Due Diligence the VCs: Part One, The Limited Partner Perspective
With the recent rise in the number of emerging mangers raising new funds, as well as the trend towards the institutionalization of pre-seed, I’ve been thinking more about frameworks through which to evaluate the VCs. In this first post I wanted to approach things from the LP perspective and think about the due diligence process through three filters, investments, people, and capital. Most of this won’t be new to the LP community, but nonetheless I wanted to outline a rough framework I would use to look at GPs and funds in the space.
The best place to start, and one of the primary factors institutional limited partners will evaluate, is portfolio construction. Without delving into power law distribution and the mechanics of venture capital returns, it should be sufficient to say that ownership percentage and how it relates to fund size will be a principle filter though which LPs view VC funds. A great question to ask as an LP would be, can the general partners write a consistent check size to meet ownership targets?
Fund size is partly determinate of the strategy. GPs who realize that upfront should be aware of how check size and ownership percentage can materially alter returns. Thus, a follow up question to ask would be whether they have the conviction to lead rounds and build concentrated ownership in the portfolio. Ask too, whether implications change if a fund is oversubscribed. I think this is true more than anywhere else at the seed stage, and particularly important for the 25–75 million dollar funds.
Apart from portfolio construction, LPs will want to know that the VC is actually going to have access to the best investment opportunities. In other words, can you determine if the GPs will see interesting deal flow? In absence of a strong track record, usually the background and network of the managers can provide an answer. Prior industry experience, domain expertise, a deep network, spinning out of a well know company, these things and others are all strong signals that a GP is likely to see the necessary deal flow.
For VC firms who may raising a third or fourth fund, a track record is starting to emerge that can at least be evaluated qualitatively. For example, what is the level of discipline in strategy? If the fund size has grown significantly or if the firm is suddenly stage agnostic, it would be a warning sign. Some successive growth in fund size is good, especially if it is allowing the GPs to refine a specific strategy around portfolio construction. LPs should certainly be evaluating the nature or the changes though, and whether there’s been any style drift.
Lastly, when it comes to investments, Do the GPs have a strategy around board roles to either increase possibility of participation in future rounds or to protect shareholder value should the company hit massive scale? For LPs with investors themselves, those are questions they will want to be able to answer.
For LPs, people is undoubtedly the most important component when it comes to evaluating VCs. Investing in early stage VC funds is primarily a people business. This is doubly true with regard to emerging managers absent a significant track record. I would argue that allocations to venture are more art than science, and the best measure of evaluation are the managers themselves.
The first question to ask is whether the firm is managed by a sole GP, a partnership, or by multiple GPs? Traditionally, LPs have avoided sole GP firms due to key man risk, risk associated with a solo decision making process, and concerns about the ability of a single person to adequately spread their time across investing, fundraising, and supporting portfolio companies. Though things are starting change with the emergence of highly focused nano and micro VC firms, institutional capital still tends to prefer partnerships and multiple GP firms.
Multiple GP firms may reduce the risks associated with sole GPs, but they incur the additional risk of the partnership blowing up, or of a bad manager dragging down the whole firm. Just like the startups they invest in, the leading cause of failure for new managers is conflict between partners. The average length of a fund is longer than the length of many marriages, and any successful firm would plan to raise multiple funds. This should underscore just how important is is for LPs to understand the relationships between GPs when evaluating a firm.
When it comes to performing due diligence on the people factor, another question to ask is about the level of diversity in the firm. Not only across gender and race, but also in background and cognitive diversity. I’m not convinced it has become clear yet to some VCs that diversity is an asset, and the makeup of many firms reflects that. I’d argue that diverse firms are better equipped to take advantage of changing landscapes, identity non-obvious opportunities, eliminate blind spots, and reduce unconscious biases. It is not only the right thing to do, but something smart managers know is a value add.
Aside from evaluating the people factor personally, almost every due diligence process will involve references from other LPs, founders, past partners, mentors, and colleagues. For GPs with at least some prior investing track record, I think a great approach to references lies with founders. Ask successful and unsuccessful founders why they chose the GPs/VC firm in question and compare with the differentiation claims made by the managers themselves. If the GP claims to be actively involved in helping their portfolio companies, but the founders you’ve spoken to name someone else as their first or second call when issues arose, that’s a red flag. Conversely if the claims match up then that should inspire a large dose of confidence.
The last question asked should be about the relationship between LP and GP. Can you work with one or more of the GPs for at least 12 years? If you can’t see yourself or someone on your team forging a long term relationship with someone on theirs, then that should tell you all you need to know.
The third part of this framework concerns the other capital GPs have already raised. The LP due diligence process will certainly include questions to understand the other LPs in a fund. There are some great questions for LPs to ask when evaluating prior sources of capital, and who might be co-investing in the fund in question. Is it primarily institutional capital, mostly HNW individuals/RIAs, or a mix? How much of a fund do the other LPs expect to own? Has there been progressive LP growth through funds? Has the firm retained their LPs through funds or been able to attract new LP commitments? Was there an LP with a tracking investment that has now made a full commitment? Having a full understanding of the profiles of the existing LPs, their preferences regarding communication and reporting cadence, and their preferred strategies will be helpful in determining whether or not to invest in a fund. You’ll want to know the size and permanence of other capital sources you may share a fund with.
Diligence through the filter of capital should also include speaking to LPs that have passed, and understanding why they decided do so. In some cases it could be structural (an institutional LP that writes 50 million dollar checks to own 10% of a fund wouldn’t be a fit for a 25 million dollar seed stage fund), though in others there may have been red flags during the due diligence process. The LP community is known for being opaque, so not everyone may be willing to speak about their investment process or due diligence findings, but it is worth asking.
An LP will also want to have a sense of the fundraising tempo for subsequent funds. If a GP plans to raise two years after closing on their previous fund, LPs should expect to make additional commitments at around the trough of the j-curve. The tempo may change based on the macroeconomic climate and trends within PE, so it would be beneficial for LPs to know where managers stand. Additionally, do the GPs want to make any changes changes to the LP base or increase the fund size in the near future? Any plans they have around those decisions are worth your consideration at present.
I would end by asking a few questions about mechanics, at what rate to they expect to call down capital? Have they distributed capital out of any previous fund yet? Are they willing to consider secondary transactions as a way to provide some liquidity? Do they anticipate opportunities for LPs to make direct investments in successful companies? Do SPVs play a role in the follow-on strategy or is capital kept in reserve? These are the questions that can round out an evaluation of the capital component and ensure expectations between GP and LP are in line.