In order to invest in a venture capital fund, LPs undertake due-diligence processes, and then based on their experience, intuition and perception, invest in them.
The venture capital industry is esoteric. From the fund management angle, the norms for operating decisions, the manner of remuneration of fund managers, issues of accountability, penalty (or its absence for non-performance) and incentive for performance are all obscure. In choosing funds to invest in, there is an element of uncertainty in decision-making because intuition and subjectivity dominate. These aspects need to be analysed, and eliminated to the extent possible to make these more predictable to enable evaluation.
There are two critical issues: First, as to how do venture capital firms undertake investment decisions and, second, what do limited partners (LPs—institutional, family offices, HNIs) look at while choosing the venture capital funds to invest in. While a few studies have been done on the issue of the rationale behind investments by funds in investee companies, the reasons for contribution by LPs to funds still appear to be a game of blind pool. If one studies the manner in which most LPs make their investment decisions, it would call for better underwriting framework and objectivity.
In order to invest in a venture capital fund, LPs undertake due-diligence processes, and then based on their experience, intuition and perception, invest in them. The decision to invest also takes precedence in case a known LP has already committed to a fund. The first credible LP to invest has a larger responsibility as others would follow with less rigorous due-diligence. However, there are no established underwriting standards about due-diligence on these funds; LPs, while gauging various subjective parameters, are only trying to guess: Whether or not the fund will be a winner?
The track record in terms of return on investments assumes a lot more significance as these investments are presumed to be very risky. The status of the companies in the fund’s portfolio will give an indication about the choice made by the fund managers. LPs also look at commitments of other LPs to the fund. Does the fund have follow-on investors from prior funds? This may be true for funds that have made exits but becomes complex when the fund is trying to raise funds for the first time. It becomes difficult to assess the experience if the fund manager approaching the LP is a first-timer, even though he/she may be having an investment experience in a different role. The background, industry experience, entrepreneurial experience, and learnings from the failures of the investment team of the prospective fund become another subject of due-diligence. Cohesiveness amongst team members is given an important place. Fund managers speak on the fund-raising strategy, investment strategy, exit strategy. It is left to LPs to understand the various strategies and approach of venture capital funds, and assess the convergence of all sub-strategies into a grand strategy. Issues like competitive advantages (which all funds claim somehow or the other), deal-sourcing strategies, etc, are looked at in detail by the prospective LPs. The networking power is also given a premium.
Further, LPs have to ensure there is agreement on investment terms such as fee structure, carry, key man clause, claw back provisions, distribution waterfall, etc. To illustrate, if the majority of the carry is cornered by a dominant partner, then the incentive for other partners becomes lacklustre. Market regulators have defined a minimum stake that should be put in by the partners. However, an enhanced level of stake by the partners inspires confidence in LPs. While respecting regulatory requirements, an enhanced stake by partners in the fund should be looked at favourably and given extra weightage.
The prevailing system is also to undertake numerous reference calls with people the venture capitalist has interacted with. The reference checks in most cases are provided by the fund manager himself/herself, and most of the feedback received varies from very positive to positive. Unless there is an element of rationalisation, correlation with other available information and people are aware of the effects of their comments, the industry will be beset with uncertainty.
These elements lend to themselves enhanced level of subjectivity rather than looking at the issues in a fine and objective manner. An individual’s approach at looking at these issues may vary, thus necessitating the need for objectivity.
A rating model with large objective parameters may hold the key in improving the evaluation process. This may result in a publicly-agreed methodology to understand and underwrite the risk in a predictable scientific manner and less by intuition. While criticism may arise on the construct of the model, the first step is always the most difficult as it tries to question the status quo.
As a first step, broad agreement on the various parameters that make up the model can be arrived at through debate and consensus amongst the various stakeholders. This may comprise a sponsor’s (having direct involvement in the fund) or a fund manager’s commitment to the proposed fund, average investment experience (fund management/angel investment) of fund managers, fund managers’ experience in segments and stage of investment of the proposed fund, performance profile of previous funds, commitments from existing LPs (past LPs in previous funds), cohesiveness of managers, age profile of key members (a balance of maturity and age), the ability to wind up the previous fund(s), and viability and sustainability of the proposed structure (including the size of the corpus, term of the fund, commitment period, number of investments, etc). As also, the follow-on strategy, quality of investment committee members, adequacy of staffing for effective handling of front office activities, investor servicing, operations, investment team, risk management, and management’s wherewithal to motivate and retain talent. While some of the elements of the model may give a sense of deja vu, but a model with an objective scoring pattern will be different.
Once there is an agreement on the parameters being assessed, each of the parameters can be defined more granularly. The suggested rating for each of these parameters can be arrived at through a debate amongst stakeholders. Once the model has been codified, the same can act as a guide to LPs (similar to ILPA guidelines) on the best practices to evaluate fund managers. This model will surely function as an important tool in the armour of LPs to evaluate funds and might provide some objectivity into a highly subjective process.
By- Mohammad Mustafa. The author, an IAS officer, is CMD, SIDBI.