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Irish Pensions Magazine Autumn 2016
26
Feature
versed in dealing with asset risk. However, as part of
the portfolio control and management process, it is
important to identify the risks associated specifically
with venture capital:
• Illiquidity and Irregular Cash Flows
- Investing
in venture capital requires investors to invest a
pre-agreed amount of capital (or commitment)
over the fund’s life. It takes time for investments
to be sourced, businesses to be built and exits to
be achieved. This makes it an illiquid investment
that requires capital to be tied up for a long
period of time. However, investors do not need to
provide the entire amount of capital committed
up front. Instead, capital is drawn down as fund
managers make investments and limited partners
need to ensure they have sufficient liquidity to
meet drawdown requests. Investors should also
expect low or negative returns in the early years
of a fund’s life because of the time required to
source and make investments. In addition, the
fund’s establishment costs, management fees and
running expenses need to be covered. Returns
start to be generated and distributed in the later
stages of the fund life as portfolio companies
mature and exits occur. When plotted against time
to show limited partner’s (LPs’) net cash flows, this
pattern of drawdowns and distributions normally
results in a J-curve effect. As distributions usually
start before the whole commitment has been
drawn, it is unusual for an LP ever to have the
full amount of its commitment under investment
by the manager. In practice, the peak outlay by
investors generally amounts to not more than
about 65% of the funds committed and net cash
flows turn positive from about the fifth year
with payback of monies committed achieved by
year 8. Strategies to mitigate or accelerate the
J-curve effect include investing the capital not yet
requested (or uncalled capital) in easily accessible
money market instruments, or over-commitment
i.e., committing more capital to a fund in the
expectation that distributions will start to flow
before the full committed amount is due.
• Manager Selection
- Choosing high-quality fund
managers is one of the most important factors in
the success of a venture capital programme. The
hands-on nature of the asset class means that the
extent of the skills and experience of the fund
manager can make a substantial difference to the
returns generated. There can be a high dispersion
or difference between the top and bottom
quartile funds by performance. Many studies have
suggested that there is a persistence of returns.
However this persistence can be weakened in
extreme circumstances like the recent financial
crisis when fund managers had to adapt to a
new investment and economic environment.
This underscores the importance of investors
conducting thorough due diligence on fund
managers before committing capital. This should
examine not just past fund performance numbers,
but also dig deeper into individuals’ track records
and experience as well as looking at how a firm
has generated its returns in the past and how it
intends to do so in the future.
• Control over Investment Choices
– LPs, as
passive investors, delegate responsibility for
deal sourcing, investing, managing portfolios
and exiting investments to the venture capital
fund manager. As such, they do not exercise
any control over individual investments made
and make a commitment to a blind pool (i.e.
they do not know at the outset which specific
investments will be made over the life of the fund).
However, the investment strategy to be employed
by the fund manager is pre-agreed at the point of
fundraising and is set out in the limited partnership
agreement (LPA), which offers investors in the
fund protection against off-strategy investments.
In addition, the LPA should also include limits
on the amount (usually as a percentage of the
fund total) that can be invested in each portfolio
company to avoid concentration risk.
• Company Risk
- Fund managers undertake
rigorous due diligence before investing to ensure
they understand the risks each portfolio company
faces and to identify areas for improvement and
growth. This helps mitigate the risk of loss of
capital, although it does not completely remove
it and there remains a risk that a portfolio
company does not perform to plan. However,
the active involvement of fund managers post-
investment, including taking board seats, should
lower the risk of this happening. In addition, the
portfolio approach taken by venture capital fund
managers helps to diversify risk across a number
of investments.
Regina Breheny
Director General
IVCA
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