LP Venture Process

Professional investing in emerging managers combines intuition with validation. This process can span weeks to months. The following article explores the path to a successful investment in an emerging manager fund for small and large investors and those with more or less time.

Step 1. Set-up

As a limited partner, reflecting and refining your Investment Criteria over time is important, incorporating learnings from your experiences. The key component of the Investment Criteria is determining how much you want to invest over what period of time, which can be a rough estimate. 

Next, you reflect upon your investment goals to have exposure to sectors, geographies, and stages. You may also consider other objectives, such as diversity or sustainability. Being agnostic in specific components of your Investment Criteria is common, as it gives more exposure. For example, you may be interested in Africa, while being sector and stage agnostic. 

Another important component of your Investment Criteria is how much time you have to evaluate managers and funds and roughly how many funds you want to evaluate. Your available time affects how many funds you can Scout and Diligence, and ultimately how many funds you can invest in. In a light professional process, it might take 10 hours to do one investment, and it can take much longer with a more thorough process.  

“[Limited Partner Name] intends to allocate [$x] over [Time Frame], focusing on [Stage] funds in [Geography] targeting [Sector/Market Companies], [prioritizing Additional Criteria] while dedicating [Time to Evaluate] to explore roughly [Number of Funds] funds.”

Once you have the Investment Criteria roughly established, the next step is to outline your Investment Process. For this, you identify a target number of candidate funds across scouting, Diligence, legal, and closing. You may want to look at at least three funds before investing in one and have a streamlined process to complete the investment in 10 hours or less, as an example. 

Investing in venture capital is as much about a process as it is about your gut or your instincts. Too much process can get in the way of making a good investment decision. Too little process and you may back the wrong manager. 

Step 2. Scouting

Begin to source emerging manager funds that meet your investment criteria. As a general rule, it is best to scout a few deals that meet your investment criteria to get a sense of what different managers bring to the table.

Finding managers who meet your investment criteria is important. There is a boom of venture capital right now, and there are thousands of aspiring new managers looking to launch funds with hundreds of new managers successfully launching funds. With a little effort, limited partners can meet numerous managers to evaluate. 

Finding managers to meet can be done in a variety of ways. Managers are not allowed to publicly solicit interest excepting special circumstances. So, networking is required. First, VC Lab is happy to provide a list of interesting managers that meet your investment criteria. Next, attending private networking events at larger conferences is a great way to meet managers. 

The initial evaluation with a manager or managers is largely subjective. Do they have a relevant background on their Thesis? Do they have an interesting track record in their Thesis? Are they able to get interesting deal flow related to their Thesis? Most importantly, do you have good chemistry with the manager or managers?

As a general rule of thumb, you want to meet the manager to get to know them first, and then get the pitch on their fund officially. This allows you and the manager to comply with general solicitation rules worldwide. You can learn about the manager, their background, and their interests while getting to know one another. 

Here are some sample questions to get to know a manager. Most importantly, follow your own intuition to connect with a manager.

• Can you share a bit about your professional background and how it led you to venture capital?
• Can you share an example of a past investment that you’re particularly proud of and why?
• How do you build relationships with founders, and how do you support them post-investment?
• What is an example of a challenging situation in your career and how did you handle it?
• What sectors or industries are you particularly interested in and why?
• What are your long-term goals?

Step 3. Diligence

The amount of Diligence to complete an investment in an emerging manager is largely dependent on the amount of money that you are planning to invest relative to the overall target fund size. A larger investor may be able to conduct a large amount of Diligence, whereas a smaller investor may not be able to do much Diligence at all.

At a minimum, all professional limited partners should request access to the Data Room, which traditionally contains most high-level Diligence items that you will want to review. Some managers may require that you sign a commitment letter, or PACT, before looking at their Data Room, which normally contains the following:

• Financials
• Fund Model
• Legal
• Portfolio
• Presentation
• Research
• Team

When reviewing materials in the Data Room, it is common to prepare a list of questions and then send those questions to the manager for answering. Diligent limited partners may ask about the team, deal flow, warehoused investments, or fund returns.

An easy way to Diligence managers is to do independent research on the deals that they are talking about. Often, managers will reference deals, and the circumstances of the deal will change. So, for example, a manager will claim that they had a great exit, and the situation around the company may have changed. This happens, and it is normal to discuss any such findings with the manager. 

For larger investors, Diligence can go deeper in a few different ways. 

