Performing detailed qualitative and quantitative due diligence is critical when analyzing a venture capital fund. Understanding the investment strategy and dissecting the track record is necessary to assess the general partners’ skills, including the ability to source a deal, finance/syndicate the investment, add operational value, position a company for an exit and generate a strong IRR and cash-on-cash return.
The results of the analysis provide a multi-dimensional perspective on the fund’s investment thesis and a clear understanding of the underlying qualifications of the general partners.
What other steps can be performed to provide further insight into the team and provide clarity on the risk/return relationship of the fund?
Poker, like trading and venture capital investing, is an imperfect information game that requires decision-making under conditions of uncertainty and skill to consistently win. Poker players deal with multiple opponents, risk management, deception and unreliable information. Poker and investing are based on probability. Participants in the event must be cognizant of the on-going risk and reward of each hand, trade or investment. Warren Buffett has said: “There’s a sucker in every poker game. After 30 minutes in the game, if you haven’t figured out who it is … you’re it!”
Analyzing the team’s approach to capital efficiency is an additional due diligence step in determining that the general partner of the venture fund is not the “sucker” at the table. This concept provides insight into how the fund’s capital is allocated among the portfolio companies, the amount that is invested in each round of financing and the decision tree that is followed in determining subsequent participation in follow-on rounds of financing.
How Much To Bet
In Texas Hold ‘Em, a popular variation of poker, the initial bet is a result of how aggressively a player wants to play his or her pocket cards (the first two cards dealt). The level of the bet is determined by the perceived odds of winning the hand. For example, if dealt two aces, this typically beats all other hands about 80% of the time. In poker, keeping track of the strategy’s likelihood of success and balancing that with the proper bet size maximizes the mathematical expectancy of the approach.
Hedge funds and commodity trading advisors (CTAs) have long understood the importance of bet sizing (or position sizing) and its effect on the performance and draw-down (reduction in account equity from a trade) of a fund. Position sizing defines what percentage of the portfolio’s total equity the trader is willing to risk (or bet) per trade. The purpose of position sizing is to control risk, enhance returns and maximize the trading strategy. The inputs used in the algorithm that determines “how much to bet” include the characteristics of the underlying securities, its’ volatility, the amount of trading capital and the degree of positive expectancy of the trading system. Most professionals agree the level of risk should not exceed 1% to 3% of the equity on any given trade. Sophisticated position sizing models including “Optimal F” and “Fixed Ratio” are often used, with the resulting preferred bet size being a function of the inputs outlined above and the maximum level of draw-down allowed (amount by which the equity account decreases).
A general partner in a venture capital fund has a similar decision to make in allocating capital to a specific investment opportunity. Like poker players, hedge fund managers and CTAs, a general partner engages in probabilistic investing, whereby both risk and return are balanced. In the world of the probabilist, a venture capitalist commits capital to a business. He is aware he can not guarantee the outcome, but he believes-based on his domain expertise and due diligence-that he can accurately handicap the distribution of those possible outcomes.
Unlike hedge funds and CTAs, a venture capitalist does not have the advantage of leverage in the fund or liquidity in the investment vehicle. Also, a venture capitalist has the additional burden of actively managing, and adding value to a portfolio company through continued product development, distribution expansion, and management team enhancements. This added burden limits the number of investments by the capacity of the general partners.
Given these constraints, a venture capitalist must rely on a more traditional position sizing approach, such as the equal units approach. This model determines “how much” by dividing the fund into a fixed number of portfolio companies. The actual number is determined by the size of the fund, the capacity of the general partners, the estimated required amount of reserves for follow-on investments, and the diversification requirements for sector and portfolio company concentration laid out by the LP agreement. Having a clear understanding of the percentage of capital that is initially invested in a portfolio company and the underlying rational is the first step in comprehending the GP’s approach to capital efficiency.
In poker, trading and venture investing, the more aggressive the approach, the greater the risk. The “player” needs to weigh the “bet” against how he or she expects circumstances to unfold. In Texas Hold Em, balancing the betting depends on the “flop, (or community cards used by all players to make the best hand) and the likelihood that those cards will help your hand more or less than the hands of the other players. In trading and venture capital, balancing the betting is accomplished by diversifying by market, sector and portfolio company.
In poker, there are several betting systems that have been used for centuries. The Martingale System is the oldest. Originally developed for play on the even chance bets of a roulette table, it can be used on any other even-chance game. Although there are many variations of the Martingale system, in its simplest form, the bet doubles after each losing bet until a winning trade occurs. That final winning bet, after a string of loses, will replace all previous lost money plus give a profit equal to the original bet. It does not matter how many losing bets occurred, as long as each bet doubles. The problem with the Martingale system is that after a run of losses the bet size starts to get enormous. This system works with certainty if the trader has a large amount of capital and time. No matter how great the string of losses, eventually a winning trade will recoup the losses. This system is recommended only for those with unlimited wealth, time and perseverance.
Pressing The Trend
So what type of “betting” system can a venture capital fund utilize to minimize risk and manage capital most efficiently? Once an initial investment is made in a portfolio company, a general partner will continue to use as a guide the fund parameters outlined earlier. These include the size of the fund, capacity of the general partners, reserves for follow-on investments, and the diversification requirements on sector and portfolio company concentration laid out by the LP agreement.
A venture capitalist can use a variation of pyramiding for adding investments in an existing portfolio. Pyramiding (also know as “pressing the trend”) is a method for increasing a position, as it becomes profitable. A hedge fund manager or CTA will often use this technique, which entails the use of paper profits in margin accounts to partly or fully finance the acquisition of additional securities.
Although a venture firm isn’t able to use leverage, it can participate in multiple later rounds of financing to add to its initial investment. The second step in understanding a venture capitalist’s approach to capital efficiency is to review the logic of the amount of capital deployed in each subsequent round and the decision tree followed to determine whether or not to invest. Analyzing these inflexion points over the time line of the deal indicates which filters are used to analyze the status of the company, including its intrinsic value, cash burn rate, financial performance, competitive advantage, customer demand and technology traction
Benjamin Franklin said, “Diligence is the mother of good luck.” Reviewing a venture capitalist’s approach to capital efficiency provides three substantial benefits: One, a clear view of the approach to risk management. Two, a framework within which to determine the general partner’s approach to bet-sizing and asset allocation. And three, an understanding that the decision tree followed at the various investment inflection points are logical, stable and efficacious.
Brett A. Nelson is founder and managing director of Altitude Capital, LLC, a Denver-based independent private equity advisory firm. Prior to forming Altitude Capital, Nelson was a Principal at INVESCO Private Capital. He may be reached at