What is the purpose of this article?
- Help individual LPs (Limited Partners) think about how to assess a fund making investments in private companies. Institutional investors, family offices, and ultra-high net worth individuals should do more than what is discussed here.
- Help fund managers prepared to engage with knowledgeable LPs.
- This article is for those people who view theses investments as part of their overall investment portfolio and thesis.
This article does not provide legal, tax, financial, or investment advice.
You may download a PDF of this article from: LP (Limited Partner) Assessment of a fund V2
What are the critical learnings in this article?
- Assess a fund (which is asking you for money) the same way they’d assess a company asking them for money.
- Understand how the fund and its managers are competitively superior i.e. managers know things that others don’t and can do things others cannot.
- Understand the potential for the fund managers to succeed in rapidly changing and different future.
Is your fund going to be part of an asset class in your overall investments?
Your overall investments have the core goal of growing and preserving your capital. This capital may be needed for:
- Heirs and estate (may include a foundation); or
- Major future spending; etc.
I’ve observed that some early stage investors, including some angel investors, do not include these expenditures as part of their overall investments. They view these expenditure as:
- Giving back; or
- Supporting worthy causes and worthy individuals.
This article is focused on those people who consider their fund investment as part of an asset class in their overall investments.
What is the fundamental approach for assessing a fund?
The critical questions you must answer regarding the fund managers include:
- How are the fund managers competitively differentiated in their capabilities to grow your investment, while managing risk? Managing risk is very different from avoiding risk.
- What do they know about selecting companies that their competitors don’t know?
- What do they know about helping portfolio companies succeed that their competitors don’t know?
- How in their career have they succeeded?
Are the fund managers above average? In the top quartile? Or higher?
Assess a potential fund (which is asking you for money) the same way the fund assess a company asking them for money.
Why focus on understanding how the fund managers are competitively differentiated?
Unlike 10+ years ago, these days there are countless funds and unlimited capital available. Some of the implications include:
- Many funds have been created by managers with limited capabilities to be successful.
- The massive increase in the total number of funds means that there has been a massive increase in the number of below average funds.
- Superb portfolio companies seek out funds that can provide more than just capital.
Do the fund managers have the potential to succeed in a rapidly changing and different future? 1
The future will quickly be very different from the past. Leading companies (of all kinds) are finding new and better ways to be successful. To what degree do the fund managers have the 6 core components of talent to succeed in a very different and uncertain future?
- Self-awareness: e.g. Do the fund managers understand their strengths and weaknesses?
- Character: e.g. Values, morals, and ethics. Warren Buffett supposedly said “…looking for people to hire, you look for three qualities: integrity, intelligence, and energy. And if you don’t have the first, the other two will kill you.”
- Relationship skills: e.g. Ability to create and sustain a network of personal relationships.
- Crystallized intelligence: e.g. what skill, knowledge, ways of thinking, mental paradigms, and facts must the managers have.
- Fluid intelligence: e.g. The ability to solve problems without past experience. This is critical for innovation, which is coming up with new and better solutions.
- Cognitive skills: e.g. Able to collect and do fact based analysis with sound logic and reasoning.
Your assessment of the above 6 talent components requires defining positive and negative indicators for :
- observations regarding the analysis of the data room;
- answers to questions for the fund managers references;
- answers to questions for others who have interacted with the fund managers;
- answers given by questions to the fund managers; and
- outcomes of the behavioural interviews of the fund managers.
What are the four decision stages for assessing a fund?
You need a filtering process to end up with a few high potential fund candidates. Why a filtering process? You might have contact with dozens or hundreds of funds. You don’t have time to do in-depth analysis of each fund.
- Should you open an email from a fund or reach out to a fund?
- Should you have a brief chat with a fund?
- Should you conduct due diligence with the fund?
- Should you make an investment?
There are three sets of assessment criteria and analysis, distributed throughout the four decision making stages.
- Alignment with and support of your investment thesis.
- Past accomplishments and plans to grow your investment.
- The capabilities of the fund managers to succeed in an uncertain future.
Some assessment criteria result in an immediate rejection of the fund (e.g. you don’t trust the fund managers) while other criteria result in a scoring.
Your assessments reflect:
- The competitive differentiation of the fund and its managers.
- Both the potential to increase the value of your assessment and to manage risk.
What is the purpose of the data room?
- The data room provides a collection of documents which are intended to help answer some of your due diligence questions.
- You’ll need to analyze the data room contents and benchmark the fund relative to other funds. The benchmark may range from an informal judgement to a factual analysis.
What are the fund’s 8 sets of data room contents, if this is the managers’ first fund?2
- Fundraising pitch deck, including: team, including managers, advisors, etc. (with biographies), the opportunity (i.e. what is the market gap and why is the team best positioned to win), investment thesis, sourcing strategy decision making process, case studies, track record spreadsheet, portfolio construction, fund structure and terms.
- Investment track record detail. If this is the managers’ first fund, the investment track record will include results from previous funds the managers were at and the managers personal investment results.
- Investment memos and market map. The market map illustrates the segments and potential portfolio companies.3
- Due diligence questionnaire. An industry standard questionnaire is provided by the ILPA (Institutional Limited Partners Association)
- LPA (Limited Partnership Agreement).
- Fund Model. A financial spreadsheet illustrating hypothetical future portfolio, with a number of key metrics
- Reference list. You may also contact people not on the reference list. You may also require a formal background check of the fund managers. Who are the other investors, their experience and value, and why did they invest?
- Fund contact list. This includes lawyers, accountants, other professionals, etc.
What are the fund’s 6 additional sets of data room contents, if this is NOT the managers’ first fund?2
- Financial information i.e. free cash flow actuals and forecast scenarios; audited financial statements.
- Examples of prior capital call and distribution notices.
- Compliance manual.
- ESG (environmental, social and governance) and DEI (diversity, equity and inclusion) policies.
- Valuation policies.
- Business continuity planning.
How are LPs engaged with the General Partner?
- What information is provided to the LPs and when?
- How often is there a meeting of all LPs and what is the purpose of those meetings?
- What authority do LPs have? What decisions must they approve? What veto power do they have?
What is the role of the LPAB (LP Advisory Board)?
- What is the purpose of the LPAB?
- What is the documented mandate?
- What authority does the LPAB have? What decisions does it make? What veto power does it have?
- How often does it meet?
- What information is provided to the LPAB and when?
- Who is on the board and how are they members selected?
What are your next steps?
- Review your overall investment thesis and thesis for the asset class your fund will reside in.
- Create your template for your personal investment memo. This will capture your facts, analysis, and judgement as to why you want to make the investment in the fund. This will be helpful in the future, both as you look back and as you consider additional fund investments.
- Prepare your plan. This will include specific decision making process and criteria, including those red flag items which result in immediate rejection of a fund candidate.
- Assemble your team e.g. lawyer with experience in LP agreements (and governance and dispute resolution), tax advisor, other professionals to assist with the data collection and analysis. Your team might include psychologists.
- Prepare your due diligence questionnaire and identify at what stage(s) the information will be collected and analyzed.
1 Core components of talent, Koor and Associates
2 “Data Room Best Practices”, Silicon Valley Bank
3 Illustration of a market map, Atlantic Canada Fintech, 2022
What further reading should you do?
“Data Room Best Practices”, Silicon Valley Bank
“Due Diligence Questionnaire”, Business Finland Venture Capital
Why are values, morals, and ethics important
How to assess director and CEO talent – regarding values, morals, and ethics.
How do asset managers assess private equity fund managers?