LP Due Diligence Checklist

The LP Due Diligence Checklist is a tool for limited partners to evaluate venture capital funds for potential investment. It covers management team assessment, investment strategy analysis, track record verification, operational and legal due diligence, and reference checks. The checklist is typically used in three stages: Initial Evaluation, Formal Due Diligence, and Closing. Each stage focuses on specific aspects of the fund to ensure a thorough evaluation process.

This article provides an overview of the LP Due Diligence Checklist and its components. It outlines key considerations for each stage of the due diligence process. The goal is to equip LPs with the necessary tools to make informed investment decisions in VC funds.

Stage 1: Initial Evaluation

1 – Management Team Overview

The initial evaluation begins with an assessment of the funds management team. This stage focuses on understanding the teams experience, expertise, and dynamics. It also evaluates the teams ability to work cohesively and make effective investment decisions.

Key Considerations

• Team experience and track record in venture capital investing
• Team cohesion and decision-making processes
• Leadership structure and individual roles within the team

Sample Meeting Questions

• “Outside of your professional life, what’s a personal passion or hobby that has unexpectedly influenced your approach to investing?“
• “What’s a contrarian or unique view you hold about the future of technology or business that shapes your investment decisions?“
• “Can you tell me about a time when you backed a founder despite initial doubts, and how that experience evolved?“

Stage 2: Formal Due Diligence

2 – Investment Strategy

A clear investment strategy is crucial for a VC funds success. This section evaluates the funds investment thesis and approach. It also assesses the funds ability to identify and capitalize on market opportunities within its chosen focus areas.

Key Considerations

• Clarity and focus of the funds investment strategy
• Target market, stage focus, and sector expertise
• Deal sourcing and investment selection process

2 – Track Record

Evaluating a funds track record provides insight into its historical performance and potential for future success. This section also examines the consistency of the funds performance across different market conditions and investment cycles.

Key Considerations

• Historical performance metrics (returns, distributions, multiples)
• Portfolio company outcomes (exits, valuations)
• Accuracy and reliability of performance data

2 – Operations

This stage involves a deeper examination of the funds operational processes and compliance procedures. It also assesses the funds ability to manage risk and maintain transparency in its operations.

Key Considerations

• Operational processes for reporting, valuation, and cash management
• Compliance policies and procedures
• Reputational risk research on fund manager and key team members

Stage 3: Closing Diligence

3 – Reference Checks

Reference checks provide external perspectives on the fund managers reputation and performance. This stage also helps verify the information provided by the fund and uncover any potential red flags.

Key Considerations

• Feedback from existing LPs, portfolio companies, and co-investors
• Fund managers responsiveness and communication with LPs
• Funds reputation within the venture capital community

3 – Legal Due Diligence and Terms

Legal due diligence focuses on the funds legal structure, terms, and investor protections. This section also evaluates the alignment of interests between the fund managers and LPs through the funds economic terms.

Key Considerations

• Fund legal structure and partnership agreements
• Fee structure, carried interest, and distribution waterfall
• Governance, reporting, and LP rights and protections

3 – Final Review

The closing stage ensures all due diligence questions have been addressed and the funds terms align with industry standards. It also involves a final assessment of the overall risk-return profile of the investment opportunity.

Key Considerations

• Resolution of all outstanding due diligence queries
• Review of side letters and potential conflicts of interest
• Alignment of LPA and closing agreements with industry best practices

LP Diligence Checklists

Stage 1 Checklist

• What unique qualifications does your team possess to achieve top-quartile returns? (Team experience)
• How does your team differentiate itself from other managers in the industry? (Team differentiation)
• Can you explain your investment strategy and its key focus areas? (Investment strategy)
• What is your funds target market and how does your sector expertise align with it? (Market focus)
• What has been your historical performance in terms of key metrics like IRR and TVPI? (Track record)
• Can you provide examples of successful portfolio company outcomes? (Portfolio outcomes)
• How do you typically communicate with LPs, and at what frequency? (LP communication)
• What is your approach to risk management and portfolio diversification? (Risk management)

Stage 2 Checklist

• What insights have you gained from reference checks with your existing LPs? (Reference insights)
• How does your teams expertise specifically align with your target market? (Team-market alignment)
• Can you walk us through the key terms of your partnership agreement? (Partnership terms)
• What is your competitive advantage in sourcing and winning deals? (Competitive advantage)
• How do you add value to your portfolio companies beyond capital? (Value-add strategy)
• What is your succession plan and how do you manage key person risk? (Succession planning)
• What strategies do you employ to build and maintain LP relationships? (LP relations)
• How do you ensure the accuracy and reliability of your performance data? (Data integrity)
• Can you describe your operational processes for reporting and valuations? (Operational processes)
• What compliance procedures do you have in place to mitigate potential risks? (Compliance)

Stage 3 Checklists

Reference Checklist

• What has been your experience working with this fund manager? (Manager experience)
• How responsive and transparent is the fund manager in their communications? (Communication quality)
• Can you provide examples of how the fund has added value to portfolio companies? (Value addition)
• How does this fund compare to others in terms of performance and professionalism? (Comparative assessment)
• Are you aware of any concerns or red flags regarding the fund or its team? (Potential issues)

Legal and Final Closing Checklist

• Have all our due diligence concerns been adequately addressed? (Due diligence resolution)
• Is your target fund size realistic given your strategy and market conditions? (Fund size feasibility)
• Have all side letters been disclosed and can we review them? (Side letter disclosure)
• How has your LPAC been established and is it appropriately structured? (LPAC structure)
• What is your approach to managing potential conflicts of interest? (Conflict management)
• Can you explain your valuation policy and how it aligns with industry standards? (Valuation policy)
• What are your specific reporting obligations, including tax-related items? (Reporting obligations)
• How does your LPA compare to industry best practices? (LPA alignment)
• Have other LPs had their legal counsel review the closing agreements? (Legal review)
• Are the funds economic terms (management fee, carried interest, hurdle rate) competitive and aligned with LP interests? (Economic alignment)
• What key person provisions are in place to protect LP interests? (Key person provisions)
• How are potential conflicts of interest addressed in the LPA? (Conflict resolution)

Conclusion

The LP Due Diligence Checklist is a comprehensive tool for evaluating VC funds. It covers management team assessment, investment strategy analysis, track record verification, operational and legal due diligence, and reference checks. By systematically addressing each component of the checklist, LPs can conduct thorough evaluations of potential VC fund investments. This process helps mitigate risks and informs investment decisions.

LPs are encouraged to adapt this checklist to their specific needs and investment criteria when evaluating VC fund opportunities. The due diligence process should be thorough but also flexible, allowing for meaningful dialogue between LPs and fund managers. By using this checklist as a guide, LPs can make more informed decisions and build stronger partnerships with VC funds.

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