ACADEMIC ANGLE. The importance of being a venture capital investment manager

The venture capital investment management model is perhaps one of the most significant developments of contemporary finance. Although not without its share of controversy, its success has spawned a huge amount of academic research.

One strand of research has focused on if the organisation of the venture capital fund has contributed in any way to its extraordinary success. And, if so, how?

To answer this question let us see how a venture capital fund is organised. Investors in a venture capital fund pool their funds into a vehicle specially constituted for this purpose. These vehicles, which are not different from a mutual fund scheme, are organised as limited liability partnerships (LLPs).

The investors, also referred to as Limited Partners (LPs), and the SPV then enter into a contract with a team of investment professionals to manage these funds. The investment team is often referred to as a General Partner (GP) although the outfit may not always be organised as partnerships.

The GP sources investment opportunities, evaluates them, structures the investment, draws up investment contracts with the enterprise it intends to fund, provides post investment oversight to the funded ventures, liquidates their investment by selling their shares in the venture at the appropriate time and distributes the proceeds to LPs.

The SPVs have a finite life of typically 7 or 10 years. This essentially means that the GP has to complete all its responsibilities starting from investing the funds to returning the funds to the investor, all within the 7 or 10 years as the case may be.

Clearly that is a lot of hard work. Contrast this with a fund manager who invests in shares of companies that are listed for trading on a stock exchange. He is helped along by regulations that mandate companies to disclose a lot of information. Regulations also help by mandating that companies are properly governed.

So what is there in it for VC fund managers to take up the challenge of early-stage investing? It is clearly the financial incentives. VC fund managers receive a generous fixed annual fee of two per cent of the capital that they manage for meeting their operating expenses and salaries.

In addition, VC fund managers also receive 20 per cent of the capital appreciation that they generate. The more successful the investments, the higher the capital gains! It establishes a direct link between what the manager does for his investors and his own financial fortunes.

It is the pursuit of these fortunes that makes VC fund managers add value to the entrepreneur by spending time with the funded enterprise, mine his network of contacts for making introductions to prospective customers, helping recruit critical talent, advising on strategy and occasionally taking the unpleasant decision to fire the founder from the CEO’s job or even pull the plug on funding. Academics also argue that the limited life of the fund makes the VC fund manager transmit the pressure of time-bound performance on to the entrepreneur that he funds. The rapid growth of VC funded enterprises may be partly attributed to this pressure.

While these incentives are believed to be at the centre of the phenomenal success that VC has been, it should be apparent that it can lead to occasional conflicts between the interests of the VC fund manager and the entrepreneur.

Countering these perverse aspects of the structure and incentives of the VC fund organisation is the importance of reputation capital that the VC fund manager needs to accumulate. A positive reputation helps the fund manager attract good quality entrepreneurs to invest in, which in turn helps build a portfolio of successful investments.

It also attracts capital from investors and thus helps the VC fund manager remain in the business of managing one fund after another.

It is important to understand this specialised nature of the VC fund management business before a government can embark on funding interventions to boost entrepreneurship. Ironically, it is a point that is lost on most policy planners!

The writer is Chairperson, NS Raghavan Centre for Entrepreneurial Learning at IIM Bangalore. Views expressed are his own.