Originally published in Pensions & Investments
By Tim Schigel
Investors pride themselves on being independent thinkers. There are times, however, when even some of us in the venture capital industry are guilty of running with the herd.
As a limited partner, it’s tempting to think you’ll only succeed if you invest solely in the top firms. But data suggest investors should be more adventurous.
When Cambridge Associates looked over an 18-year period, it found that 60% of the total gains generated from the top 100 investment firms came from those ranked 11 through 100. The top 10 performed well — just not well enough to justify ignoring the rest of the field.
There’s never been an easier time to find somewhere new to invest: diversity funds, frontier markets, and regions in the U.S., such as the Midwest, and other areas outside of the traditional Silicon Valley area hotbeds. Last year, the U.S. venture capital industry invested roughly $84 billion in 8,035 companies, making 2017 the busiest year for venture capital deployment since the early 2000s, according to the National Venture Capital Association. That money generated a lot of interest, and by September 2017 there were 590 first-time funds.
Of course, with more options comes more uncertainty. When investors are deciding whether to invest in a fund, they might ask these questions to make sure that the right fundamentals are in place.
How do you source deals?
There are a lot of ways to source investments, but the best performing funds tend to align toward one of three methods:
The first is based on the Matthew Effect, or power principle. The firm, or one of its general partners, was an early investor in a huge winner, like Apple Inc., Google (now Alphabet Inc.) or Facebook Inc. Because of this impressive track record, the most promising entrepreneurs go to them first. These venture capitalists are the fortunate ones who don’t so much have to source as sift.
The second is domain expertise. Becoming an expert in a vertical creates a positive feedback loop. Venture capitalists and entrepreneurs will seek out the go-to fund in particular industry, not the other way around. For example, Arboretum Ventures is a Michigan-based fund whose success is based on being thought leaders in health care.
The third is to manufacture a proprietary deal flow. Funds based on this approach can take the form of accelerators, venture builder models like Pioneer Square Labs and studios like Sidebench. They’re involved not just in providing capital, but also in company creation.
If the firm doesn’t have an intentional sourcing strategy, it might be a red flag.
How are you optimizing your portfolio?
There is only one acceptable answer here: optimize for ownership.
What managers should be saying, either directly or indirectly, is that they’re looking for as large an ownership stake in the startups they invest in as possible. Optimizing for ownership also means the fund needs to have a thoughtfully constructed portfolio. A top-performing fund should aim for returning three times the committed capital. I don’t know of any fund that has done this without at least one investment exit that’s alone worth as much as the entire fund combined. Big wins like this are required.
A follow-up question should center on the fund’s size. The stage of investing and average check size will vary as the fund size varies. If the fund manager is in the fortunate position of raising a new, bigger fund, you might ask how that will change the portfolio construction. Investing a $20 million fund is dramatically different from investing a $100 million fund.
I like what Benchmark’s Bill Gurley has said on the topic: Venture capital is “not even a home-run business. It’s a grand-slam business.” Look for managers who invest with conviction and have a thoughtful approach to portfolio construction.
What do you do after you write the first check?
The best performing venture funds understand that decision-making doesn’t end after the first investment. It should be expected that as many as 40% of the companies might fail to return capital, but ideally this would only be 20% of the capital if you properly manage the follow-on decisions. Fund managers who understand this will be more active in managing the portfolio to preserve time and capital for the most promising companies.
Investors should look for a fund that is actively involved with its entrepreneurs and, perhaps most importantly, is willing to have difficult conversations well before a cash crisis occurs. You can tell a lot about the fund manager by finding out what happens when an investment isn’t performing.
The best fund managers are the ones who recognize early on which companies are struggling, and proactively work with their entrepreneurs to figure out a solution or move the company toward an exit. They also need to be influential with the board and other investors. The alternative is to let the company hang on and burn cash, which happens more often than it should. This isn’t fair to the entrepreneurs, employees or investors.
Why did you do that deal?
Many fund managers have the ability to craft a great pitch. But there are times when you look at their portfolios and there doesn’t seem to be a match between what they say and what they do. If they say they focus on Series A investments in enterprise software as a service startups, look at how many of their investments consistently fit that criteria. Perhaps there is an outlier where they might have deep relationships or other factors that warrant an investment; this is OK as long as that is the exception and not the rule. But investors should be looking for discipline and commitment to a sound strategy.
This is the overarching question. It should encompass elements of all the other questions asked, and serve as a summation of the fund’s understanding of what’s needed to make gains.
If working with a first-time fund, ask about other deals and how the principals would have managed them. The fund doesn’t need to have a long track record to be worth an investment. What it does need, however, is to prove it’s composed of people who are disciplined, consistent and committed to their strategy.
The problem for limited partners will never be finding a place to invest. The issue is always finding which funds will outrun the pack. These four questions can point investors in the right direction.
Tim Schigel is a partner at Refinery Ventures and founder at ShareThis, based in Cincinnati.