As a private equity or venture capital investor, you need to carefully consider how you'll allocate your capital across investments. This process is called capital allocation, and in this article, leading expert, Mark Drugan from Capital Dynamics, will explore how to effectively allocate your capital when making investment decisions.
Three Things You Need to Focus On
Mark starts by explaining the importance of having a clear understanding of the main areas of focus for your capital allocation process. By knowing where to allocate your resources, you can make the most efficient and effective use of your limited capital, Mark adds.
As a fund investor that builds high-quality portfolios, Mark explains that the three main areas you should focus on for capital allocation in private equity and venture capital firms are:
1. Investment strategies: allocating resources across different investment strategies in order to achieve the best risk-adjusted return;
2. Portfolio management: ensuring that the portfolio as a whole is well diversified and delivering the desired return; and
3. Investor relations: maintaining strong relationships with limited partners and other investors to ensure continued funding.
Each of these three areas requires a different approach and skillset, but all are necessary for success in the private equity and venture capital industries. Once you develop a clear understanding of these key areas, mark ensures that your firm is making the most effective use of its limited capital.
What resources do you need to invest in private equity and venture capital?
In order to be successful as an entrepreneur, it is not just the number of people you know or how much capital you have access to. Part of what makes this difficult is being able to change with trends in the real estate or venture capital industry and having quick access to money.
"The key resources are knowledge and relationships – both of which are people factors. It is not so much the number of individuals, but their ability to know and understand the ever-changing PE and VC landscape." says Mark
How Allocating Capital Plays A Part in Driving Returns
Allocating capital smartly is critical to driving returns in private equity and venture capital investments.
In VC, picking the right GPs is essential. A portfolio approach to ensure appropriate diversification also remains essential. How many LP investors in 1992/93 had their mind on the Internet? Or the rise of social media in the early part of this century?
Mark further explains "The best VC GPs do not necessarily predict the future, but see opportunities early, have the ability to recognize the opportunity and to nurture companies through the crucial early stages."
There are a number of factors to consider when allocating capital in private equity and venture capital investments. But at the core, it boils down to two things: making sure you're investing in the right companies and making sure you're investing the right amount of money.
"In VC, picking the right GPs is essential," says Mark. Do your homework on the companies you're considering investing in. Make sure you understand their business models, their competitive landscape, and their financials. And make sure you have a clear thesis for why you believe in the company's long-term potential.
Managing Longer-Term and Higher-Risk Investments
One of the most important things to keep in mind is your investment time horizon. For example, if you're investing in a new technology that's still in development, you'll need to be comfortable with a longer-term investment horizon than if you're investing in a more established company.
Another important factor to consider is the riskiness of the investment. A high-risk investment will typically require more capital than a low-risk investment.
Mark explains that Capital Dynamics' successful track record at the higher risk end of the spectrum has always been based on high quality relationships and diversification.