Portfolio Management in Venture Capital Funds

Posted by in Business & Entrepreneurship, Leadership & Management

A venture capital firm’s capability to assist and provide support to companies under its portfolio differentiates leading venture capital firms from other ones in the industry. This process of providing assistance to their portfolio companies is also termed adding value, and it comprises of four basic components. The components are venture capital decision making, portfolio monitoring, portfolio company assistance and company analysis. In investing venture capital funds, portfolio management illustrates the process investors and venture capitalists use in making decisions, analyzing information and committing resources to protect and increase the value of their investments. The four basic components in portfolio management start when an initial investment closes and continues repeatedly till when the exit transaction closes. As a result of the complex nature of analyzing venture financial statements, venture capital firms rely on pattern matching and past experience in determining the most appropriate response and interpretation to different scenarios.

Market Research and Real-Time Oversight

The National Venture Capital Association (NVCA) conducted a research in 2012 on the venture capital industry. From the research, it was revealed that venture capital funds were responsible, directly or indirectly, for creating about 20 percent of the gross domestic product of developed countries and about 11 percent of the employment in their private sector.

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Due to the unpredictability of the venture capital industry, venture capitalists take very high risks when investing in a startup or even when making any major investment. The National Venture Capital Association (NVCA) sets the amount of startups and companies that receive venture capital funds and fail as 40 percent of the total number of companies that venture capitalists invest in. Another 40 percent is also estimated to be the percentage of companies that generates “average” returns. Therefore, only about 20 percent of the total number of companies that venture capitalists invest in produces profits that are significant to the venture capital firm. This is the 20 percent that venture capitalists look out for, they generate enough returns to make up for even the loss accrued from the other companies that failed, and is what consistently makes the venture capital industry achieve more than other markets.

In the venture capital industry, proper market research skills and real-time oversight are overly consequential in sorting through investment potentials, companies, individuals and markets that are related to a potential investment suited perfectly for a modern venture capitalist. While technological growth, economic growth and job creation are important to a venture capitalist, generating maximum returns from the entrepreneurs and companies they invest in remains the highest ideal. Venture capital firms do not just throw money at every entrepreneur with a brilliant idea that walks through their door. Even with a supposedly brilliant idea, proper market research and intelligent predictions on how profitable the startup will be at the end is extremely important to the success of any venture capital firm. While venture capitalists with enough investing experience are adequately suited to make thorough research through financial statements, regulatory issues, technologies, companies and various markets, an information professional or research analyst with expert research skills and tools is also capable, and sometimes better, to carry out these researches.

Risk Profiling of Holdings

As one of the most distinguishing characteristics of venture capital firms, venture capitalists have embraced the idea of investing a portion of their total funds in startups with the promise of generating high returns on their investments. This industry has generated a lot of traction as a result of the high return it generates which are arduous to accomplish in other traditional investment options. It is not surprising, however, that capital venture funds are associated with a higher degree of risk, unlike other investment options. These risks are attendant with investing in startups and small companies that are in the early growth stages. Venture capital firms invest in these startups and small growth companies, provide funds for them and hope to generate returns from them after a period of time. However smart this investment strategy might sound, there are a lot of risks associated with it, especially for those small businesses that are just starting up.

One major concern of venture capitalists is liquidity risk. Startups can take a lot of time while growing and venture capital firms are required to invest their funds with these companies for about three to seven years. Some venture capital investments even require a longer period of time before the investing firm receives any return. In other classes of investments, investors have the prerogative to sell off a rapidly declining investment in days as quickly they can. Venture capital firms are not offered such luxury.

Venture capitalists are also faced with greater market risk since no one can guarantee that any of the startups they fund will grow. A greater number of these startups fail, only about a couple of them make meaningful returns for the venture capital firm and their investors.

Exit Strategies

The surplus returns that the online industry and its entrepreneurs brought along are gone; venture capitalists are now faced with the struggle of finding the right approach to cash out and exit their investments. In the venture capital industry, both venture capitalists and entrepreneurs’ themselves usually have exit strategies at the start of the business. An ideal entrepreneur develops an exit strategy and incorporates it into the business plan. The choice of exit strategy the entrepreneur decides to use can have great influences on the development choices of the business and the most appropriate exit strategy for a business depends on a number of factors ranging from the type of business to its size. Some of the strategies that venture capitalists use in exiting their investments are mergers and acquisitions (M&A), management buyouts (MBOs), and initial public offerings (IPOs). Each of the individual exit strategies also offers entrepreneurs and venture capitalists different liquidity levels. A venture capitalist uses an exit strategy or a contingency plan to liquidate business assets or dispose of tangible financial assets as far as an already predetermined criterion or criteria have been met or reached for both.

Most times, exit strategies are executed when the venture capitalist or entrepreneur decides to exit the business or close the investment as a result of under-performance or if the business is running at a loss. Exit strategies can also be executed when the profit target of the entrepreneur or venture capitalist has been met. Legal concerns, changing market conditions, liability lawsuits, a retiring investor or entrepreneur are also other reasons why an exit strategy may be executed.

New regulations are however threatening to impede the growth of the industry instead of helping it necessitating that venture capital firms employ watertight strategies to ensure sustainable growth.

Exit Targets and Negotiation Engagements

At the start of an investment or before a venture capitalist decides on whether to invest in a startup or not, her/she determines an exit point and sets a target that is profitable. This profit target is usually expressed as a return percentage and is set to avoid allowing emotions interfere with the business. On the other opposite end of exit target, we have a stop loss point. This is a point where a venture capitalist has recorded an already predetermined amount of loss and he exits the investment to avoid recording further losses. Venture capitalists use chart patterns to set their exit target and look out for triangles and head & shoulders pattern that simplifies the identification of these points.

Due to the current decline in economic conditions, venture capitalists are under a large amount of pressure from different constituencies. General partners within venture capital firms are in search of early hints of possible risks within a portfolio. Limited partners, on another hand, are searching for transparency of information and more meaningful information from company’s updates.  As a result of current challenges in economic conditions, portfolio companies are in need of greater levels of assistance. This has resulted in an increase in the amount of effort and resources a lot of venture capital firms spend in providing support and assistance to their portfolio companies so as to generate maximum returns on their investment and also limit the effects of the loss generated by underperforming portfolio companies.

Key Takeaways

  • Portfolio management illustrates the process investors and venture capitalists use in making decisions, analyzing information and committing resources to protect and increase the value of their investments.
  • In the venture capital industry, proper market research skills and real-time oversight are overly consequential to an investment potential suited perfectly for a modern venture capitalist.
  • While technological growth, economic growth and job creation are important to a venture capitalist, generating maximum returns from portfolio companies remains the highest ideal.
  • Both venture capitalists and their portfolio companies have exit strategies at the start of the investment to reduce the impacts of any loss.
  • Exit targets are profit or loss targets set by venture capitalists to avoid allowing emotions interfere with the business.
  • Liquidity and market risks are some of the problems faced by venture capitalists and they arise as a result of the unpredictability of success in the venture capital industry.