If it takes $10 million to make a good VC, that $10 million better come from the LP next door - Anonymous LP
Fund due diligence is much like startup diligence. It's about the team and strategy. And the odds are the same - LPs source a thousand fund opportunities, invest in a dozen, and get returns from a few. For LPs, due diligence begins and ends with the fund's investment team. The one question LP seeks to answer - Can this team generate strong returns?
Top-quartile managers with demonstrated & repeatable track records over fund cycles are sought after. Yet other LPs focus on emerging managers, who may bring fresh thinking. All fund-raising is at the mercy of markets. With Mr. Market on its side, even a mediocre group may have an oversubscribed fund.
A typical investment process for any LP follows the following steps:
- § Sourcing and screening of fund managers: The art of finding the right fund managers
- § Fund due diligence: The ability to assess the various risk-return measures
- § Negotiations and closing: Investment terms, negotiations & 'middle-of-the-road' positions
- § Post-investment fund monitoring: Do both sides have the ability to build a transparent relationship?
Sourcing and First Screens
While some seek to invest proven top-quartile established funds, others seek emerging managers. Some start the search with sectors and whittle down the universe of fund managers based on additional criteria. For LPs, the primary filter—performance—remains high on the list.
Lisa Edgar, managing director of Top Tier Capital Partners, a fund-of-funds prefers to start her screening process with performance. "In an environment defined by change, it is important to assess the fund manager's ability to produce superior returns across various technological and economic cycles," she says. A GP's ability to produce superior returns across various cycles is evident only after the venture firm has raised and invested a few funds. Georganne Perkins, managing director at Fisher Lynch Capital, a fund-of-funds seeks proven GPs as well. "A roman numeral V or higher is a good start," she points out. The "V" indicates the firm has invested capital over four previous fund cycles. Such a firm would have established a track record and a brand in the investment arena. Perkins, who formerly managed the PE investment portfolio at Stanford University, reviews over 200 fund documents, or private placement memorandums (PPMs), each year to invest in a handful of funds.
Most institutional investors typically see anywhere from 200 to 600 fund documents on a yearly basis. With such a high volume, the best way to stand above the ambient noise level is to begin a relationship via an introduction. Without a warm introduction, fund documents that come in the door cold often head for the trash can. But who makes the introduction is equally important. A trusted relationship, ideally another peer-level limited partner, an existing GP, or a respected attorney can make this path much easier. An inappropriate starting point could blow up this process very quickly.
"For state pension fund managers, getting calls from politicians is typical, including calls from the governor's office. Those who use pressure tactics, despite stellar performance, are starting with a deficit," says Robert "Bob" Clone, who served as director of private equity State of Michigan and Indiana retirement plans, managing over $50 billion in assets. Institutional investors often like to take it slow and warm up to a new fund manager over time, cautiously observing the fund's evolution and performance.
G. Thomas Doyal, managing director of global private equity investments for a family office, says, "We watch managers over several years and multiple investment cycles before we are ready to engage." Doyal, who sees about 50 fund documents each year, reviews them only after a strong relationship has been established with the investment team. "It is very unusual for us to look at anything cold," he says.
For newer managers, the ability to engage via an introduction and proactively build these potential institutional relationships is important. Providing meaningful updates on investments and performance can make the path easier. "Like any entrepreneur looking for the next best opportunity, we are always seeking the most promising managers—the Kleiner Perkins of the future,"advises Kenneth Van Heel, who manages $10 billion in assets as the head of the corporate pension fund for Dow Chemical Company.
Alex Bangash, an advisor to institutional LPs has found the best managers by watching for those who become magnets for smart entrepreneurs. “How desirable is a VC to entrepreneurs? Do they want your service?” he asks. Alex is the founder of Trusted Insight, an institutional investor platform for Alternatives, with over 60,000 LP members in 98 countries. A social network of LPs, Alex Bangash launched Trusted Insight to share LP expertise and due diligence across various sectors and geography.
Fund diligence - How LPs evaluate the venture firms
Institutional investors evaluate venture firms on the two primary criteria: the fund managers' expertise and their investment strategy. Secondary criteria include investment terms and market conditions.
- § Fund managers' expertise. The foremost and primary criteria, limited partners seek to understand entrepreneurial / domain expertise. Performance is one of the foremost criteria.
- § Investment strategy. What is a fund's investment strategy, and how does it stand apart from the rest of venture funds? What unique factors / differentiators or "unfair advantage" does this combination of people and strategy bring to the VC arena?
In "What Drives Venture Capital Fund Raising?" authors Paul A. Gompers and Josh Lerner conclude that "Fund performance is an important determinant of the ability to raise new capital. Reputation, in the firm age and size, also positively impacts the ability to raise a new fund."
This theme, "performance is primary," recurs in various strands of academic literature. In a survey of investment criteria, over 200 U.S.-based LPs confirm the importance of performance. In order of priority, the LPs started with internal rate of return with a minimum floor of 12 percent and ideally closer to 30 percent to be considered for investment. The returns are also typically tied to a benchmark index for comparing performance. A performance of 400 basis points above the benchmark index, Russell 3000 or S&P 500 is often a threshold established by institutional investors. Other criteria included a consistent track record, diversification of the limited partners, team experience, and fund strategy.
In their book Beyond the J Curve, authors Thomas Meyer and Pierre-Yves Mathonet propose qualitative scoring criteria, which ranks the fund management team and fund strategy as the two top weighted factors, as shown below.
- Management team skills 30%
- Investment and operational experience, sector expertise, regional connections, size of team, and complementary skills
- Management team stability 10%
- Clear roles, responsibilities, decision making, historical relationships and stability, economic alignment of incentives, financial stability of fund, and succession planning
- Management team motivation 10%
- GP commitment percentage, incentive structure, reputation, team independence, outside activities and conflicts of interest
- Fund strategy 15%
- Sourcing, stage/sector, fund size, exit strategy, and overall strategy fit
- Fund structure 10%
- Costs/fees, governance and compliance
- External validation 10%
- Track record of previous funds, performance of comparable funds, quality of co-investors and recurrence of investors
- Overall fit 15%
- Considers the overall picture. For example, the fit between the team, fund size, and the strategy.
Source: Thomas Meyer and Pierre-Yves Mathonet, Beyond the J Curve—Managing a Portfolio of Venture Capital and Private Equity Funds (Chichester, UK: John Wiley & Sons, 2005), 221.
While all the listed criteria are important, Lisa Edgar of Top Tier Capital Partners asks a fundamental question - "Are we going to make money in this fund?"
Which pretty much sums it all up. It may be easier for a proven team to raise Fund V but what if you are just getting started? In my next post, we'll look at emerging managers - those who are on the path to raise Fund I.