There are plenty of reasons to invest in a Venture Capital Fund instead of making direct investments into Startups. Especially if you are new to the game and are still developing your own evaluation framework, some VCs can provide you with valuable insights. I will be the first to admit that we have learned a lot from our VC partners who co-invest with us 😊
VCs are meant to provide Professional Portfolio Management & Diversification. Let’s face it, it is unlikely that we can pick out a unicorn from the hundreds of thousands of Startups as an Angel Investor. We do angel investing because we enjoy being part of the ecosystem (and plenty of other reasons which we can explore in a separate post).
Professional Portfolio Management Generally, a VC is expected to achieve more than 3X return multiple. The 2% (management fee)/20% (carried interest) charged covers the deal sourcing, screening, due diligence, terms negotiation, mentorship, continuous oversight and regular reporting to the Limited Partners (You!). Each of these tasks can be a full-time job, if done properly. Diversification Minimum participation in a VC is between USD250K to 1M while minimum direct investment into each Startup is between USD10 to 50K. You do the math! If you are the kind of investor who invests in ETFs you will appreciate the benefit a VC can offer. According to some, diversification is the key to successful angel investing. (See the chart from Hatcher+ at the end of the article)
There are also options around participating in Fund of Funds which we can discuss more on if you are keen. We are continuously monitoring some of these funds’ performances, do contact us if you are interested!
But VCs aren’t made equal… So how do you tell the good from the bad?
Qn 1: What is your track record - Multiple on Invested Capital (MOIC) & Distributions to Paid in Capital multiple (DPI)?
MOIC, in layman’s term, is the total current fund value versus the amount you have invested. Now, value can be realised and/or unrealised which is why you should also ask for DPI which measures how much the actual fund has been returned to investors in relation to the capital they invested. Generally, a DPI of 3X and above is good!
If this is the first fund of the fund manager, you can only look at the projected MOIC, which to be honest, doesn’t mean much. So you should focus on the other factors below 😊
Qn 2: What’s the background and job scope of each of your Fund Management Team member?
You should always do a background check on the people you work with, ESPECIALLY those who are managing your money! Look out for their fund management experience, industry/technical expertise, track records and team dynamics, just like how you would evaluate a Startup’s founders.
Another thing to look out for is the committed capital of the fund management team. It shows their confidence in their ability to perform when fund managers invest their own money into the fund. Typically, the fund manager of a Venture Fund invests 1% or more. This ensures that the fund manager’s interests are aligned with that of the investors.
Qn 3: Do you have a clear Industry and Geographical focus?
This may seem like a rather general question, but it is an opportunity to check how realistic their projected returns are. Different industries in different geographies have varying average IRR. You may also check if the team has relevant expertise and network to manage the industries and locations they are targeting. We believe a VC cannot be all-rounded, the clearer the focus the higher their chances in selecting the right targets.
Their answer should match the capabilities of the fund management team and advisors and more importantly, it should match your personal investment direction and beliefs.
Qn 4: At which stage of the Startups do you intend to invest and exit?
As expected, super early stage investments are very risky but has an attractive upside. Given that most Venture Capital Funds has a life-span of 10 years and Startups are pushing their exit timeline, a fund is unlikely to see through the entire lifecycle of every Startup. It is therefore important to understand when is your VC intending to invest, at what point they are planning to exit and how do they plan to achieve the MOIC or IRR that they promise.
Thereafter, you can drill into their deal sources. Depending on the Startup stage they are targeting, their deal source needs to provide consistent and quality deal flows to put your money to work. In terms of exit, if they are looking at secondary sales at Series C and later, you can look into their existing network of potential buyers and gauge the probability of exiting with targeted returns.
Here is a table to shed some light on the probability of exit and subsequent funding based on the different stages for your reference. (This is by no means exhaustive but gives you some point of reference)
Qn 5: How will the management fees be spent?
You know the fund size and you know the % of management fee charged. Looking at the targeted number of investments, a quick calculation will let you know if their budgeting is sensible. For example, some VCs try to invest in as many start-ups as possible to increase their success rate but the trade-off is higher operational expenses to build and manage a larger portfolio. If the management fee is unable to cover for the operational expenses, 2 things could happen: 1 - the quality of deals and support provided to the startup suffers; 2 – they will not meet the targeted number of investments. Either ways, it will affect the Fund’s performance.
Ideally, each investment manager should not have more than 8 companies in their portfolio and on average a fund size of USD50M should not have a portfolio larger than 50 companies. These benchmarks are based on our conversations with VCs we spoke to, if your understanding is different, please let us know!
Finally, we do have one small request - if you could spare 2 mins of your time we have just 6 questions for you!
Charts, tables and all the goodies
Data from Hatcher+ suggests that you may want to avoid funds that focuses on startups located in regions with low probability of exit potential.
Other Sources
Hatcher+ Venture Data Analysis (2020)
Straitstimes – Investing in venture capital funds: Do your homework first
FundersClub – Understanding Venture Capital
AllenLatta – LP Corner: The Four Phases in the Life of a Private Equity Fund