It is well-know that predicting or even explaining VC performance is extremely difficult if not impossible.
A fund can invest only in a limited number of companies and their results can vary from bankruptcy to global market dominance. However, there have been many attempts to find performance determinants – correlations or dependencies between fund’s strategy and performance. Needless to say that these studies tend to demonstrate questionable and often contradicting results.
Most literature on VC suggests that it is not possible to create an optimal investment strategy. However, it is possible to create a VC structure that serves the best interest of fund’s investors and makes it attractive for potential limited partners (LPs) by:
- Ensuring transparency of funds’ economics for investors;
- Aligning interests of investors and the management team;
- Optimizing operating expenses and minimizing agency cost;
- Ensuring balance between short and long-term interests on the fund and investors.
There are certain changes that fund managers can undertake in order to accomplish these objectives. The suggested ways below are based on extensive academic research and my personal experience in the industry.
Who is a limited partner?
A limited partner (LP) is a partner in a partnership whose liability is limited to the extent of the partner’s share of ownership in a venture. LPs generally do not have any kind of management responsibility in the partnership in which they invest and are not responsible for its debt obligations. Because of this, LPs are not considered to be material participants.
Investigate alternative fund structures
Traditionally VC funds are structured as Limited Partnerships, but it is not uncommon in the VC industry to say that this structure is broken.
Among the key disadvantages investors and fund managers name inflexible investment cycle, need to go through the fundraising process every 2-4 years and defective compensation structure. In the meantime, funds have an alternative structure to consider: so called open-ended (or evergreen) funds.
In the open-ended structure a fund is set up as an investment company where both investors and fund managers are shareholders and investment process is continuous rather than cyclical since managers have the opportunity to reinvest profits from successful exits. Open-ended funds are more flexible in terms of the investments cycle because fund managers are not limited by the traditional 5-7 years investment horizon and can hold an investment until they see a good exit opportunity in the meantime enjoying dividend gain. In this structure the traditional “2 and 20” model is often replaced by the budget-based approach to covering operating expenses and management compensation.
Specialize in a specific industry
It has been awhile since Markowitz suggested his Modern Portfolio Theory and introduced diversification as an integral part of any investment strategy.
Yet, VC funds are not traditional investment institutions.
First of all, the essence of VC investments is not necessarily in line with some of the key assumptions underlying the Modern Portfolio Theory (illiquidity of investments, information asymmetry, etc.) and secondly – VCs don’t face the cyclical and speculative nature of the traditional financial markets (even though they are still exposed to the more traditional economic cycles).
Most VC research suggests that diversification in terms of investment stage leads to less risk; however industry specialization has very little effect in terms of risk mitigation.
At the same time it provides a lot of value to the fund. It allows reducing investment costs as the fund’s team does not have to spend as much time and money on expertise development and research on potential investment targets. It also enhances the resource base and infrastructure of the fund – long time exposure to a certain industry allows fund’s management team to generate a great deal of knowledge and contacts which helps to reduce costs and increase efficiency in pipeline generation, deals screening, portfolio management, etc.
Invest in infrastructure by developing a network
An extensive network of contacts is the most valuable resource of a VC fund.
Startups name introductions as the most important thing they can get from a VC investor. Fund’ value proposition significantly benefits from the ability of the management team to introduce a portfolio company to potential clients, advisors, partners, investors and buyers.
Extensive industry network is as valuable to the fund itself as it is to startups. A heavy Rolodex can help building a sustainable pipeline of deals; attract relevant experts for deal screening; find potential buyers for a fund’s portfolio company or co-investors for a perspective project.
These things have greatly contributed to the success of Talent Equity Ventures (TEqV), an HR and Ed-tech focused VC I am involved in (evergreen, specialized, with a vast network in the industry) and similar logic lies behind HRTechTank, a global investor club for funds and angels interested in HR tech, where we are helping investors to benefit from in-depth industry expertise and network of contacts while taking away the need to build an infrastructure for it internally.