An emerging venture capital landscape
In private market investing, identifying skilled fund managers is a constant pursuit. Traditionally, Limited Partners (LPs) – the investors in these funds – have relied on past performance as a key indicator for future success. However, this approach can be limiting, especially when evaluating emerging managers who lack previous fund performance or track record. This is particularly relevant in Europe and the Nordics, where an estimated 90% of all fund managers are considered emerging, managing three funds or less.
The challenge is amplified by the lengthy investment cycles typical in venture capital, often spanning a decade or more. Fund managers often face a problem: they need to raise money for new funds before their existing investments have fully matured and generated realized returns. A general partner (GP) might spend two years raising a new fund, four years investing the capital, and then another four to five years managing and exiting those investments. Consequently, when a manager is fundraising for their next vehicle, the performance of their prior fund is often based on unrealised valuations rather than actual cash returns. This can make it difficult for LPs to assess the managers skills and fund performance capabilities.
Past performance can't predict the future
The venture capital landscape is constantly evolving, and the successful managers of tomorrow may not be the same as those who thrived in the unique market conditions of the past decade. The "zero interest rate period" (ZIRP), characterized by low interest rates, quantitative easing, and a global pandemic, created an unusual environment that fostered unique success stories and strategies. However, as we move into a new economic era, past performance becomes less indicative of future success.
While historical returns can provide valuable insights, they shouldn't be the sole predictor of future success. The innovation economy and the venture capital landscape are constantly evolving, and the tools used to evaluate potential investments, especially those led by emerging managers, must evolve alongside them.
An LP Framework for fund managers assessment
The primary goal for LPs is to determine if a fund aligns with their risk/return objectives. By adopting a broader evaluation approach, encompassing various criteria beyond performance, the absence of a prior track record becomes less significant. Instead, LPs can focus on a comprehensive assessment of the people, thesis, strategy, process, and other key aspects of the fund under review.
LPs are increasingly adopting a framework that considers a wider range of factors beyond historical performance. This approach evaluates the following nine key areas:
1. Venture Understanding: LPs will seek fund managers who demonstrate a thorough understanding of the venture capital market, encompassing fund management principles, investor relations, and the ability to to navigate the VC landscape and create value for portfolio companies and LPs.
2. Investment Strategy and Market Fit: LPs will scrutinize the fund's investment thesis, target market, differentiation strategy, and alignment with current market opportunities, ensuring the strategy is coherent, relevant, and positioned for success in the existing market landscape.
3. Team: LPs assess the fund management team's expertise and experience, looking for technical and operational knowledge, fund management experience, complementary skills, and a history of successful collaboration. The team's ability to navigate the VC landscape and create value for portfolio companies is a crucial factor.
4. Track record: While first-time fund managers and some emerging managers may lack a direct fund performance and track record, LPs look for evidence of past success, such as prior fund performance, successful angel investments, or leadership roles in startups. LPs need to gain confidence on the team capacity to manage the fund and successfully execute on the strategy.
5. Deal Flow: LPs will evaluate the GP's ability to source high-potential investments through its network, partnerships, and unique strategies, assessing if the deal flow is robust enough to generate a consistent pipeline of quality deals and differentiate the fund in the market.
6. Portfolio: LPs will perform a comprehensive financial analysis to understand the fund's expected returns, fee structure, and risk management strategies. They also evaluate the fund model's realism and adherence to VC principles, ensuring the fund is financially sound and well-structured.
7. Differentiation: LPs will seek a clear and compelling unique value proposition for both founders and LPs. The GP should articulate their unique capabilities in buying, managing, and selling assets, as well as how they add value to portfolio companies to attract top-tier entrepreneurs.
8. LP-GP alignment: LPs value a significant personal investment from fund managers in the fund - skin in the game-, as it demonstrates alignment of interests and confidence in the strategy. LPs will also scrutinise the fairness of fee structures, carry splits, target returns, and capital call/distribution schedules to ensure interests are aligned.
9. ESG integration: LPs increasingly scrutinise a GP's approach to environmental, social, and governance (ESG) factors. This includes evaluating the extent to which ESG considerations are embedded in the fund's strategy, how ESG risks are identified and managed within investments, and the potential impact of ESG on overall fund performance.
The nine key areas highlighted here serve as a guide, not a rigid prescription. Each fund and manager is unique, and the diligence process should be tailored accordingly. There are no single "right" answers, but rather a search for consistency and alignment between the LP's goals and the GP's approach.
Conclusion
The venture capital landscape is dynamic, and what constituted success in the past may not hold true in the future. Market conditions shift, new technologies emerge, and investor preferences evolve. Therefore, the ability to adapt and navigate these changes is crucial for both emerging and established managers going forward.
Under the new market conditions, anyone can win. By embracing a holistic approach that considers a wider range of factors, LPs can confidently consider investments in both emerging and established managers, ultimately leading to more informed investment decisions, a more diversified portfolio and more adapted strategies for the new market conditions.