Direct vs Indirect investing

Venture Capital is a form of private investment that focuses on financing early-stage, high potential, high-growth startups. Venture Capital is also commonly  referred to as “risk capital”. According to various estimates, between 75% and 94% of startups fail, indicating to investors that losing money is an intrinsic part of venture investing. Luckily, there exist several strategies for Venture Investing providing investors with different flavours for potential risks and returns.

Let's start with the basics. The two primary approaches to venture capital investing are direct and indirect investment. 

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Direct Investment: In direct investing, you personally select and invest directly in a startup company, becoming a direct owner. This hands-on approach provides greater control throughout the whole investment process, from decision making to portfolio management and exit, and the potential for astronomical returns (100x or more) if the chosen company skyrockets in value.

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Indirect Investment: Indirect investment involves investing in an investment fund by a fund manager. The manager is then entrusted with the capital to select and invest in companies on behalf of the fund's investors, who become indirect owners through their stake in the fund. When investing indirectly, investors lose control in the investment decision making and process, however this diversified approach opens access to deals that individual investors might miss. In venture investing, there are two main ways to invest indirectly:

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1. Investing in Venture Capital funds: Investing in a VC fund grants exposure to a portfolio of typically 20-30 startups, selected and managed by dedicated fund managers over the fund's lifespan. 
2. Investing in Fund of Funds (FoF): FoFs invest in multiple VC funds, offering broad diversification in across 10-15 funds and, ultimately, 300-500 companies

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Strategies for Venture Investing

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The world of venture investing offers a variety of strategies, each with its own balance of risk and potential return. Here's a breakdown of the five primary approaches:

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1. Direct Investing (Self-Sourcing): The highest risk, highest reward option. While the potential for massive returns exists, so does the likelihood of a total loss. This requires extensive time, expertise, and deal flow. In direct investing, you might be lucky and generate with one company 100x or more your money, but research on venture outcomes show that you are more likely to get a 0x.  
2. Investing Alongside a Sponsor: This is a more tempered approach to direct investing. You partner with a sponsor who brings promising deals to the table to invest alongside them. These sponsors could be anything from co-investors such as angels and VCs, to  investment managers such as Multi-Family Office. By leveraging the expertise and network of active and professional investors, you can access carefully vetted opportunities and reduce the burden of due diligence.
3. Investing in Emerging Managers: This strategy offers perhaps the greatest potential within indirect venture investing, but also carries the most inherent risk. In this strategy you invest in new managers or emerging managers, characterised for managing three funds or less. These newer VC funds often focus on early-stage companies and tend to be more aligned with LP interests due to their focus on performance-based carry rather than management fees and in general are hungrier to prove themselves. However, their lack of a long track record increases the risk of underperformance or even fund failure. 
4. Investing in Established Managers: This is a lower-risk approach in indirect investing where you invest in funds with a proven history of generating returns. While the potential returns may be more modest compared to emerging managers, the likelihood of losing your entire investment is significantly reduced. Established managers typically invest in later-stage companies with more predictable growth trajectories and have been able to consistently prove capacity to manage and return investor capital. 
5. Investing in a Fund of Funds (FoF): The most diversified and lowest-risk strategy. FoFs invest in multiple VC funds, providing exposure to a broad range of startups across various stages and sectors. This diversification aims for consistent, moderate returns over the long term.This is the most diversified and conservative venture investing strategy. FoFs invest in multiple VC funds, providing exposure to a broad range of startups across various stages and sectors. This diversification minimizes risk and aims for consistent, moderate returns in the range of 2x-2.5x net.

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Considerations for Choosing an Investment Approach

When choosing between direct and indirect venture investing, several key factors should guide your decision:

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• ‍Time Commitment: Direct investing demands a substantial time commitment. Are you prepared to dedicate countless hours to sourcing, evaluating, and conducting due diligence on potential deals? Do you have the bandwidth to meet with hundreds of potential managers or thousands of potential founders each year ? Professional venture investing often involves a thorough diligence process that can take 40-60 hours or more per deal. If you are not able to do venture investments full time, it is wise to outsource the sourcing, evaluation and DD to more dedicated investors. ‍
• Risk Tolerance: Venture capital is inherently high-risk, and it's essential to assess your risk tolerance realistically. As highlighted in research, the majority of venture-backed companies fail to return invested capital, with only a small percentage achieving significant returns. Before diving into direct investments, ask yourself: How much capital am I truly comfortable potentially losing?‍
• Experience: Your experience level in venture investing plays a significant role. If you're new to the asset class, it's wise to start with indirect investing. This allows you to learn the ropes, gain exposure to a diversified portfolio, and benefit from the expertise of active and full time fund managers. As you gain knowledge and confidence, you can gradually transition into direct investments if desired.

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These three considerations are interconnected. A high-risk tolerance might make direct investing more appealing, but only if you have the time and experience to navigate the complexities involved. Conversely, if you lack the time or experience, indirect investing offers a more manageable entry point with lower risk.

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SUMMARY 

Choosing how to invest in the venture capital landscape is a decision with significant implications. Direct investment offers control and the potential for exceptional returns, but it demands extensive time, expertise, and risk tolerance. Indirect investment, through VC funds or Fund of Funds, provides diversification and access to professional management, but at the cost of reduced control and additional fees.

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The following summarises the key pros and cons of each approach, along with essential factors to consider when making your investment decision:

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Direct Investment

• Pros:
  • Greater control over investment decisions.
  • Potential for outsized returns (100x or more) if a single company becomes a massive success.
  • Direct involvement in a startup's growth and development.
• Cons:
  • Requires significant time and effort for deal sourcing and due diligence.
  • Higher risk due to lack of diversification.
  • Limited access to deals compared to larger funds.

Indirect Investment

• Pros:
  • Access to a wider range of deals and diversified portfolio.
  • Expertise of fund managers in sourcing, evaluating, and managing investments.
  • Potential for strong returns through diversified exposure to multiple successful companies.
• Cons:
  • Management fees and carried interest reduce overall returns.
  • Less control over individual investment decisions.