will take 5+ years though.

    Meanwhile government assistance can help, and the ECF programme here in the UK is a good example of a scheme based on the right principles – not quite first loss, but taking 1/3 of the profits for 2/3 of the capital makes it much more attractive for other investors. Critically, the other investors still need to believe there will be profit…

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  • http://www.facebook.com/people/Sharky-Rechinas/100003609817993 Sharky Rechinas

    Assuming Europe is on the right cultural path.. Which I do not think. Even US is struggling to go back to the roots. It is not the VC or the govt.. it is about 500 million people or so who need to change. It’s the attidtude. WOuld be interesting to see how many people quit a university in Europe to start a business compared with US. Europe is stil old money driven.

  • Chris Coy

    Hi Nic,

    I have a quick question for you.

    In regards to this part of your article:

    “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.”

    What is the job title of the people at a VC firm who call, pitch, and close potential investors? Is this done by the Partners of the firm, or do VC firms have “sales guys” that only focus on gathering continued funds into their pools of money?

    Thanks!
    Chris

  • http://www.theequitykicker.com brisbourne

    It’s done by partners at the firm. Typically there is one partner with responsibility for fundraising who does less investing than the others. There are some funds that raise from retail investors and that takes a more concerted effort from dedicated sales guys.

  • Chris Coy

    Thanks, brisbourne! Do those sales guys have specific titles? Are they internal or contracted?

  • http://www.theequitykicker.com brisbourne

    Internal, and they are usually just called partners.