6 common LP mistakes
Alternatives such as PE and VC have become an increasingly attractive asset class for investors, driven by its strong historical performance, the extended time tech companies stay private, and the growing influence of technology in our daily lives.
Many LPs of all backgrounds and sizes are now adventuring themselves into this emerging asset class, however it is important to note that Venture investing is in effect complex and requires discipline, if the goal is to maximise returns. Limited Partners can easily stumble if they're not careful. Here are some common mistakes we see:
1 Going solo
Many LPs prefer to invest directly into companies that indirectly into funds, but there is a reason VC funds charge a fee. And that is that the tech landscape -in Europe, US, the world - is highly mature and very competitive and is getting more and more difficult to access and win the best deals. Partnering with the right VC funds, in the form of committing to their fund, co-investing or a combination of both can provide access to better deal flow and valuable expertise than trying to source direct deals alone.
2 Lack of a defined Strategy
Many LPs prefer to invest in managers that they know. While that is a general good practice, it can sometimes translate into under diversification and investments into funds without a clear understanding of how they fit into the LP overall portfolio strategy. Instead, LPs should approach VC investing with a clear strategy and a well-defined thesis to be able to invest in the best performing funds of each category and in funds with a strategic fit. LPs should diversify across managers, stages, and vintages to capture a wider range of opportunities, mitigate risk and achieve sustainable returns.
3 Ignoring the Power Law
The joke in the venture industry says that “Venture is not normal”. This is, Venture capital doesn't follow a normal distribution. Instead, it follows the Power Law distribution, meaning that a small percentage of investments drive the majority of returns. This principle applies to both individual companies and VC funds themselves. Unfortunately, most VC funds will not return the committed capital (1x), so LPs should understand and be very aware of this dynamic and how it impacts their portfolio and liquidity.
4 Overrating past performance or experience
Track records as well as successful exits or entrepreneurship stories provide a glimpse into a manager's abilities and potential, but they don't guarantee future success. LPs should look beyond the LinkedIn followers or social media presence of the managers and instead evaluate the underlying reasons for a manager's performance, considering team dynamics, fund size, market conditions and deaflow quality and consistency overtime. Dig deeper than surface-level.
5 Momentum Investing
Venture capital is subject to market cycles and it will always bring many ups and down moments. Chasing returns during hot markets and retreating during downturns can lead to missed opportunities and high-point investing. Furthermore, FOMO (Fear of Missing Out) can lead to investing in overvalued companies during hot trends. Instead, LPs should establish a long-term strategy and discipline with consistent investments across various market conditions.
6 Focusing on the wrong things
Some LPs fall in the trap of focusing solely on the management fees or negotiating the ticket size, among many other examples. While fees matter, the ultimate goal is maximising your DPI. Top-performing funds may have higher fee structures or larger minimum ticket sizes, but they are able to consistently deliver results and distributions. LPs should establish a consistent portfolio model with standard terms and ticket sizes and then spend the time finding the right funds for their strategy and risk-return appetite.
Learning Venture investing is expensive
New LPs entering the venture space will have to face two options: learning by doing, or doing and then learning, with the potential to make costly mistakes, or partnering up with venture experts to develop a solid, long-term strategy. It all depends on how much time and money they have available to lose.