Venture capital can fit into an investment portfolio as a high-risk, potential high-reward asset class. It typically targets early-stage startups with significant growth potential, and the returns can be substantial if the company becomes successful.
Venture Capital’s Place in an Investment Portfolio
Venture capital investments are often illiquid and high-risk, but they offer the potential for outsized returns. By adding venture capital to a portfolio, investors can diversify their holdings beyond traditional stocks, bonds, and real estate, which may reduce overall portfolio risk and may provide uncorrelated returns. Startups, especially in technology or emerging industries, may offer exponential growth opportunities that are not available in more established companies. For investors willing to take on risk, these investments can potentially provide high returns that can significantly outperform other asset classes over time. Due to the considerable risk of failure in early-stage companies, VC investments should generally represent a smaller portion of an investor’s overall portfolio— often around 5-10%. VC investments typically require a long-term commitment to realize returns, often 7-10 years or more, as startups take time to mature and reach liquidity events (like an IPO or acquisition). This time frame makes venture investing suitable for investors with a longer investment horizon and for those who can afford to lock up capital for extended periods. Unlike publicly traded stocks, venture capital investments are inherently illiquid. If you invest directly in a startup, you may not be able to sell your investment until the company is either acquired or goes public, which can take several years.
Incorporating venture capital into a portfolio can be a strategy for investors who are willing to take more risks in exchange for the potential of higher returns, but it should be done with caution and as part of a well-diversified portfolio. The ability to access early-stage companies in emerging industries creates a unique return profile for institutions, which complements existing allocations to more mature asset classes.
Historically, venture has outperformed the public markets over a longer time horizon. We believe a large part of this growth can be attributed to several layers of technological disruptions which have transformed innumerable industries. Revolutionary platform shifts over the last several decades have pushed the boundaries of productivity across the economy at large. Investing in this innovation economy provides exposure to high-growth industries, market disruptors, and breakthrough technologies that shape the future. Per the charts below, we believe that we are on the cusp of another major platform shift, making early stage VC managers well-positioned to capture the benefits of the latest innovation before they reach the public market. A strategic, long-term approach through venture capital may allow investors to capitalize on this economic transformation and global progress.
But What About the Risk?
The potential for higher returns inevitably comes with higher risk. As seen in the chart below, venture capital sits in the high-risk high-return quadrant of the efficient frontier1, which is the curve that defines the set portfolios that offer the most optimal trade-off between risk and return. Though VC has a low correlation with public markets, its risk-adjusted returns depend heavily on fund selection. A balanced allocation can improve portfolio efficiency, but overexposure increases risk.
Given this asset class is represented by a longer holding period, interim pricing volatility, and significantly higher loss rates. It is thus imperative to clarify the investment goals for a venture investor:
• Determine the holding period appetite: There may be a 7-15 year investment horizon based on the investment stage of managers chosen.
• Understand the liquidity needs: Evaluate if the portfolio can withstand being illiquid in the first few years of the J-curve, compared to steadier potential income from other asset classes.
• Determine loss capacity of the portfolio: Assess if there is appetite for volatility that comes with venture-backed companies. A duly noted phenomenon of VC investing is that venture outcomes follow the power law distribution, unlike returns of other traditional asset classes that follow a normal distribution. Which means that only a handful of investments in each portfolio drive the bulk of the returns. Many ascribe this largely to the idea that only a few companies per portfolio can become massive successes, and the ones that do end up returning the fund.
Building a Venture Allocation
If investing in venture capital makes sense based upon your assessment of its return profile and risk level, you are not done. There are a few additional factors to consider for the next steps. A well-constructed venture allocation requires more than just setting a target percentage— it demands a thoughtful approach to fund selection, access, and diversification.
Selecting Top Managers
Institutional investors can optimize for potential outsized returns by funding upper-quartile managers. Venture as an industry tends to be opaque given the lack of publicly available performance data. The spread between top-performing and median-performing funds in venture can be wider than in other asset classes. We have observed that the best funds consistently outperform because of a self-reinforcing cycle: they attract top founders, which drives better exits, which in turn generates an even higher quality deal- flow – a flywheel effect. Success breeds success and getting into these funds means being positioned at the center of that reinforcing cycle. If you are not able to access to the best-in-class managers, you end up reverting to an index of the industry which is often on par with public markets – meaning you are not being rewarded for the commensurate risk you are taking.
Dedicated Resources
You need to dedicate resources and time to build relationships with the best venture managers. This alone does not guarantee access. Top performing managers are often highly selective about their LP base. The most sought-after funds rarely look for new sources of capital, which makes gaining an allocation to them a real challenge. Why? Because if they are successful, their existing LP base will absorb the available capital allocations leaving no room for new LPs. Building relationships with the best managers takes time, credibility, and strategic positioning within the venture ecosystem. For an institutional portfolio, it is necessary to gauge the availability of resources to develop expertise and on-the-ground connections. Without this, institutions may find themselves only getting looks at second-tier options, which could make the asset class significantly less attractive.
Diversification of Portfolio
An essential tool for managing downside risk and building a resilient portfolio is diversification across vintages and stages. Market cycles are unpredictable, and even the most experienced managers cannot consistently time the market to capture just the upside. Deploying capital across multiple fund vintages increases the chances of capturing a high-performing years while reducing the impact of weaker cycles. Furthermore, balancing exposure across stages of investments also enhances portfolio stability and return potential. Early-stage funds carry higher volatility and longer holding periods but offer the potential for outsized returns from breakout companies. Growth-stage funds provide more predictable paths to exit and comparatively lower loss rates, with the added benefit of quicker liquidity. A well-diversified portfolio, across both time and stage, is better positioned to improve liquidity, stabilize returns, and increase the likelihood of capturing long-term outperformance.
For institutional investors seeking exposure to growth and technological innovation, venture capital has the potential to become a reliable driver of long-term returns. And while access to top funds can be a hurdle with success compounding at the top in a seemingly closed loop— this is where the right partner in the industry makes all the difference. A partner who has established relationships, deep market knowledge, and pattern recognition built over time, can provide access to otherwise closed opportunities and help navigate the intricacies of fund selection and deployment. Thus, a strategic approach to manager selection and diversification can allow investors to harness the potential of an often-opaque asset class into tangible value.
Disclaimer: Top Tier Capital Partners, LLC (“TTCP”) provides this material as a general overview of the venture capital asset class for educational and informational purposes only. It does not constitute or form part of any offer to issue or sell, or any solicitation of any offer to subscribe or to purchase, shares, units or other interests in any security or investment and must not be construed as investment or financial advice. TTCP has not considered any reader’s financial situation, objective or needs in providing this information.
The value of a venture investment may fall as well as rise and you may not get back your original investment. Past performance is not necessarily a guide to future performance or returns. TTCP has taken all reasonable The value of a venture investment may fall as well as rise and you may not get back your original investment. Past performance is not necessarily a guide to future performance or returns. TTCP has taken all reasonable representation or warranty, express or implied, is made as to the accuracy, reliability or completeness of such information and TTCP undertakes no (and disclaims any) obligation to update, modify or amend this document or to otherwise notify you in the event that any matter stated in the materials, or any opinion, projection, forecast or estimate set forth in the document, changes or subsequently becomes inaccurate. This material is intended only for the direct recipients to whom it was sent. Any distribution, reproduction or other use of this presentation by recipients is strictly prohibited.
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