What makes a good VC manager?

(This feature is taken from Private Equity Europe, the pan-European publication from the publishers of unquote")

Venture capital can reduce portfolio volatility

Most private equity portfolios have large commitments to buyout managers who focus, amongst other things, on investments in traditional industries and sectors such as manufacturing, consumer goods and the financial services. Venture capital, however, tends to focus mainly on newer, pioneering industries such as IT, life sciences, optoelectronics, as well as new technologies like “cleantech” or nanotechnology. By allocating a proportion of a private equity portfolio to venture capital, part of the capital will be invested in companies active in industries with a weak correlation to the traditional industries favoured by buyout managers. As such, the addition of venture funds to a private equity portfolio can help reduce the volatility of portfolio cash flows and stabilise valuations.

Investors, however, have to be aware that the spread of returns between the top-quartile and the bottom-quartile funds has been larger for VC funds than for buyout funds. On the other hand, performance studies show that, particularly in the upper-quartile, the cash on cash return from venture capital funds has been higher than that from the buyout sector (see chart A). In addition, it has to be taken into account that the average payback period for capital invested in VC funds is longer than for buyout funds. As such, it is critical to select and obtain access to good managers as well as to diversify. The addition of just a few individual venture funds results in increased risk, a particular problem for investors new to venture capital investing. They tend to have low allocations and are inexperienced at fund selection. For them commitments to dedicated VC fund-of-funds, which offer diversification, access and good selection skills can be a solution.

What to look out for in a venture manager

There are three main elements that need to be aligned for a manager to be successful: the team, its strategy and the market in which the team operates. The team needs to be stable and cohesive with a good blend of technological understanding, financing skill and operational experience. The strategy should be consistent, sustainable, supported by appropriate processes and aligned with the team’s skill set and experience. Finally, the team and its strategy need to be in sync with market requirements.

The team should be well-positioned in a market, capable of generating high-quality deal flow and have an extensive network of professionals and a track record of forming effective syndicates. Furthermore, the market should show future potential in terms of sourcing and exiting. Successful implementation of the above should be reflected in the team’s track record. Successful managers are able to generate high absolute performance (high multiples) combined with an attractive cash flow pattern (IRR) over several funds and over several cycles.

While most venture funds focus on demonstrating their technological knowledge, financing skills and investment strategy, less attention is spent on the market, and often cash flow considerations at the fund level are neglected. This is often the case with inexperienced managers, with the result being that a number of successful companies are produced, but overall fund performance is disappointing.

Successful managers, however, are able to consider the whole portfolio when investing in individual companies. They have the skills to invest at the optimal entry time for a given company and get the right mix and timing of investments at varying degrees of maturity during the investment phase. Chart C illustrates what this optimisation can look like. Successful managers are also able to manage follow-on capital effectively such that they give maximum support to the promising companies and are prepared to write off those companies where the anticipated potential does not materialise early. In this way, they are able to conserve the available capital for the potential winners.

As with buyout managers, there is no one single way for VC managers that guarantees success. Similarly for LPs, there is not a concise set of criteria or “checklist” that ensures the successful selection of a fund. The due diligence should aim to achieve a detailed understanding of how a given manager operates, evaluate whether teams have the right complementary skills and if the strategy fits well and positions them uniquely in the market. All this should be reflected in a successful track record.

These key elements have not changed since the early days of VC investing. What has changed is that the VC industry has become increasing global. Home-run companies need to be global blockbusters and managers have to be able to adopt an increasingly global perspective when building their portfolio companies.

Dr. Katharina Lichtner is a co-founder, member of the board and managing director of Capital Dynamics and heads up the research department of the Swiss private equity umbrella fund manager. In addition, she is a board member of the IPEV (International Private Equity and Venture Capital Valuation Guidelines) where, among other things, she represents the European private equity association EVCA. She was previously active with McKinsey & Co.

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Send to  

• Topics
• Early-stage
• UK / Ireland