Investors turn to venture capital not only for its potential for outsized returns, but also for its unique ability to capture growth where traditional markets may lag. Understanding the fundamental principles of how VC works—its unique return potential, access constraints, and long-term nature—is essential for any investor considering an allocation to the asset class.
What is Venture Capital and Why It MattersVC is a form of private equity where capital is invested in startups that are believed to have high growth potential, particularly those with an emphasis on technology adoption. Historically, a startup would raise a few financing rounds before considering an initial public offering (“IPO”) or a sale to a larger company. Today, growth of the technology opportunity set has fueled the emergence of many sub-asset classes within VC (angel/pre-seed, seed, early stage, venture growth, late stage and pre-IPO). This access to capital is resulting in startups compounding for longer in private markets, to the benefit of VC investors.
More than just capital, VC managers provide invaluable expertise, leveraging their networks and company-building experience to support portfolio companies post-investment. This role is critical within the broader innovation ecosystem, providing the necessary fuel for advancements in technology, healthcare, and artificial intelligence.
Historically, venture capital has been instrumental in shaping major industries and has generated significant returns irrespective of financial cycles. Iconic, category-defining companies like Google, Amazon, Airbnb, Facebook, Uber, Databricks, and OpenAI, among many others, were built with venture capital. VC’s importance lies in its ability to identify and nurture the next generation of disruptive companies, driving economic growth and technological progress.
Perhaps the most critical concept to understand in VC is the power law of returns, a unique dynamic that differentiates VC from other asset classes. This principle dictates that a small number of outlier investments drive the vast majority of a fund's, and indeed the industry's, total returns. A single investment can yield returns larger than all other investments in a portfolio combined, often by orders of magnitude. Data from our 35 years of venture investing illustrates this principle:
This dynamic also means that many venture-backed companies will fail. Historical data shows that in older vintages, over 40 percent of portfolio companies returned less than their invested cost, with up to 20 percent being complete write-offs. This is the nature of venture capital; there will be winners and losers. Lower-quality competitors are expected to face funding challenges, which is healthy for the industry. The key to success is gaining exposure to the power law companies that become outliers.
Given the power law, the ability to invest with top-tier managers who consistently see the best opportunities is paramount. Manager selection is critical because experienced managers with strong track records are best positioned to gain access to, invest in, and build future outlier companies. Unlike many other asset classes, past performance in venture capital is often predictive of future success. Established managers with proven track records tend to replicate their performance across fund vintages. While any manager can produce top-quartile returns in a given vintage, only a select few have demonstrated the ability to do so consistently across different economic cycles. For LPs, concentrating capital with these managers is essential, but this can be challenging given these funds are often highly oversubscribed, accepting only a limited number of investors and typically giving preference to existing LPs.
VC is a long-term, illiquid asset class. Returns materialize over a period of many years, often a decade or more, requiring patience and discipline from investors. This is often visualized as the "J-curve" effect, where a fund's net asset value will typically be negative in the early years due to management fees and initial investments that have not yet appreciated. Over time, as portfolio companies mature and successful exits occur, the curve is expected to slope upwards, generating returns. The term of a typical VC fund is 12 years, often with extensions—underscoring the long-term commitment required.
We are in the midst of a decades-long innovation cycle, and still in the early stages of the digital transformation of the global economy. In addition to the US, this innovation flywheel is accelerating in large and growing global markets, including Europe, Israel, China, India, Southeast Asia, and Latin America, presenting a diverse and expanding menu of opportunities.
The venture market has historically been buoyed by technological shifts such as Internet and mobile devices, and we see a similar pattern emerging today with artificial intelligence. While the ecosystem around AI will take years to develop, the potential economic impact could stretch into the trillions of dollars with impact across a myriad of industries and geographies, and we believe the future category winners in AI are being founded and backed by venture managers today. By partnering with high-quality managers that have proven their ability to identify and shape the outlier companies of tomorrow, investors can position themselves to capitalize on the enduring power of innovation.