UNDERSTANDING VENTURE CAPITAL
© Tien Nguyen
Rekindled in the 1950s in the California wilderness that nurtured the daring and the American dream, the venture capital industry is a powerful driver of the rapid development of not only modern business but also of technology and innovation around the world. Today’s tech companies turn to venture capital funds to share ideas, find connections, financial backing, and strategic perspectives.
Understanding the historical origins, investment motivations, profit expectations and day-to-day operations of Venture Capital VC (Venture Capital VC) management companies is a key factor in helping (1) innovators have an appropriate fundraising strategy, (2) traditional investors have more new investment approaches and (3) policymakers have an effective way to attract investment in the context of closed technology. role in promoting the economy. The series of articles on UNDERSTANDING VC FUND aims to provide official perspectives on the venture capital industry and analyze related factors, serving the three groups mentioned above.
In each part of the world, depending on the level of economic development, the quality of enterprises and government policies, VCs will operate in a number of different ways and serve different audiences. Essentially, however, a venture fund will (1) raise capital from other institutions to (2) invest in the equity of (3) small and medium-sized enterprises (SMEs) or Startups that have a high growth rate.
Part 1: Capital of VC
VC management companies (venture investment firms) do not use all their own money to invest, but they are professional capital managers, using the capital of many other organizations to make profitable investments.
Partners investing in VCs are usually organizations such as:
Pension Fund: Usually a state fund and manages employees’ pensions. These funds are familiar partners of VCs, especially in the Euro area due to their ability to unify several technology and sustainable development goals. Not many Southeast Asian VCs have access to this fund. AP4 and AP6 of the Swedish government are among the funds that coordinate the most capital into VCs today with about 11% to 15% of total assets under management (Asset Under Management AUM).
In our view, to promote innovation and effective investment, countries in the region need to expand the possibility of cooperation between pension funds and VCs. This needs thorough research, relevant human resource training and institutionalization to increase the efficiency of this capital management.
University Endowment: University endowments contribute to the development of fundamental scientific research. These funds, along with a wealth of knowledge from the university, are the basis for increasing the ability to connect and solve problems of the companies in the VC portfolio. In 2019, UE’s investment in VCs was rated as the most effective, bringing an average return of 13.4% per year, according to The National Association of College and University Business Officers – 2019 NACUBO-TIAA Study of Endowments.
The majority of universities in the region focus their cash flow on optimizing infrastructure and research activities, we do not have enough long-standing and sustainable capital flows like Western economies to increase the rate. contribution rate to the UE from which to navigate into the VCs. The most successful case of this type of fund is the National University of Singapore Endowment, which invests in the style of Yale University: long-term, diversified assets, diversified foreign currency sources and global investment audience. This fund also only spends 20% for equity investments, a very small part of which is VC.
Banks: As a risk-sensitive group, banks have maintained a very small amount of their capital invested in VC funds throughout the industry’s history. Currently, some banks like Goldman Sachs invest directly in startups such as the recent case of leading Series C $ 81 million in fintech startup Amount based in Chicago, IL. Banks are interested in FinTech startups because of the possibility of strategic cooperation rather than direct profits. The investment banking group makes a more prominent contribution to the VC industry in IPO listing activities than an investor.
Asian banks in particular have not yet applied much interaction with VCs to their operations. The main reason is that the risk tolerance of both well-trained bankers and financial policy makers is not high. This market has also witnessed many financial crises that have had a lasting effect that has caused the investment behavior of the majority to remain oriented towards traditional and low-risk options. Moreover, the number and quality of startups in the region is not as high as in the West.
High Net Worth Individuals (HNWI) and Family Offices: European VC funds often source funds from Middle Eastern oil billionaires due to historical ties and the lack of specialized fund managers. industry in this area. However, managing relationships with many of these investors consumes a lot of VC resources. Large VCs tend to raise capital from a small number of large investors rather than many HNWIs. Small VCs will typically raise HNWI funds until they have the reputation and experience to raise money from larger partners. Some of the celebrities such as Jared Leto, the Joker in Suicide Squad, the lead singer of the band 30 Seconds to Mars, have an impressive portfolio that includes Uber, Airbnb, Spotify, Nest, Reddit, Slack, Snapchat.
HNWIs in Asia are quite large and the amount of money they have is enough to create a very good motivation for VCs and startups. However, the majority of HNWIs have the need to invest in U.S. regions to benefit from immigration policies as well as more trust in Western fund managers. The HNWIs in the region themselves reap the same amount of capital from traditional industries, leaving a gap in trust between them and the tech VCs.
These organizations/individuals when contributing capital to VC will be called Limited Partners (LP).
Some VCs formed by founders who have successfully exited startups will tend to use their own cash flow to generate initial capital for that VC. For example, VC Andreessen Horowitz was founded in 2009 with an initial AUM of $300 million from Marc Andreessen after divesting from Netscape.
An important principle for minimizing investment risk is portfolio diversification. This principle is stated as “never put your eggs in the same basket”.
The organizations mentioned above have large resources that need to be managed. In addition to investing in the traditional bond and stock markets, they have a need to put a small portion of their funds into high-risk alternative assets with high return expectations. such as Hedge Funds or Private Equity funds, of which VC is one of them.
Typically, the portion of capital authorized or contributed to VCs will account for about 2-5% of the total AUM. However, this proportion is increasing because of the interest in the impact of technology on national development and successful divestments of VCs. Sweden’s AP6 pension fund currently maintains an 11% share of its $2 billion AUM to invest in VCs. One successful case of this fund is music and media platform Spotify through VC Northzone.
In addition, pension funds have a long life cycle, which is very suitable for the life cycle of VCs, most of which are 10 years.
WHAT DOES VC GET WHEN MANaging MONEY FROM THESE ORGANIZATIONS?
VCs usually charge fees with the “2 and 20” principle. 2% annual management fee on the total AUM and 20% performance fee (Performance Fee or Carried Interest) based on the total growth of the VC fund. Depending on the market and the strategy of the VCs, this fee may change. Compared to some other sources of capital, especially loans, VC is considered an expensive source of capital. However, LPs always know that this industry requires thoroughness, high concentration, practice with companies in the portfolio and a system of specific knowledge and skills. That’s why LPs still trust and more and more VCs are born.
In order to ensure the interests of the LPs, the VC is subject to legal constraints related to the obligations of the trustee (Fiduciary Duty). In this case, the VC is entrusted to manage the funds owned or raised by the LPs according to a number of purposes and scopes agreed between the parties. This legal constraint forces VCs to perform their professional obligations in the best possible way, serving the interests of the LPs. In the opposite case, the LPs can sue the VC in court and the individuals who commit the wrongdoing will have to pay compensation depending on the damages. However, the publicity of the lawsuits is relatively low, and the parties involved often choose to negotiate to resolve the issue. The biggest price VC has to pay is not being able to raise new capital sources if it shows poor fund management and profitability.
In part 2, we will analyze the equity-only characteristics of VCs and their expectations during the investment process.