Before investing in a private equity or venture capital fund it is critical to do your due diligence. When buying a share of Apple, for example, most investors do no diligence. This makes sense. Apple is a known quantity and, as a public company, has to file quarterly financial statements with the SEC. There is a lot of regulation controlling how public equities are traded.
However, when investing in private companies via private equity or venture capital funds, that same level of quarterly reporting is not required by the SEC. This isn't inherently bad, in fact it helps to reduce a lot of administrative burden for small startups and for funds that could otherwise would be overbearing. This does however increase the need for investors to research the PE and VC funds where they are considering putting their money. We call this process "due diligence".
When diligencing a fund, there are several factors that potential investors should consider such as the performance, team, and strategy. We'll go over each of these and some key metrics to consider within each bucket.
While past returns are not a guarantee of future returns, it is good place to start when looking at a potential fund in which to invest. A proven ability to generate historical returns can indicate several things about the management team, primarily their ability to get in to competitive deals and select winning portfolio companies. Some key metrics to analyze performance include...
Internal Rate of Return (IRR): IRR is the most commonly used metric to evaluate PE and VC fund performance, and our favorite at OneFund. It measures the annualized rate of return that the fund generates on its investments. A higher IRR indicates stronger performance.
- Multiple of Invested Capital (MOIC): MOIC measures the total return on investment as a multiple of the total amount one invested. For example, a multiple of 2x means you doubled your money over a given timeframe. Keep in mind this figure does not take time in to account, it is only the ratio of capital earned to capital invested. This is why at OneFund we prefer to consider IRR when looking at investment opportunities. A 10 year investment could have a very high MOIC but a dismal IRR while a 2 year investment may have a low MOIC but a fantastic IRR. We philosophically prefer high IRRs to higher MOICs.
- Gross vs Net Metrics: When examining PE fund returns you will often come across the terms "Gross" and "Net" in front of IRR, MOIC, or other metrics. Gross means the figure is before the PE fund takes their fees, and Net means the figure is post fees. Investors should only care about Net returns. This is the return investors in the fund actually received. The delta between Gross and Net represents the fees taken by the PE fund.
When you select a PE or VC fund to invest with, you are placing significant trust in the management team of that fund to invest your money. It's critical to understand who the key players are at the fund, their role, and history with the firm. When examining a team, a few factors we consider include...
- Track Record and Attribution: The track record of the management team is paramount. Not only should one evaluate the performance of similar funds where members of the management team have previously worked, but also evaluate the specific deals that are attributed to those team members. They may have worked at a great fund in the past, but were they responsible for the good investments at that fund?
- Experience and Expertise: A strong management team should have a deep understanding of the investment strategy, the industry, and the competitive landscape. What are the backgrounds of the management team? Preferably they have strong investing experience and a deep expertise in the industry where they primarily invest.
- Alignment of Interests: A strong management team should have a significant personal investment in the fund they are managing. They should be focused on generating strong returns for investors and have financial incentive to do so. For example, at OneFund we invest our own capital in every offering on the platform.
Most funds will have a specific strategy they follow and a mandate to make certain types of investments. For example, a firm may specifically invest in growth stage software companies, or late stage North American industrial and manufacturing companies. Additionally, a firm may have a "secret sauce" they apply to try and get the best returns such as deep expertise in highly technical areas such as machine learning or fintech. When evaluating a fund's strategy, here are a few lenses to consider...
- Investment Focus: The investment focus of the fund can heavily impact returns. Funds that specialize in a particular industry or sector may be more knowledgeable and able to identify promising investments in that area, while funds that invest more broadly may have a more diversified portfolio. It is important to ask which kind of exposure you are looking for and what fits with your portfolio.
- Investment Horizon: Investment horizon measures the length of time that the fund expects to hold its investments. A longer investment horizon may indicate a more patient and strategic investment approach, while a shorter horizon may free up your invested capital sooner.
- Changes in Strategy: It is extremely important when looking at a fund to understand if they have changed their investment strategy at any point in the firm's life. It is best if the fund has consistent returns and a consistent strategy. If the fund has good historical returns but recently changed its strategy, their past may not hold as much weight.
This is not a completely comprehensive guide to private equity and venture capital fund due diligence. Some professionals spend their entire lives learning and perfecting that. It is, however, hopefully a helpful place to start if you're considering investing in a PE or VC fund.