There was a substantial increase in the number of venture firms operating in both the US and Europe over the latter part of the 1990s and 2000. Many individuals who joined the venture industry had inappropriate or insufficient experience. A large amount of capital was easily raised, and a great deal of that capital was squandered on poor investments and will never be returned.
The venture industry has now entered a period of consolidation, as venture firms merge, are acquired or, most significantly, start to close down. Closure is rarely immediate, given the 10-year life of the typical venture capital partnership, but for many firms the writing is on the wall. Poor investment records preclude them from raising further funds, and what funds they have left are largely earmarked for supporting existing portfolio companies that are running low on cash.
Investors should always conduct thorough due diligence before committing their funds to venture capital. Now, with the onset of consolidation in the industry, the financial strength and security of the venture firm itself should be under more scrutiny. This article highlights some of the key questions to ask during the due diligence process and thereby to reduce some of the risk associated with selecting the right funds.

Investment strategy
A stable and sensible investment strategy is critical. The strategy itself must be appropriate to the experience of the venture firm’s investment professionals. The recent past is littered with firms that have failed to stick to their knitting, and consequently are expected to deliver very poor returns to their investors. Many will not return the capital that they invested during the internet bubble. The long-term future of a number of these venture firms is now in question.

Track record
In our experience, the majority of venture capital firms claim top-quartile performance! Investors should ensure that superior returns have been earned across the breadth and depth of previous funds. Most good venture funds will experience the 20:60:20 Rule, or in other words, benefit from a handful of ‘home run’ investments, a larger number of investments that produce single digit return multiples, and a number of investments that don’t work and that return less than cost or nothing at all. In a difficult fund raising environment, like today, venture funds without a good track record find it hard to raise capital, and consequently find it hard to manage their own businesses.

Investment team
Just as the management team is critical to the success of a young company, a well-rounded and experienced team of investment professionals is key to the success of a venture fund. A mix of venture capital and operating experience within the team is viewed as a strength. Make sure that the members of the team interact well together and that there is not one individual who dominates. Finally, ensure that the successful venture firm has taken care of succession issues – if it hasn’t it is unlikely to thrive for long once the founding partners have retired.

Alignment of interests
It would be unwise to commit to a fund whose investment professionals are not committing a meaningful proportion of their own wealth and who are not properly incentivised through performance-related fees – known as ‘carried interest’. Investment in a venture fund is a long term ‘partnership’ between the investor and the investment professionals at the venture firm itself. Ensure that interests are fully aligned for the duration of a fund before committing – the partnership will encounter problems if they are not.
Carried interest has been a lucrative source of income for the investment professsionals of successful venture firms.
Ensure that carried interest is distributed fairly amongst all members of the investment team, including younger partners. Good investment partners without appropriate share of carried interest are less incentivised to take on risk and more incentivised to change jobs. Ensure also that carried interest ‘vests’ over a number of years. If it doesn’t, disintegration of the investment team becomes a very real prospect.
Some investors are imposing stricter terms on venture firms – for instance, insisting on funds meeting return ‘hurdle rates’ before payment of carried interest to partners. This is a mistake. In difficult times, or when a fund gets off to a poor start, a hurdle rate creates less incentive for the investment partners to remain with the firm and work the fund out. Such a situation is an unhappy one for the investor, who is ‘locked in’ to the fund for its full life (usually 10 years).
Some investors are now encouraging a reduction in carried interest levels from the 20% to 30% that funds have historically charged. This too is the wrong approach. A fund with low carried interest is less likely to perform well. Carried interest must provide sufficient incentive to encourage investment partners to take measured investment risks.
Recently, it has become apparent that a number of previously successful venture firms have overpaid carried interest to their investment professionals. In some cases, these individuals are now legally bound, under a ‘clawback’ provision, to return this capital to their investors. Before committing to a venture fund, investors should determine to what extent (in monetary terms) the investment partners are personally liable and assess what impact this is likely to have on the future stability of venture firm itself.

Management fees
Venture capital firms finance operations from the management fees they charges investors in their funds.
As fund sizes grew, many venture firms failed to reduce management fees as a percentage of assets under management. There is pressure now on venture firms from many investors to reduce management fees and fund sizes. These investors should ensure, however, that remaining management fees are sufficient to retain the necessary infrastructure for successful venture investing. This may include, for example, maintaining a multi-office structure, which can be helpful if the venture firm is to avoid becoming myopic.
Ultimately, we believe that the venture industry should and will move towards management fees calculated on a budgeted break-even basis. Our own analysis has demonstrated that a high management fee is far more harmful to net returns than is high carried interest. As an institutional investor, we would rather a good venture firm increase carried interest and reduce management fees.

Carried interest
Venture firms should really view management fees as a loan, given that carried interest is usually not paid out until principal is returned. In fact a number of very good venture firms have reduced management fees voluntarily once carried interest has started to be paid.
Venture firms unable to raise another fund may soon find themselves in difficulty, as management fees from maturing funds rightfully decrease over time. Falling income may necessitate slimming down of operations. Closure of offices and the forced or voluntary removal of investment partners and back office staff can impact on a venture capital firm’s ability to invest successfully. Lower management fees can mean lower salaries, and lower salaries are less appealing to investment partners. Team instability is a natural consequence.
A good partnership is based on trust, and trust develops over time. An investment in a venture capital fund should always be viewed as a long term ‘partnership’ between the investor and the venture firm itself. By asking the right questions and spending time getting to know a venture firm and its professionals, the investor can be more confident that the relationship will flourish.
Rupert Montagu is a founding general partner with Montagu Newhall Associates in London

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