LP Due Diligence Flags

When evaluating emerging venture capital managers raising their first or second fund, limited partners (LPs) face unique challenges and opportunities. These managers often lack extensive track records but may offer fresh perspectives and hungry, innovative approaches. This article outlines a system of flags categorized by severity to help LPs assess and quantify potential risks and rewards when considering investments in Fund I and Fund II offerings from emerging managers.

The flag system is designed to provide a structured approach to evaluating the potential risks and rewards associated with emerging VC managers. By categorizing various aspects of a fund and its management team into different colored flags, LPs can quickly identify areas of strength, concern, and potential dealbreakers. This system is particularly useful for assessing Fund I and Fund II offerings, where traditional track records may be limited.

Flag Overview

Our flag system consists of four categories: Green, Yellow, Orange, and Red. Each category represents a different level of potential risk or benefit, with corresponding penalty points assigned to help quantify the overall assessment of a fund.

Green Flags (+1 Bonus each)

Green flags for emerging managers indicate promising characteristics that could lead to strong future performance. These positive indicators suggest a well-prepared team with the potential to build a successful VC firm.

• Strong relevant experience (e.g., successful operators or angel investors)
• Clear, differentiated investment thesis aligned with market opportunities
• Early evidence of quality deal flow and network effects
• Robust operational processes and compliance procedures for fund size
• High level of transparency and proactive communication
• Notable advisors or venture partners complementing the core team
• Early signs of value-add to portfolio companies beyond capital
• Significant personal GP commitment relative to net worth
• Positive references from co-investors or initial LPs (for Fund II or III)
• Initial promising performance of early investments (especially for Fund II or III)

Yellow Flags (-1 Penalty each)

Yellow flags represent minor issues that are common among first-time or second-time fund managers. While these concerns warrant attention, they are often expected challenges that can be addressed as the firm matures.

• Limited track record as institutional investors
• Small team with key person risk
• Slight adjustments to investment strategy between Funds
• Incomplete back-office systems, but with plans to improve
• Fund size ambitious relative to team’s experience
• Limited diversity in investment team
• Some portfolio companies underperforming but within expected range
• Lack of experience in certain operational areas (e.g., LP reporting)
• Minor misalignments in partnership agreement terms
• Incomplete track record of exits (natural for early funds)

Orange Flags (-2 Penalties each)

Orange flags signify more significant problems that require careful consideration. For emerging managers, these issues could indicate potential stumbling blocks in their journey to establish a successful VC firm.

• Significant strategy shift between funds without clear rationale (Fund II+)
• Unproven ability to lead or win competitive deals
• Lack of institutional LP support (especially for Fund II)
• Inadequate operational infrastructure for proposed fund size
• Opaque or inconsistent valuation methodologies
• Signs of team discord or lack of role clarity
• Excessive fees or carried interest for the team’s experience level
• Weak governance structures or lack of LPAC (especially for Fund II)
• Pattern of unsuccessful exits or down rounds (for Fund II)
• Significant deviation from target fund size

Red Flags (-3 Penalties each)

Red flags for Fund I and Fund II managers represent critical issues that could severely impede the fund’s success. These warning signs demand thorough investigation and may be dealbreakers if not adequately addressed.

• Unresolved regulatory issues or legal disputes
• Misrepresentation of track record or experience
• Severe misalignment of interests between GP and LPs
• Catastrophic loss or failure of multiple early investments
• Inability to raise Fund II after a reasonable period
• Major team changes or departures without explanation
• Gross violation of Thesis or investment strategy
• Significant personal misconduct by key team members
• Persistent pattern of misleading or withholding critical information from LPs
• Severe underperformance of Fund I with no credible explanation or improvement plan

How to Score

The scoring process for evaluating emerging VC managers requires a nuanced approach that goes beyond simple arithmetic. To quantify the potential risks associated with an emerging VC manager’s Fund I, Fund II, or Fund III, LPs can use the following scoring system:

• Green Flags: +1 Bonus each
• Yellow Flags: -1 Penalty each
• Orange Flags: -2 Penalties each
• Red Flags: -3 Penalties each

Recommended Threshold

No fund should have a total score exceeding 5 Penalties

While the flag system provides a quantitative framework, it’s crucial to interpret these scores within the broader context of the fund, its market, and your investment strategy. Here are five key considerations to guide your scoring process:

Fund Stage Weighting

Adjust your scoring based on whether you’re evaluating a Fund I or Fund II. For Fund I, place more emphasis on green flags indicating potential, while for Fund II, focus more on the execution and performance of Fund I.

