Amidst a more challenging fundraising environment and increased uncertainty around global economic conditions, limited partners (LPs) have become more discerning with their investment decisions and more rigorous in their due diligence processes. In general, LPs may source and engage with hundreds of VCs, but ultimately only invest in a handful. While there is no absolute or fool-proof method for conducting due diligence on these funds, LPs are ultimately trying to answer one key question: can this team generate strong returns?
Fund Diligence – How LPs Evaluate Venture Capital Firms
When investors conduct due diligence on potential venture capital (VC) investments, their focus can be grouped under 5 main categories:
1. Track Record
LPs want to understand the historical performance of the firm. To do so, they will assess:
- Fund performance. What is the fund’s historical performance against public market benchmarks? How is the fund’s historical track record compared to other VCs with similar strategies, industry focus, geographical focus, etc.?
- Status of existing portfolio. How are companies in the fund’s portfolio performing?
- Other Investors. What other LPs have made commitments to the fund? Does the fund have follow-on investors from prior funds?
To determine the capabilities of the fund’s team members, LPs will examine factors such as:
- Expertise within their investment domain/ industry. What is the background of the team members? What entrepreneurial or industry experience do the members have? How strong are their networks?
- Individual performance. What is the historical track record of specific team members? How have they invested/reacted in various market conditions?
- Cohesiveness of the team. How long have the team members worked together? How many deals have the members closed together? How are investment decisions made – is unanimous approval required or are there key decision makers/ investment committees?
LPs want to understand the investment thesis and approach of VC funds, and so will assess the fund’s:
- Investment theory. What is the fund’s approach to investing and does the LP believe it will be successful? Does the fund invest in a specific sector and does that align with the LP’s interests/strategy?
- Competitive advantage. What unique factors or differentiators enable the fund to have an advantage over others?
- Deal sourcing capabilities. How does the fund identify and secure the most promising investment opportunities? Does the fund have access to proprietary deal flow or the ability to consistently win great deals?
4. Investment Terms & Fit
Agreement on investment terms and assessment of fit with the VC fund is crucial to LPs. LPs must ensure that there is:
- Alignment on key contract terms. Do both parties agree on issues such as fee structure, carry, key man clause, clawback provisions, distribution waterfall, etc?
- Fit with the LP’s current portfolio. Is the fund a good complement to the other investments in the LP’s portfolio? Is there good chemistry between the GP and LP?
- GP Commitment. How much investment capital do the GPs themselves have in the fund? Do the GPs have enough “skin in the game”?
5. Market Dynamics
LPs want to ensure that the VC fund will be able to perform well in current and anticipated market conditions. LPs will conduct due diligence on:
- Fund performance under various market conditions. How is the fund expected to perform under various scenarios for the broader macroeconomic environment?
- Competition from other funds. Who are the other players in the space? What challenges will competitors pose for the fund?
With the above considerations in mind, LPs will request documentation from the VC funds and conduct numerous reference calls. LPs will speak with dozens of people the VC has interacted with including those they have worked for, those who have worked for them, their current and prior portfolio companies, etc. Following a very thorough vetting process, LPs will make a final decision as to whether or not to go forward with the investment. If so, the deal will be finalized and documents will be signed. On an ongoing basis however, LPs will continue to actively monitor progress and require updates as it relates to fund activity and progress.
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