Topic: How To Invest

Deciding how to invest in venture capital funds could be as simple as staying out of them

Want to know how to invest in venture capital funds successfully? For small investors, that starts with being aware of how the odds are stacked against you.

Funds invested in venture capital in the U.S. amounted to $4 billion in 1994; the 2018 figure was a record $100 billion. Note that this is not the total value of U.S. venture capital holdings. These are the amounts of new investment.

Back when this burst of growth was just getting started, most venture-capital investment managers acknowledged that perhaps only one in 10 of the deals they financed wound up making any money for investors. However, that one success was often big enough to provide a payday for everybody involved: the insiders, the investment managers, and even the outside investors who put up the money.

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Acknowledging the negatives is the first step in learning how to invest in venture capital funds (or why to avoid them!)

In good years, the returns were high enough to justify the drawbacks to venture-capital investing: high risk, weak investor communications, lack of liquidity, hidden conflicts of interest and so on. But high fees in venture capital eat up a lot of investor capital, in good years and bad.

Since the 1990s, much has changed. For one thing, billionaires (individuals with a net worth of $1 billion or more, sometimes much more) are far more common now than they used to be. In many cases, this is due to gains on venture-capital start-ups. This fact alone attracts many new investors to the field.

Some early winners in venture capital-financed technology start-ups have gone on to enter the financing and marketing side of venture capital. Having made tens or hundreds of millions in venture capital, they are now seen as authorities. Their involvement in a venture-capital deal lends credibility that can draw in new investors. However, it seems the success ratio—“perhaps one in 10”—still applies.

Factoring in the “broker-media limelight” is a key part of learning how to invest in venture capital funds

Our warnings about the “broker-media limelight” apply just as much in venture capital as they do in any risky investment area. In venture capital, however, enthusiasts in the media and the business have lowered the definition of “success.” The term used to suggest profitability: a successful company was one that had begun making money, and seemed likely to keep doing so.

Now, success in venture capital means a company is merely enjoying fast growth in measures (like revenues, or customer account openings) that suggest it could be headed toward profitability. Before that day comes, however, many current venture capital investors look forward to a takeover by a major company, or a successful new issue or IPO. That long-term goal may be getting harder to achieve.

In recent years, more major companies have written off investments they made in venture capital start-ups. Meanwhile, a number of long-awaited, high-profile venture capital start-up IPOs have stumbled when they hit the market.

Low interest rates have spurred demand for venture capital funds

Advancing technology has created some genuine successes, and this has attracted many new investors. But the biggest boost for venture capital probably comes from historically low interest rates.

Low rates have lured reluctant new venture-capital investors who would really prefer to invest in bonds, but can no longer afford to do so. This includes insurance companies, plus private and public pension funds. These organizations used to invest mainly in bonds. But they all have fixed obligations that they agreed to decades ago, when bonds yielded 5% to 7% or more.

Many venture capital firms are rife with conflicts of interest

Before you try to get in on the venture-capital bonanza, you need to keep some unsettling facts in mind. Professional venture-capital firms and private-equity investors have large sums to invest. They have expertise and connections in a wide range of fields that are creating or profiting from today’s technological gains. They tend to get first pick of startups that are looking for investors. Yet even so, they depend on a handful of blockbuster results to make an overall profit. The rare winners take years to pay off.

If you’re tempted to invest in startup companies through funds that offer venture-capital opportunities, you face an extra layer of risk. Many venture-capital firms have complicated finances. Insiders get to decide which investments they will bundle in with public offerings, and which they will retain for themselves. Every one of these choices exposes the insiders to a conflict of interest.

As we’ve often pointed out, failing to consider conflicts of interest is one of the riskiest and costliest mistakes you can make as an investor.

Bonus tip: Use our three-part Successful Investor approach to make better stock selections

  • Hold mostly high-quality, dividend-paying stocks.
  • Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.
  • Downplay or stay out of stocks in the broker/media limelight.

Some venture capital firms are renouncing their status as a VC firm to go after riskier investments. How do you feel about this evolution of the VC space?

Is venture capital investing a “get-rich-quick” scheme or do you think there’s a place for this type of investment in your portfolio?


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