Contextual Scoring

Consider the broader VC market conditions and the fund’s specific sector focus. Some flags may carry more or less weight depending on current market trends and opportunities.

Qualitative Assessment

Use the numerical score as a starting point, but don’t neglect qualitative factors. A fund exceeding the penalty threshold might still be worth considering if there’s a clear plan to address identified issues.

Benchmarking

Compare the fund’s score to other emerging managers at a similar stage. This helps calibrate your expectations and identify standout opportunities or risks relative to the peer group.

Dynamic Updating

View the scoring process as ongoing throughout your due diligence. Regularly reassess as new information becomes available, recognizing that flag colors may change or new flags may emerge.

By applying these principles, you can develop a more comprehensive and nuanced understanding of the potential risks and rewards associated with emerging VC managers, enabling more informed investment decisions.

Example Fund Scoring

To illustrate how the flag scoring system works in practice, let’s examine two hypothetical emerging VC funds.

Fund A: Tech Innovators Fund II

Tech Innovators is launching a $150MM early-stage venture fund in Silicon Valley to back North American AI and robotics companies with a focus on enterprise applications.

Flags:

• 3 Green: Strong tech background, clear thesis, early signs of value-add (-3 Penalties)
• 2 Yellow: Ambitious fund size, limited diversity (+2 Penalties)
• 1 Orange: Slight strategy shift from Fund I (+2 Penalties)
• 0 Red (+0 Penalties)
• Total: 1 Penalty

Reasoning: The strong green flags offset the minor concerns, while the strategy shift warrants attention but isn’t critical given the team’s expertise.

Assessment: PASS – With a score of 1 Penalty, it’s well below the 5 Penalty threshold. The green flags demonstrate strength in key areas, outweighing the minor concerns.

Fund B: Disruptive Fintech Fund I 

Disruptive Fintech is launching a $50MM late-seed to Series A venture fund in Singapore to back Southeast Asian fintech startups with a focus on blockchain-enabled financial services.

Flags:

• 1 Green: Notable advisors (-1 Penalty)
• 3 Yellow: Limited track record, small team, incomplete back-office (+3 Penalties)
• 2 Orange: Unproven ability to lead deals, lack of institutional LP support (+4 Penalties)
• 1 Red: Misrepresentation of team’s past experience (+3 Penalties)
• Total: 9 Penalties

Reasoning: Multiple yellow and orange flags raise concerns about the team’s readiness, while the red flag severely impacts credibility.

Assessment: FAIL – At 9 Penalties, it significantly exceeds the threshold. The combination of multiple risk factors, particularly the red flag, indicates a high-risk investment that requires substantial additional due diligence or reconsideration.

The scoring system provides a clear, quantitative basis for initial assessment, but should always be complemented by thorough qualitative due diligence. These examples demonstrate the effectiveness of the flag scoring system in quickly assessing the risk profiles of emerging VC funds. By applying this scoring system, LPs can quickly identify which funds warrant further investigation and which may be too risky, ultimately leading to more informed investment decisions in the emerging manager space.

Conclusion

The LP Due Diligence Flag Scoring System offers a structured approach to evaluating emerging VC managers raising their first or second fund. While the scoring system provides a valuable framework, it’s important to remember that it should be used in conjunction with thorough qualitative assessment and comprehensive due diligence. The nuances of each fund, its team, and its market context should always be considered alongside the quantitative score.

LPs should pay particular attention to the team’s ability to learn and adapt between Fund I and Fund II or Fund II and Fund III, their network and deal flow, and their potential for long-term success in the VC industry. By balancing the flag scoring system with in-depth analysis, LPs can make more informed investment decisions in the exciting but challenging space of emerging VC managers.

About The Author