Do you know how to analyse any venture capital fund correctly and accurately? Our ‘eagle eye’ approach and six-step analysis will help you do just that.
There are several investment opportunities within financial markets, such as alternative investments. Among these are those of venture capital.
We can classify investments within the VC industry as: direct, if you invest directly in startups (controlling the underlying asset), or indirect (when you do not have control of the underlying asset) by investing in other VC funds.
Alternating between these two types of investments allows risk diversification and access to higher returns.
Eagle eye approach
Like investments in startups, investing in funds involves a pre-established process that must be fully followed.
This process begins with the approach we call “eagle eye”, which involves:
- Telescopic vision: to detect good venture capital funds
- Panoramic view: to establish points of comparison between venture capital funds
- Acute vision: to analyse in detail and calibrate the investment
Six-step methodology
Continuing with this process, we will complement the eagle eye approach with the six-step methodology.
First step: fund strategy and alignment
The first thing to do is to understand the type of fund in which you want to invest, so it is convenient to keep in mind the risk and return profile of the portfolio you are going to manage.
You must find a fund with a close alignment to your investment strategy. So be sure to check out the following items:
- Vintage: determine the year the fund was raised to make it comparable with other funds
- Investment stage: validate if they invest in seed, early, growth, etc. (that is pre-Series A, Series A, B, C and so on)
- Investment ticket in startups: understand the amount of initial investment and the subsequent investment amount (follow-on) per investment and as a portfolio
- Sector: identify the verticals where the vehicle focuses. For example: AI, deep-tech, retail technology, fintech, logistics, distribution, supply chain.
- Geography: know in which territories the fund will seek to invest (for example the US or Asia). On some occasions, VC funds will seek to invest according to the nationality of the entrepreneur (such as companies established by Israeli founders).
- Size of the fund: it must be aligned to the geography and the investment stage. Not necessarily the smallest or largest funds are the best for your portfolio as an investor.
- Other elements to consider: where you get investment opportunities from, strategy aligned to macro factors, competition with other funds, active or passive role when making investments, geographies where the fund operates
Second step: management team skillsThe team is the one that executes the strategy, makes things happen and takes care of the return on your investment. Some considerations are:
- Relevant investment experience: look for teams that have experience making investments, it may be within the same fund that you plan to invest, in other funds or as angel investors
- Relevant sectorial experience and education: look for a team with relevant experience in the sector you plan to invest, and make sure that their investment thesis is consistent with their experience
- Wide network of connections between the geographies and verticals of the fund: look for a team that has superior strategic and complementary connections to other funds
- High capacity to originate investment opportunities (dealflow): this is one of the main elements within any team. Without a broad origination channel, the ability to select relevant opportunities is greatly reduced
- Team stability and cohesion: evaluate if the team members have worked together before and if the team has stayed together through time and different economic cycles
- Interaction and support to companies in their portfolios: understand if they support startups, not only with money but with other variables (for example: with introductions to corporations, investors, associations, mentors). In addition, it is important to understand if they support all the companies in its portfolio or only those that are on the right track.
> Other elements to consider: team size, complementary skills, clear functions, responsibilities, decision-making, succession planning, brand recognition, implementation of analytics in their investment processes.
Third step: external validation (track record)
Although past performance does not ensure future returns, do research on the historical performance of previous funds managed by the same team or other individual partners related. This is essential. For this you must consider:
- History of previous funds or of partners’ portfolios: try to ensure that they have had a positive or superior net return to other comparable funds (internal rate of return, cash-on-cash). If the fund has a comparative analysis with the entire industry, make sure it is in the first decile and that the returns have been real; that is, with outflows (sales of portfolio companies or initial public offerings) of their investments and not just paper returns.
- Continuity of the partners in the fund: make sure that the partners that generated the returns of the fund are still part of the investment team and have not switched to another fund.
- Quality and recurrence of fund investors (limited partners): having institutional investors (who belong to a recognised organisation) is a way to validate the quality of the fund. The recurrence of these investors is a good reference of a good and continuous performance of the venture capital fund.
