PE 101: How investing in a PE or VC fund works

While PE & VC have historically performed quite well, investing in a PE or VC fund is VERY different than investing in the traditional stock market. From how the investment is made, to performance, to liquidity, investing in funds is very different than directly owning  public stock.


What is a Limited Partner?

When you choose a PE or VC fund and make your investment, you become what is called a “Limited Partner” (LP) in the fund. This entails signing a formal agreement that you will allocate a set amount of capital with the fund and in exchange the fund invests that money and distributes any returns net of fees to you.

Given this added complexity of investing in PE & VC funds, why do people go through the trouble of becoming LPs? There are a few reasons…

  1. 1.   Investing in PE & VC funds means you have exposure to privately held companies, giving instant diversification to a portfolio that otherwise may consist entirely of public securities
  2. 2.   Historically, PE & VC funds have generated excess returns compared to public stock benchmarks
  3. 3.   PE tends to provide increased stability compared to public stocks, in part because it is a less liquid market


Evaluating a Fund

Before investing in a PE or VC fund, prospective LPs should conduct due diligence to assess the fund's strategy and the track record of its managers. A fund with a history of generating returns, a stable management team and thesis, and a proven ability to handle risk can indicate a more sound investment opportunity. Below are some of the criteria OneFund looks at for example when evaluating funds.

Diligence categories 

Making your investment

Once you find a PE or VC fund that you want to investment with, the process is very different compared to investing in stocks via your brokerage account. Instead of simply clicking a button, to invest in a PE or VC fund, you need to complete a “subscription agreement” detailing your capital commitment and your rights as a limited partner in the fund. Once the fund has sufficient LPs and total committed capital, they will close the fund and sign the “Limited Partnership Agreement” (LPA_, representing the official formation of the fund. After this, the fund will begin "calling" capital committed by the LPs and investing.


Capital calls

Unlike investing in public stocks, when you commit money to a fund you may not actually owe them all the money upfront. Instead, the fund may issue "capital calls" as the managers find opportunities in which they intend to invest. This helps increase your return as a Limited Partner and the performance of the fund. A fund may call all capital upfront, but in all likelihood the fund will issue successive capital calls over time after the first close of the fund. It is important as an LP to make sure you have sufficient capital reserves to meet future capital calls as they occur or you could face sever penalties. This is because an LP missing a capital call can create significant administrative burden for the fund and impact other LPs.


Getting your returns

Once you’ve made your capital commitment to a fund, the fund will begin investing your money and hopefully, generate returns. Typically, these returns take the form of capital gains as the fund sells their shares of companies in which it invested. These profits are then distributed, after fees, proportionally to the LPs in the fund. It’s important to keep in mind that while historically PE returns have outperformed public equities it takes time to generate the returns and an investment in a fund cannot typically be exited early.

For example, a fund may invest your capital over the course of 2 years, allow the companies to grow for 3 years, and then sporadically sell its assets and distribute returns over the following 3 years. So in this example, it took 5 years to begin retrieving your capital and 8 years before all capital was distributed. Actual timelines can vary from fund to fund and it's possible to take 10 years or more.


Closing thoughts

Understanding how PE and VC investments work and differ from investments in public securities is important before you invest with a fund. First, before becoming an LP, potential investors should do their due diligence to understand the fund they are giving their money too. Second, actually making the investment requires you to sign documents and give your capital to the fund over time. Third, the return profile of PE and VC, while historically strong, can be unpredictable and may take a few years to achieve. With these considerations in mind, LPs can pursue investment opportunities in private equity and venture capital with increased confidence.