One of the many ways to get access to multiple startups is to invest via funds. A fund or investment vehicle is a type of investment product where the money of several investors are pooled into an investment product and used to purchase specific assets that correspond to the fund’s investment goals.
There are many venture capital firms which issue funds and that many other investment companies that may provide diversified exposure to startups. These vehicles and funds may be a great opportunity if you are starting as an angel and want to see the investment decisions of “the big guys” for example. Or, even if you are an experienced angel, funds can be a great way to get exposure to a different industry, area, geography or investment thesis that you don’t master, but would like to dip your toes.
So once you have made the decision to invest in a particular area through a fund (or similar investment vehicle), the options may be overwhelming as there are plenty of venture capital firms issuing funds for various different purposes. There are two key participants within a VC fund: general partners (GP) and limited partners (LP). The GPs are the people in charge of managing the fund and making the investment decisions – selecting the startups, funding them and working with them to help them grow. LPs are the external investors, the people, institutions and organizations who provide the capital needed for those investments. Becoming a limited partner or LP is an important decision, so there are several things to consider.
There are many funds but not all of them are accessible for all investors. Funds are usually open for a limited time and/or until the target funding is reached. Many funds are also for selected clients only such as Family Offices or large institutions. For that reason, if you see and have access to a fund you like, you should act quickly.
In the below article we will focus on the general principles you should follow when selecting a fund to invest in. We have broken it down into a general due diligence checklist which could serve as a quick reference guide.
What is your strategy?
A good start is to think about what you want to get out of the fund. Which market, industry, geography, investment stage, do you want to get access or exposure to? What is your investment timeline, how much money will you allocate to this specific market, what do you expect as a return?
These are all good questions to start off and their answers will limit the availability of existing funds to invest. Once you selected your strategy and narrowed down the number of funds or fund managers, you can use the quick due diligence guide below to select the appropriate fund for you.
General due diligence criteria for fund selection
Fund Managers or General Partners
Perhaps the most important thing to look at when selecting a fund or a VC are the General Partners (GPs). These are the people that you are relying upon to make the investments and choose which will be the next unicorn you are invested in. There are many things that you can search for in a GPs, including:
Most of these are self-explanatory, but we would like to highlight that, in our view, the past investments from the GPs can come from either past funds or private investments. It is not always easy to find accurate information about past investments, but you will always see how the GPs advertise the good (and sometimes the bad) investments. Tools such as Crunchbase or Pitchbook may help in verifying some of the information, although the information is limited. In any case, references will always help when studying GPs.
Another area we would like to focus on is “location”. Nowadays, and with COVID-19 in the midst of disrupting our lives, we still believe that location is important. This becomes a key component when the geography in the investment thesis (as mentioned below) is in areas where you need local expertise (mainly emerging markets). In these cases, we would insist that the GPs have boots on the ground wherever their thesis leads them.
Do have a look at Angel Investor School Day 5, where we have discussed plenty of incredibly interesting regions such as the Middle East, Africa, Israel and Latin America, all of which have their particularities.
As discussed in detail with Francisco Coronel, the investment thesis of a fund is of vital importance. As an angel investor, you too should have an investment thesis, but whenever you want to step out of your comfort zone, looking for the right fund that fits whatever you want exposure to starts with reviewing their investment thesis. This will be the one place where you can tell if this is the market, sector, geography, and investment stage you want to have exposure to.
Regarding the investment stage, as an angel investor you will usually be drawn to deploy your angel capital in the first investment stages (pre-seed and seed). However, there is no reason why you shouldn’t aim for better established companies through a fund or vehicle.
Factors such as the “secret sauce” also become very relevant for certain investors and GPs. For example, there is no better angel or investor in marketplaces than Fabrice Grinda. His expertise and knowledge of this sector makes him the go-to person when looking at marketplaces.
Finally, it is important to look at the exit strategy of the fund. Not all are the same as many will look to exit their investments at a certain round in order to provide a specified exposure. For example, a fund may focus on early-stage or pre-seed investments, and have a policy of exiting whenever the startups fundraise at Series A or B. This may be a good strategy as it limits risks and allows for re-investments into other companies. Other funds may have discretion over the exit or hold until IPOs or liquidity events.
There are several other considerations to take into account, especially as an angel investor. We particularly like those funds where the GPs welcome and encourage the LPs to invest alongside them, should they wish to. The companies where the fund has invested will carry a high degree of due diligence and, if they happen to be interesting to yourself or you know the market/sector/geography, it may be an interesting idea to invest alongside the fund and/or engage the with the company to provide advice and become an integral part of them. Many funds will allow for co-investments without any upfront or carry fees (see below), so this is an added value.
The fund’s jurisdiction also plays an important role, as you should research tax and legal implications of investing in a certain location. Nowadays, most funds are established in “friendly” locations, but it’s always a good idea to choose.
Furthermore, you want a responsible fund administrator which will provide timely answers to your questions and periodic updates, so as to review the development of the startups and the investments.
Although costs are usually standard, there may be cases where there are significant deviations you should be careful with. A standard fund will have between 1.5% and 2.5% running per annum management fees and there may or may not be placement fees.
Moreover, funds usually have a “carry” percentage. Carried interest, or carry, in finance, is a share of the profits of an investment paid to the GP in excess of the amount that the manager contributes to the partnership. So for example, if the carry is 25% and the fund returns 100% excess the GPs will retain 25% of the profits over and above a hurdle rate, the minimum expected rate of return of an investment, and the LPs will receive 75% of the profits. This, although may sound high, is the main incentive for GPs. Wherever you participate and decide to co-invest alongside the GPs (for the funds that allow this), there is usually no running fees nor carry interest.
Unlike ETFs or Mutual Funds, VC or startup funds do not have much liquidity. You may be able to sell your portion privately (provided the GPs and administrators allow it), but bear in mind that liquidity will usually come from sales or exits that the fund has. Therefore, it is important to note that: (i) your money will likely be locked for a period of several years, and (ii) the fund’s strategy in terms of exits is important and relevant.
As with any investment, your capital gains will be subject to tax. It is important to take into consideration tax relief that might be provided by certain funds, such as SEIS and EIS in the United Kingdom. You might also want to consider whether you are investing as an individual or as part of a business organisation.
Always dig deep
These high-level and general criteria should help you narrow down your options and make a reasonable choice. However, it is always good to probe and research the particular funds individually, ask for references, and check as much as you can.
But remember, among the most important factors to consider is how your investment fits into your overall strategy. Bear in mind that within the startup world the risks are extremely high, so diversification should always be within your strategy as one good investment may compensate for all other losses. This is what most funds focus on, rather than selecting a handful of startups to invest in.
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