- Validate investments: review the quality and performance of the fund’s previous portfolios, as well as the quality of the co-investors (which are those other individuals or institutions that have invested in the same portfolio companies). Also take into account the subsequent investments (follow-ons) they made in these companies and understand the write-offs (companies that failed) that they have had historically. Validate if there are red flags in their previous portfolios.
- Other elements to consider: size of the funds and growth over time, consistency in the investment thesis (for example, VC vs private equity, type of investment: equity vs venture debt, industrial sector), references of other funds and startups in which they have invested (preferably those startups that have failed since they will have a more critical perspective), vision of the entire ecosystem (that is, determine if they are legendary funds, tier one, two, three, etc), main investors or participants in syndicated transactions.
Fourth step: team motivation and incentives
It is important to understand the culture, motivation and incentives of the team as the duration of a venture capital fund is usually around 10 years and the expected returns are in your hands. The main elements are:
- GP commitment percentage: usually the fund manager (general partner or GP) contributes to the fund with a percentage of the total (1% to 5%), in this way their money is at stake too. This helps to align expectations with investors (limited partners or LPs).
- Incentive structure (management fee and carried interest): the management fee (ranges from 2% to 2.5%) allows the fund to pay salaries, office rent, travel and per diem. The members of the fund usually go for the carried interest (around 20%), which is the benefit that the investors of the fund (LPs) share with the GPs and is directly related to the financial performance of the vehicle (profit of the fund).
- Fund-related activities: understand what percentage of their time GPs use in other activities not related to the vehicle.
- Other elements to consider: Define if there is a key-person in the fund (key-man provision), team independence, external activities, possible conflicts of interest, division of carried interest by partner, culture of the fund (aggressive, passive and so on), team energy, among others.
Fifth step: fund structure
As in any other type of investment, the structure and terms of the fund must be considered. Some of the considerations are:
- Fund size
- Term: 10 years (divided into: five years of investment and five years of exit)
- Jurisdiction: usually the fund is established in the country where you are going to invest. For foreign investors you can make pre-established vehicles domiciled in the US, Canada, the Cayman Islands, the Netherlands, Holland and Singapore, among others.
- Waterfall: defines the guidelines for the contributions and distributions that the fund will make to all its participants.
- Economics: management fee, carried interest, average commitment of GP and LPs.
- Other elements to consider: expected investment portfolio, expected closure, investment committee, among others.
Sixth step: additional rights for the investor
Usually, the financial return is the main objective of the investor; however, other rights can be sought when analysing and negotiating with a VC fund, for example:
- Fund governance: establishes whether the investor can seek to have a seat on the investment committee or at least have an observer seat.
- Co-investment rights and generation of investment opportunities (dealflow): defines the investor’s opportunity to invest additional money in the investment opportunities of the fund and receive additional opportunities where the investor could invest independently.
- Information and consulting rights: establishes access to the fund’s databases; specific portfolio reports; from industries or technologies; consulting on particular topics.
- Access to the fund’s network: establish whether you will have access to the different interest groups in the fund such as startups, investors, allies, other funds. Usually through fund events (for example: annual meetings, demo days, showcases, executive education programmes).
Find the total fit
These six elements must be completely intertwined to achieve a perfect fit, when this happens the result will be the fund where you could invest. Each item must have at least a minimum desirable rating for you to advance in the process. Each element is relevant by itself, but it is not the only consideration for a final decision. Always keep in mind that it will be difficult to find a fund that is 100% aligned with your goals.
Additional tips
- The momentum of fundraising: When did the survey start, when was the first closing, when is the final closing, the hard cap and what is the minimum ticket?
- Marketing: do not be intimidated by the appearance, branding or scared by the pressure they may exert on investing, focus on the content and the hard data during the analysis.
- Face-to-face meetings: physically visit their offices, talk to the different team members, assistants, analysts, associates and partners, together they demonstrate the culture of the fund. These characteristics are essential for investment.
- When the fund is managed by a friend of yours or someone you know: be stricter in the due diligence and always do a comparative thorough analysis to avoid biases.
- Entrepreneur funds do not have higher returns than traditional funds. Each fund has its own merits.
In summary, consider that you are going to establish a long-term relationship (10 years), so follow the dynamics of the eagle eye and use the six-steps methodology calibrating the speed and detail of your analysis to ensure a successful hunt.