Venture Capital: Growing Start-Ups

Venture capital made its mark during the dot-com era about ten years ago.  There were $100 billion of capital committed for the strategy at its height in 2000.  In the early 1990's, they totaled $5-$7 billion annually.  The strategy invests in young, emerging companies.  Because these companies are small and illiquid, banks and normal investors deem them as too risky for their portfolio..  Venture capital funds target high returns, about 30%, for this risk.  Looking at the three, five, ten and twenty year returns, venture capital investments beat the S&P 500 by a significant amount in all the different stages of funds.  There are three types:

• Seed Capital / Early Stage:  Invest in companies with little or no revenues
• Late Stage / Mezzanine Stage:  Invest in companies with revenues
• Balanced:  Mixture of above two

Investors usually have to keep their money in the fund for at least ten years.  As a result, pension funds, endowments, foundations, high net worth individuals and fund of funds are the sources of capital.  In 2008, pensions invested in 50% of all venture capital funds.  This was down from 70% in 1990.

There are five stages in the life cycle of a fund:

• Fund raising:  Take six months to a year to gather capital commitments
• Finding investments:  Take up to five years to conduct due diligence on start-up companies
• Investment of capital:  Invest in different companies
• Monitoring and managing portfolio companies:  After funds have been invested, the venture capital fund's principals grow the company for an IPO or to be sold to another company
• Windup and liquidation:  IPO or sale is closed or company is liquidated

Investing in venture capital takes a lot of patience.  The payoff is ten years into the future.  The investment has a negative return for the first five years as management fees are collected but no profits are created.  This is called the J-curve.