I’ve asked many general partners this question over the course of my 20-year career. It seems to be a reasonable question, especially for venture funds that are nearing their five-year anniversary.
What I’m looking for is the fund manager’s view of which companies look like winners and which companies aren’t quite cutting it, so that they can manage the portfolio to support only those that deserve additional capital. I understand this is an extremely difficult exercise—especially for very early-stage companies or when the outcome is truly binary, like with many health care investments.
I would suggest that picking the winners from the losers—and more importantly, effectively managing the fund’s capital—is specifically the role of the GP (and for which the limited partners pay a management fee). Keeping that in mind, maybe the better question to ask is, “How are we going to make money in this fund?”
The natural tendency is for VCs to talk to LPs only about their portfolio companies and omit a broader discussion about the fund. While this level of detail is important, the discussion I’d also like to have is more holistic in nature. I want to hear about how a VC incorporates the performance of an individual company investment into a broader view on the projected outcome of the fund.
In other words, I want to know how the VC’s micro-views on each company and macro-view of the exit environment is directing overall capital allocation. That’s what we call “portfolio management,” and to those of us at Paul Capital Investments, effective portfolio management is one of the core criteria we use to evaluate managers.
During the recent global financial crisis, VCs were forced to more actively manage the capital available in each of their funds and to make some tough decisions to determine where to cut their losses and where to allocate scarce capital. Since portfolio companies no longer had a seemingly infinite runway to prove a concept and deliver results, VCs had to consider future capital requirements, syndicate risk, and the reality of the exit environment in combination with the progress of each underlying company investment.
As we all know now, total disaster was averted—for the most part—because costs were cut way back, some liquidity was achieved for recycling, strong companies continued to grow revenues during the downturn, and the industry slowed considerably, which gave everyone some breathing room.
I can’t tell you how many meetings I had with managers during that time period who told me they needed access to additional capital because—in short—they could not make the tough decisions between which companies to support and when to cut their losses! As experienced LPs, our decision-making process relies upon pattern recognition in order to identify the characteristics of success and of failure—something GPs should be able to do, too.
There are many companies today (especially in the consumer Internet space) that operate as capital-efficient business models where traction can be observed early in their lifecycle with relatively small amounts of investment. As one would expect, these are the companies most attractive to angels and managers of smaller funds. I’m thinking that one of the real reasons these fund managers have been garnering so much attention in the LP community is because a GP with a smaller fund and the right company ownership can clearly articulate how they are going to manage the portfolio and make money for their investors.
Lisa Edgar is a managing director of Paul Capital Investments, a venture capital fund-of-funds manager based in San Francisco, California. Reach her at firstname.lastname@example.org.