What is Venture Capital?

Venture capital is a form of private equity investment into early-stage companies that are not quoted on a stock exchange. Venture capital is distinguished by its active investment model, in which it seeks to deliver operational improvements in its companies, through direct investment and involvement with the companies themselves.

Understanding Venture Capital

It is important to understand that venture capital is an investment class all by itself. By that we mean that it doesn’t correlate with other investment classes such as stocks, bonds, fixed income, commodities, property, cash or other forms of alternative investment. So what can venture capital do for your investment portfolio? Firstly, it provides balance by adding a non-correlating asset class. This means that when all your other investments are volatile and reacting to market conditions, private equity normally remains stable and can offset any losses or enhance any gains in the long run. Secondly, being a long-term investment, venture capital can overcome short-term dips or troughs suffered by shorter-term investments. Finally, venture capital has the ability to provide returns measured in multiples of your investment rather than percentage points. So, although investing directly in privately owned companies has a higher risk profile, the possible returns are also much higher.

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Who Invests?

Pension funds, insurance companies, retirement funds, endowment funds, institutions, family offices, banks and more. Warren Buffet built his fortune investing in private companies and many wealthy investment portfolios allocate a fair portion of their investment to venture capital. So what do all these people know that makes them invest in venture capital? Well lets take a look at public-traded companies, or stocks first to see how they differ.

Stock market investing is much better known than venture capital. But there are important differences in how venture capital governs and controls companies. Since listed companies have so many owners, they can’t all be involved in the running of the business. So the task is given to ‘executives’ who wield significant power, with reference to their disparate owners. This system of executive stewardship severs the concept of management of businesses from their ownership. Even with the best intentions, the result can be a misalignment of interest and sometimes excessive personal rewards despite poor performance.

In venture capital, companies are owned by a small number of professional investors, through a chain of command that directly links value with reward, from company managers through to venture capital firms, and back through to investors. Such clear accountability has many benefits. For instance, it gives comfort to potential investors, and allows companies to pursue long-term goals rather than short-term gains. It also means the underlying investors into firms funds must commit their money for a long time. They can’t trade in and out easily. Such investments are viewed as ‘illiquid’. That means short-term performance is irrelevant. It is irrelevant to the company managers, the private equity firm and the underlying investors, since none of them get remunerated for short-term performance. Unlike in listed companies, where management-stewards receive bonuses based on annual performance, venture capital rewards only come when an unrelated buyer sees greater value in a company than was originally paid for it.

How to Invest?

As venture capital cannot be bought on the stock exchanges you have to invest through a venture capital firm and they come in all shapes and sizes. There are firms that invest in entrepreneurial start-ups that have just the germ of a business idea and there are firms that acquire established companies in old industries, with the aim of reviving their fortunes. Venture capital firms are the talent scouts of company investment. They spend time assessing the potential of companies, to understand their risks and how to mitigate them. Some firms are made up of just a handful of people, often former entrepreneurs themselves. Others are big institutions with a global network of business contacts and know-how. But the idea is the same: to invest in a company and make it more valuable, over a number of years, before finally selling it to a buyer who appreciates that lasting value has been created. These buyers might be large conglomerates and corporations, larger financial investors or stock market investors (through an initial public offering or IPO). If the company is not much more valuable when it is sold – normally it needs to grow 8% or more every year of the investment – the venture capital firm doesn’t get their anticipated reward.

How Much to Invest?

You should look at allocating about 5-10% of your overall investments to venture capital and ensure that you diversify that allocation as much as possible. Do not invest if losing that investment would seriously affect your lifestyle or long-term financial goals. Remember venture capital is a “high risk-high reward” alternative investment and some companies may fail while some may hit a home run. Pension funds and insurance companies have understood for a long while that by diversifying and pooling their money with an experienced venture capital firm, they can achieve attractive long-term gains in their private equity portfolios. As an individual investor you should ensure you follow their time-tested model.

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