By Gabriel Le Gloahec and Edouard Barret
With reputations and capital at stake, Private Equity and Venture Capital firms endeavor to make the best possible investment decisions. However, complete information is often impossible to obtain or takes too long to acquire resulting in opportunity costs from deferring investment. This problem is especially prevalent in VC, where target companies can arouse so much interest that due diligence has to be conducted in very constrained time-frames. Given these structural challenges, how have firms structured their decision making processes so that good outcomes are more often realized?
First, we should get an overview of the stages a proposed investment goes through once it comes to a PE firm. This gradual process is known as Deal Socialization, wherein the information gaps present in an investment opportunity are defined so that they can be filled by the deal-team. This process is an essential part of reconciling the fact that the firm will most likely be working with information that is to some degree incomplete. It’s also a process whereby the investment can be determined unfeasible, as critical questions may not be answerable or new questions may incessantly arise. The reason it’s called a “socialization” process is because it’s a period in which the wider firm can become familiar and comfortable on a high-level with the opportunities and risks presented by a specific investment. The typical socialization process can be summarised in the following 4 steps:
- The deal arrives to the firm and is assigned to a GP or partner: it is assigned based on partner experience in the sector or contact with deal source. The partner can choose to immediately turn it down or investigate it, and then recruit a second partner or principal to help them work on the deal.
- The deal becomes active: The partner must write a memo (1-5 pages) outlining important company information. The deal team solicits questions from the rest of the firm and works to resolve them. Active deals are reviewed weekly at partner meetings and the investment opportunity continues to be exposed to more of the firm. At a later stage, the company in which they’re contemplating investment would present to the firm, and take part in a due diligence dialogue.
- The deal becomes widely known: At this point, many of the partners are aware of the investment prospect, and in some cases the firm has approved the investment, subject to the resolution of final outstanding questions. If not already done, the company would then present itself to the whole firm.
- An investment is recommended: Approval of the deal is almost guaranteed, but there is still a chance that it will be refused or paused for due diligence. The final decision is made by a decision making body, often called and investment committee, according to the firm’s decision making practices.
The most common practices
To make an investment, a VC or PE firm must find a company, assess its offering and team, and structure a deal. At the beginning of the investment process, an important decision has to be made regarding whether an opportunity will be explored, and at the end of the Deal Socialization process, whether the opportunity should be executed on. These decisions are made either by vote, or far more commonly, by consensus, a mechanism more appropriate for a partnership.
Within the consensus mechanism, there is a lot of variation in strength and breadth required before exploration or execution. Strength can vary from everyone saying yes to no one saying no, with everything in between. Breadth of consensus varies based on the deal in question, the state of M&A markets and the reputation of the partner spearheading the deal. In some cases, firms leave the final decision to the GP sponsoring the deal, while others (typically smaller firms) require unanimous agreement. Depending on the system, anything from unanimity to weak consensus (no one actively opposing the investment) can be satisfactory. The degree of consensus typically depends on the objectives of the firm and whether the process is meant to only convey rationale, so everyone is on the same page, or actually share responsibility for the investment being made. Lenient consensus requirements can also be implemented by firms for achieving diversification objectives, since unusual deals in new areas that would have previously been rejected may become approved.
The decision making body usually includes between 4 and 11 of the most senior members (GPs or partners), but in the broadest cases it can also include lower level personnel and even non-principals. Venture partners and chief operating officers (brought on board for managing investments but not members of the partnership), who would be familiar with specific if not all investments, may also be included, but more often than not they aren’t.
Putting it to the Touch
So far, we’ve only discussed the consensus mechanism, but firms use a myriad of other decision making systems as well, including rating systems, modified consensus and even allowing sole actors to make decisions at the various stages of the investment process. As an example from surveys done by HBS professors, some VC firms make investment decisions by coming up with a rank for the investment prospect by including perspectives from a broad swathe of the firm’s personnel. Then the sponsor of the deal, based on his own knowledge and dialogue with colleagues, takes the final decision, be it either consistent or inconsistent with the firm’s ranking. Here faith is put in the partner most closely involved with the deal, but their reputational capital is put at stake if their decision to invest is at odds with the ranking that the firm attributes to an opportunity. Other firms surveyed adopted different systems of ratings, one such system functioning with each voting partner rating an investment on a scale from 1 to 10. If the average of all the votes was less than 6, the deal would be abandoned. A number of firms also adopted the consensus mechanism, albeit with slight modifications, such as anonymous written votes instead of show of hands, or the choice between: no, abstain, yes satisfactory, yes enthusiastic.
Among the decision makers, firms also consider the fact that certain individuals have a greater influence over the overall opinion of voting partners, and therefore, some firms impose that the most junior person in the room speaks the first, in order to prevent a senior partner from prejudicing people’s views. Different PE and VC firms also diverge in the amount of paperwork which is required prior to making a decision, ranging from no investment memo at all for certain firms, to memos of more than fifty pages in others. However, most of the time, the abandonment of an investment prospect happens before it comes to this final stage.
