How to invest in a Venture Capital fund?
Investing in a venture capital fund is very different from investing in a hedge fund. An investment in a VC fund is similar to an investment program, and at the end it offers a lot more accessibility and hedging against cycles.Let’s take a look at the differences between the two.
Hedge Fund v. VC Fund
Investing in a hedge fund occurs entirely up front. The investor wires 100 percent of their commitment at signing. They can then access their money at any time that the fund’s rules allow, as long as the liquidity is there when they need it.
Investing in a VC fund happens more gradually over time. The initial investment is typically between 5 to 10 percent of the total commitment. The investor will then continue to fund their commitment regularly over the investment period, which is typically 3 to 5 years. During the investment period, investors will usually reap some cash flow benefits before their last commitment call and can also use leverage or borrowing.
Do your own simulation here. For more details, keep on reading.
The commitment
The opening question for every investment is how much are you willing to invest?
Venture capital funds are closed-end funds: once the subscription period is over, you cannot increase or decrease your commitment. That’s why it’s essential to calibrate the commitment wisely.
Most funds, whether venture capital, private equity, or hedge fund, have a standard minimum of $500k.
Many funds will agree to lower this amount depending on their strategy, the investor’s value-add as a Limited Partner (LP) of the fund, or whether the fund is in high-demand. Funds can also accept syndicates where a group of investors co-invest in a fund, as long as the syndicate meets the minimum funding commitment. The more LPs a fund has, the more complicated it can be to manage. Some funds will lower their minimum commitment to $50k or $100k, but other funds opt to increase their minimum to a few million dollars to simplify management.
But does committing $500k to your favorite VC fund require you to hold $500k in liquid assets in your bank or investments accounts?
The Time Period
As mentioned previously, the magic of committing money to a VC (or PE) is the ability to spread that commitment out over a long period of time. Funds will periodically ask for a percentage of your commitment, usually in quarterly capital calls.
For example, if you have committed $500k to a fund, you will be expected to wire $25k every three months for the next 5 years.
Warning: There are some VC funds that deploy all capital over a shorter time period, perhaps just two or three years max.
Actual Cash Commitment
In addition to the gradual investment process, another exciting aspect of VC fund investing is that the fund will likely sell initial investment positions before your last capital call. What does that mean for you? It means that you will receive some capital back that you can use for future capital calls, diminishing your net exposure.
Most funds typically aim for a max exposure of 80 percent. Therefore, investing $500k will expose you to a maximum of about $400k spread out over several years.
This makes investing in a VC fund a lot more “affordable” than just wiring $500k up front to a hedge fund.
Use of debt in VC
Debt can also be used differently in venture capital general partnership (GP) / limited partnership (LP). Investors can invest in a VC fund using leverage or borrowing if their bank allows it. And funds can also use debt to time capital calls and optimize the internal rate of return (IRR) of LPs.
Some argue that VC funds should avoid this IRR optimization in order to focus on capital deployment instead — but remember, a venture capital fund’s goal is carried interest which pays off above a certain IRR threshold.
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