• References: Basic Diligence includes reference checks on the manager or managers. This includes contacting cited references and may include conducting off-list checks. You may also reach out to former portfolio companies to verify claims and performance. Large institutions can do more than 40 reference checks per investment.
• Track Record: When doing Diligence on track record, you validate claims about past performance, including sourcing, leading, and managing deals. You may review Deal Memos to understand the rationale behind past investments and decision-making processes. Additionally, you may check with vendors, like attorneys, to verify professional relationships and operational efficiency.
• Model: Validating that the fund model is realistic is an important step in Diligence. You examine projected returns, portfolio failure rates, and projected exit scenarios relative to market size. Using your own research, assess the realism of these projections, ensuring they align with market trends and the fund’s investment strategy. 
• Engagement: Another important area of Diligence is the engagement of the manager. You evaluate their communication skills, responsiveness, and transparency. You assess the manager’s ability to share information, provide updates, and respond to inquiries effectively. This may involve reviewing past correspondence, assessing the quality of reporting and updates, and possibly speaking with other investors or stakeholders to gauge their experiences with the manager.

It is important to remember to keep Diligence efficient for you and for the manager. It’s also important to explain your Diligence process to the manager to manage expectations. Not everything that you learn in Diligence will be favorable, but that does not mean you should not invest.

Step 4. Commitment

Once Diligence has been completed, a decision to invest in the fund needs to be made. The ideal scenario is to have multiple funds that have completed your Diligence process to choose from to invest in. When choosing between multiple options, you will have a greater perspective on the market and on managers, and you may even decide to invest in multiple funds.

No matter how much Diligence you complete, investing in a new or emerging manager will have risks. You will need to make investment decisions with imperfect data. You may even decide to invest in a fund where you have received some negative information. The main thing to remember is that you will be working with the manager or managers for a decade or longer. Strong chemistry is definitely important.

Once a decision to invest is made, you will inform the manager of the decision, often by signing a commitment letter or PACT, if you have not done so already. The manager will then inform you of the next steps in the process. Ultimately, you will get the limited partner agreement (LPA) to sign.

A limited partner might choose to invest before the first close to take advantage of lower minimum check sizes and potentially gain first look at co-investment and follow-on opportunities. Investing early can also allow the LP to influence the fund’s direction and strategy. On the other hand, an LP might choose to invest after the first close or participate in the final close once the fund has demonstrated its viability, secured other investors, and begun deploying capital. This can provide the LP with more assurance about the fund’s potential for success.

Step 5. Legal

Reviewing the limited partner agreement (LPA) is an important step in the investment process. You may have quickly reviewed the LPA during Diligence, and, now, you will do a more formal review. These documents can be very complicated, sometimes being hundreds of pages long. This is why we created the Cornerstone Agreement, which is a short and easy to read limited partner agreement for emerging managers.

For larger limited partners, you will want to have an experienced fund formation attorney review the documents. It is generally a good idea to have experienced counsel and to ensure that they have a time and price limited review of the documents. For smaller limited partners, you may complete the legal review on your own. The main areas that you want to review include:

• Economic Provisions: The Economic Provisions outline the financial aspects of the fund. These include Management Fees paid to the General Partner (GP) for managing the fund’s operations and investments, which are typically 2%. They also include Carried Interest, the GP’s share of the profits, which is often set at 20%. Fund Expenses can be defined in multiple ways and often include costs associated with running the fund, such as legal and accounting fees, diligence costs, and other operational expenses. There may be a Hurdle Rate, which gives limited partners additional upside before paying out Carried Interest.
• Voting Provisions: The Voting Provisions outline the decision-making process within a fund. Significant decisions, including disputes,  often require approval of the Majority in Interest, which can have multiple definitions and percentage thresholds. The limited partner Advisory Committee (LPAC) is another key component, typically composed of select limited partners who are consulted on certain matters, such as potential conflicts of interest. The specific roles and powers of the LPAC vary.
• Timing Provisions: The Timing Provisions for a fund include the active investment period, typically between 2 to 4 years, which is the time allowed for a fund to deploy capital into investments. The active fundraising period is the number of months from closing when the fund is actively seeking capital commitments from investors. The fund duration is the lifespan of the fund, after which remaining assets may be distributed to limited partners, or the fund life may be extended to wait for an exit. Distributions are usually made upon exits, with the timing and details specified in the LPA.
• Capital Call Provisions: Capital Call Provisions outline the process for the fund to request that limited partners contribute a portion of their committed capital for investments and fees. The amount and timing of Capital Calls are defined in the LPA, and they can either be rather flexible or more strict. Penalties for missing a Capital Call are also outlined in the LPA, which can include interest charges, forfeiture of interest, or other remedies at the discretion of the General Partner.
• Key Person Provisions: Key Person Provisions protect investors in the event that key individuals whose skills and expertise are vital to the fund become incapacitated or unavailable. It is important to know who the Key Persons are and what happens if they become unavailable. If all Key Individuals are incapacitated, the fund commonly enters a “Limited Operations Mode”. 
• Limited Operations Mode: Limited Operations Mode is a state in which the fund is placed on hold and may be liquidated or otherwise dissolved. This mode is often triggered when there is a loss of key persons, a dispute, a breach, or an event, such as a felony. Limited Operations Mode is the main remedy for limited partners, so it is important to understand how it works.

