The due diligence process for venture capital funds is often considered challenging for LPs due to the relatively high risks and uncertainty associated with the asset class.
A lack of historical financial data, longer horizons for returns and unpredictable exit strategies all contribute to the complexity of evaluating a VC fund's potential. With the significant increase in the popularity of the asset class among LPs, questions about best practices for due diligence have come to the fore.
"The fund-of-fund investment scene has become very crowded over the last few years with a lot of new players emerging," Jonathan Sibilia, partner at Molten Ventures, said. "I am sometimes appalled by the lack of due diligence those guys do. It's very easy for inexperienced LPs to be convinced by (VCs) because they sell very well."
According to Sibilia, doing due diligence can be more art than science, and the process may vary depending on the individual LP's strategy. A pension fund targeting established managers will likely be asking different questions than a fund-of-fund focusing on emerging GPs.
We spoke with experienced pros and asked about the best ways for LPs to do due diligence. Here's what those pros recommend.
Start with the team
The starting point for most should be the investment team, which can make or break the future of the fund irrespective of strategy.
"For me, the team is more important," David Dana, head of VC investments at the European Investment Fund, said. "If you have a great strategy but a very weak team then the fund won't go far. A good team will be able to evolve and refocus even if their strategy is not the best one at the start."
Dana adds that evaluating track records is one of the most important parts of due diligence.
With a GP that is on their fifth fund, the task is simpler as there is concrete evidence of their achievements. However, Sibilia says that LPs still scrutinize past performance to avoid "paper money VCs" that may have highly valued portfolios but have not delivered concrete, realized value.
Distributed to Paid-In Capital—which is a measure of the cumulative value of money paid out to LPs relative to the money invested—is key to determining whether GPs have a proven track record of generating liquidity.
Evaluating a track record is more difficult with emerging managers, and particularly first-time managers. It comes down to a GP's experience in the sectors they are targeting, which demonstrates their understanding of the market. Emerging managers can also demonstrate a track record by setting up a microfund or warehousing investments before trying to raise institutional capital.
Joe Schorge, managing partner at venture capital fund-of-fund Isomer Capital, recommends reaching out to other LPs who may have been invested in previous funds or are looking to commit to the new vehicle as references in order to gain insight into a team's capabilities. Reaching out to founders who have worked with the team to determine how much value they have added to portfolio companies can also be helpful to LPs.
Then check the strategy
Next on the list for due diligence is the strategy. Schorge says that the main things that LPs need to consider are whether the fund proposition has high return potential and if the vehicle can add diversity to the LP's existing portfolio.
"Cutting through the mist, the question we're asking is where is my money in five years," Schorge said. "What we're saying is: 'walk me through precisely the types of businesses you may invest in, where they are, the growth rates, exit assumptions, and so on.' We need to see how we can make money."
Key questions that arise when evaluating a strategy are the size of the market, ownership levels and the pipeline of deals that are available to the GP. LPs also need to make sure that the team has thought about average check size, holding period and follow-on capacity when pitching their fund. LPs should educate themselves on the market that a GP is targeting to better determine whether a strategy makes sense, although for niche sectors this can be difficult.
Skin in the game
A key sticking point for LPs when it comes to fund commitments is the alignment of interests, Dana said.
"We receive offers where the team is taking very limited risk, and that is a red flag for me," Dana said. "(GPs) need to be capable of showing how much they believe in their strategy by taking on some of that risk."
When choosing to invest, an LP must also make sure that the potential manager has skin in the game to incentivize them. Adequate levels of GP commitment—the amount of invested capital that a GP is expected to put into the fund themselves—show that they are invested in the future returns of the fund.
Sibilia also said that the recent trend of GPs not taking portfolio company board seats is a potential warning sign that the manager is not as committed as they perhaps should be. He believes that LPs should be wary of investors who are passive and seem to be following bigger funds.