Making Your Case
Firms admit that a deal can be derailed even at the last step of the process as it is possible for some critical issues to arise. A partner could “pound the table” and kill a deal, and while most say that it never happens, others assign a 25% chance to it. Typically, goodwill between partners usually stops deals from progressing far enough to be opposed vehemently by a partner in the final stages. But even where there is goodwill, it is wise to have systems that can deal with the fact that there may be partners that hate a deal. To tackle this, some firms put the most opposed partners on the deal team, so that the decision making body will be realistic about the weaknesses and benefits of an opportunity. A partner’s negativity regarding a deal is important in ensuring that risks and weaknesses are accounted for. The converse is almost never true, where only one partner is actually positive about an opportunity. This is not surprising in any democratic decision making system, but on rare occasions, firms may grant partners a few ‘silver bullets’ for deals of personal interest; a risky initiative for both the firm and the individual’s reputation. Nonetheless, in the vast majority of cases, the burden is squarely on the faithful, and it is much easier for an individual to kill a deal than to keep it alive.
There are several factors other than the investment opportunity itself that affect the degree of consensus required to do the deal, and good decision making processes will have to account for them in one way or another. These are: diligence time-constraints, macro environment, and the partners involved.
- Matter of time: Due-diligence is an extremely important part of the investment process, and in cases where there are time-constraints on due-diligence, and information is less complete than it could be, the degree of consensus required to approve the deal will change. Typically, the less time that was put into due-diligence, the more unanimous the consensus needs to be. The reasons why firms might have to accept that they can’t allocate more time to do research are numerous, but it can be boiled down to a determination of whether or not the marginal benefit of investing time to acquire more information exceeds the marginal risk of not taking the opportunity immediately.
- Macro environment: the general market environment affects the rigor with which the process is followed. For example, during the dot.com boom, consensus became weaker so that VC firms could flip start-ups faster and achieve astronomical profits.
- Particular partner: the reputation and expertise of a partner may affect the degree of consensus to do the deal. Partners with less clout and who aren’t as trusted, either because they’re less experienced or otherwise less compatible, will usually need their case to garner more unanimity to be approved.
Process of decision-making regarding follow-ons
Once a VC firm has decided to commit to an initial investment in a company, it then may decide whether or not to proceed with a follow-on at a later date. The main factor when deciding whether a follow-on is a good investment or not is if the company is on track to meet its milestones which were established during the initial investment. A follow-on decision can be complex in cases where an investment has performed badly, as the firm has already invested time, money and reputation in the company, and therefore they will naturally tend towards a follow-on to salvage mistakes. A common view regarding follow-ons is “PE firms don’t fail because they back bad companies, but because they keep shovelling money into them”. The fact that a company’s performance reflects a VC partner’s acumen also helps exaggerate the tendency to fixate on sunk costs. To mitigate this risk, some firms have a policy for follow-ons that they will not invest more than 10% of its total investment to date, and at other firms the policy is to pass the follow-on deal to the second in charge of the initial investment, or appoint a totally new team. However, in most cases the same deal team works on the follow on that worked on the initial investment.
Despite the mentioned issues with follow-ons, they benefit from being much more informed than initial investments, and when done right they can be very profitable. Follow-ons also give VC firms the chance to modify their influence over the firm, and therefore it is a decision of great importance. Follow-on decisions differ in process, with some firms requiring long and exhaustive spreadsheets which are to be discussed in lengthy and frequent meetings. Generally, however, if an investment is well-performing, it will get follow-ons with little administration.
There are essentially infinite approaches that firms can take in investment decision making. Nonetheless, VC and PE firms who were asked what the best practices were all had some convergent comments. The first was the importance of a functional partnership in which there is open, honest communication and general goodwill and understanding between principals. This emphasizes the idea that there is a difference between true partnerships, and a collection of individuals sharing overhead. A true and effective partnership functions in a “fuzzy” way, without strict delineations of rule and responsibilities. The overall definition of best practices is neither a guy with the golden eye, nor the set of rules that are to be followed to achieve success; but a small group of hard-working people who sit in a lot of meetings, ask a lot of questions, and do a lot of work to know what they can know and be comfortable with what they can’t. Even though decision making practices are important in mitigating investment fallacies and leveraging the experience and knowledge of the firm’s members, where the most effective decisions are being made, resorting to these technicalities almost never happens, and good decisions are more a function of good partner dynamics.
Editor: Stefan Larsen
Authors: Gabriel Le Gloahec, Edouard Barret
Sources: Private Equity and Venture Capital: A Casebook – by Hardymon, Leamon, Lerner