A helpful tool to answer any questions about confusing legal language is Decile Base.  

Step 6. Closing

When you finalize the Diligence and Legal, you enter the Closing. This normally requires signing the LPA and completing your first Capital Call. With certain LPAs, the firm will require limited partners to complete a Subscription Agreement with various regulatory requirements, such as being accredited in the United States.

You do not invest the full commitment at the time of closing. Instead, the manager calls capital as needed for operating expenses and to make investments. There are three major expense categories in a fund: management fees, organizational expenses, and fund expenses. For most emerging manager funds, the expenses are small, so managers rely on the carried interest for upside, aligning incentives.

The initial Capital Call for most emerging managers is between 20% and 30%. The schedule of Capital Calls is dependent on many factors and may be outlined in the LPA. As a general rule, managers will not call additional capital until after the full amount of the fund is closed, and then additional capital is primarily called during the Active Investment Period of the fund.

Step 7. Reporting

Reporting of emerging manager funds varies widely. Some funds report quarterly and other funds report annually. Reporting frequency is specified in the LPA. In general, managers supplement the formal financial reporting with regular newsletters and events.

A saying among limited partners is “a fund investment is an expensive newsletter,” as the manager provides insight on the focus of the fund Thesis. This gives the limited partner deep insights into specific portfolio companies, market trends, and other related insights. 

Funds generally have a J Curve, which means that for the first two to four years, the various fees of the fund cause the returns to be negative. Once the portfolio companies start to get marked up, the funds will report positive “unrealized” returns, normally measured as TVPI or IRR. 

Limited partners can help the managers to succeed. The term limited partner clearly implies that the role is limited in nature, and, as a result, the LP has limited liability, which is important. There are two ways to help that keep the limited nature intact. 

First, LPs can share any news, investment opportunities, or other limited partners that they see that might be helpful to the manager. This can be done selectively and politely to not overwhelm the manager. Nearly every emerging manager appreciates a qualified introduction to other LPs. 

Additionally, managers can use encouragement. Launching a venture firm is a hard endeavor, among the hardest things to do. Good managers will report the bad news along with the good news. 70% of venture-backed companies fail. A nice word or congratulatory message goes a long way.

Step 8. Exits

The ultimate goal of a fund is to generate exits, which are cash on cash returns or DPI. Initial exits may come after a few years, and then the larger exits come toward the end of the find life. The venture saying is, “lemons ripen first.”

It is not uncommon for some of the largest opportunities to take more than the term of the fund, which is why most funds have an extension period of two years where there are no fees taken. Managers may choose to liquidate some opportunities in a secondary sale or distribute the shares to limited partners. 

Multiple funds that invested in Google ended up distributing the shares before the IPO, generating unprecedented returns for the limited partners. Working with the managers to identify the best solutions for companies that have long exit timelines can allow for the best possible outcomes, as pressure to exit may reduce overall returns. 

There are multiple ways that returns are handled by funds. First, there are the American and European waterfalls specified in the LPA. The American waterfall in venture capital refers to a deal-by-deal method of allocating carried interest, where the General Partner (GP) entity receives its share of carried interest on a deal-by-deal basis before investors are made whole overall. The European waterfall is a method where all limited partners’ capital contributions have been repaid before the GP entity receives its carried interest, ensuring that investors are made whole first.

Next, a fund may have an option to recycle returns. Recycling refers to the process of reinvesting proceeds from the sale or exit of a portfolio company into new investments. This allows for greater deployment of capital, potentially increasing the fund’s overall returns by giving the fund the opportunity to invest in more or larger deals without requiring additional capital commitments from limited partners.

In the end, limited partners often need to be patient for the best returns, which can take a decade or longer. The wait is often worth it, as top-performing companies can produce 1,000x returns or greater.

Conclusion

A successful investment process in emerging managers requires a blend of intuition and validation. When you set your Investment Criteria and start a process, opportunities will arise to invest in interesting managers. When the opportunity feels right, and the fund passes Diligence, even if it has some issues, you will learn and improve by completing the investment. The best way to learn is by doing.

About The Author