Risk Management Approach and Control Techniques in VC Funds

Posted by in Business & Entrepreneurship, Leadership & Management

One of the most difficult tasks entrepreneurs and owners of small businesses face is finding a venture capitalist or a venture capital firm, another even more difficult task is convincing these investors to take risks by investing in them. The reasons for this are not far-fetched; venture capitalists take on an enormous amount of risk when investing in a startup or an entrepreneur. These startups or small businesses usually make very little or no sales at inception and are characterized by having business strategies based on hypotheses or based simply on a prototype. Also, entrepreneurs usually have poor management skills and very little business experience. Nonetheless, venture capitalists still fork out millions in investing in these startups despite their tiny and untested potentials with the hope that one of the startups in their portfolio will make headway or becomes the next big thing. Without the needed risk management skill and technical experience, entrepreneurs, and new business owners can take wrong steps that could have adverse effects in the long run. A good idea or a great business strategy is practically not sufficient in eliminating the risks associated with venture capital funds, entrepreneurs still need good risk management skills and control techniques to enable them acquire lesser loss and generate maximum returns on their investment. At the same time, all could come to nothing without the right strategy to manage their finances.

Venture capital investments require a lot of risk management techniques, unlike investments in mature companies. Mature companies produce cash flow, sales and profits that can be used in estimating the reliable value of the company; startups, on the other hand, have none or little of these.

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How Risks are Developed in Venture Capital Funds

A good knowledge of capital allocation, risk management, and effective investment is mandatory for a thorough understanding of the risks involved in the venture capital industry. Insurance companies, investors, and pension funds invest in stocks, real estate, and other resources. They invest a small proportion of the money they have into startups and small businesses that have high risks but have the potential to generate very high returns, and they make those investments through venture capital funds most times. Financial Experts, venture capitalists, and ex-entrepreneurs also establish venture capital funds, they agree on how large the fund should be and where the fund should go to. A lot of investors put their money into the venture capital fund and on this notion they become limited partners in the fund. Once the fund is committed from other shareholders and pension funds, leaving the fund closed, the general partners find investment opportunities that are available and have the potential to generate high returns. They look at lots of business opportunities and scrutinize them before they select one to fund in exchange for equity. Even though venture capitalists use rigorous scrutinizing processes, investing in these startups still come along with a lot of risks. Over the years, investors in venture capital firms have developed numerous approaches for managing the risks associated with the companies in their portfolio. Measuring the risks involved in investing in venture capital funds can be cumbersome because it entails investing in an asset class that is illiquid. However, stakeholders in the venture capital industry are of the opinion that measuring the risks associated with investing in the venture capital industry is not only important but also valuable.  In times past, a large percentage of investors have applied very simple methods in reporting and measuring the risks associated with the venture capital industry. Understanding and quantifying the risks associated with investing in this investment class is overly important due to growing exposure. It helps give a more decisive approach to risk management. The risk management approach to be applied when deciding internal capital allocation and investment decisions should also have a high standard because it enhances good corporate governance where which policies to be implemented when investing are set to account for both the risks involved and the returns to be expected.

Some of the biggest economic failures decades ago in the venture capital industry have made way for one of the most profound global financial crisis in recent times. The participants in the market became tremendously risk hostile, financial markets for risky properties closed, while earnings on safe assets cut down to record lows. Venture capitalist’s cash flow prototypes were mostly not intended to handle this tail risk, and numerous long-term asset allocators found themselves short of liquidity as allocations from venture capital funds became dry at the same period as margin calls improved and redemptions were adjourned by venture capital funds and like means. After being met with a substantial amount of unfunded commitments and a serious deficiency of liquidity, many venture capitalists began selling stakes in venture capital funds. As a result of the shortage of liquidity, an enormous aversion for risks and a large macroeconomic insecurity, only a few buyers were present. The quick decline in the operating performance of companies in their portfolio and a deterioration in the public markets resulted in a gradual adjustment of the net asset values (NAVs).

In the industry, a venture capital funds partner gets his or her returns after getting a startup or its initial public offering and a venture capital fund is considered to be doing well when one-third of the portfolio companies provide the partners with good returns. The usual time-frame to approve an exit is five to seven years, and the lifespan of the fund is usually about 10 years. The general partners take a yearly management fee of two to three percent of the capital injected into the fund, for expenditures and remunerations. They will also get a 30 percent share of the spoils from exits; usually, after the limited partners have gotten their capital investment back. Depending on the venture capital preference, the fund can be invested anywhere from the initial phase to the developing phase. The rest of the fund will go into the follow-up stages for portfolio companies which gain impulse and can be placed up for an acquisition or initial public offering. The rest may be left to their own device. So a basically funded venture capitalist has a three-year life span to get going and move up. However, the general partners need some early winners, so they can go back to the limited partners to raise another fund midway through the lifecycle of the first one. All of these are based on assumption as there is no 100 percent guarantee that the companies in their portfolio will generate enough returns. In the venture capital industry, both the entrepreneur and the venture capitalist are susceptible to a significant amount of risks and while entrepreneurs consider themselves to have risks that cannot be reduced, the venture capitalist is more inclined to research into risk management approaches. As one of the major differentiating characteristics of the venture capital industry, venture capitalists are aware that not all the companies in their portfolio will make headway, they try to reduce the effects of the companies in their portfolio that fail by offsetting them with fast moving ones.

Criteria for Measuring Risk in Venture Capital Funds

The process of controlling and managing risks by venture capital firms start right from the screening stage. Venture capitalists are aware that entrepreneurs are very likely to overestimate the value of returns or profit they can generate and underestimate the amount of risk associated with the business. Hence, venture capitalists have adopted rigorous scrutinizing screening processes and review only about 30% of the proposals they receive. Out of the 30 percent they received, only about 3 percent is backed.

The criteria that should be fulfilled by the portfolios under venture capital funds when adopting a risk model are:

  • Monotonic

All other things being equal, for a fund A that is younger than fund B, the range for the projected outcome of IRR or multiple for fund A should be larger than that in fund B.

  • Observable

A condition for back-testing a risk model, for instance, publicly quoted asset prices are observable in the sense that it is possible to transact at such a price, but for illiquid asset observable prices do not exist. Liquidity events, however, are observable and thus a model can be tested against a fund’s cash flows

  • Interrelated

The risks related to one fund cannot be determined in isolation. For example, risk stemming from over-committing or risk mitigation from diversification over portfolios of funds; have to be factored into the risk measurement.

  • Completeness

All significant constituents that incorporate a fund must be duplicated in a suitable risk measurement.

  • Reconcilable

Every specific outcome (e.g. IRR or multiple) for a fund needs to be a result of an individual cash flow scenario of the fund’s inflows and outflows

  • Unbias

For the total population of funds at the same level of their lifetime, the weighted average net present value (NPV) needs to be 0. In other words, risk measures should eliminate a systematic J-curve.

Major Risks in Venture Capital Funds

The major opportunity for institutional investing in venture capital is a limited partnership that usually spans for over ten years. It comprises the fund manager and a group of Venture capitalist. The investors (venture capitalist) in a venture capital fund invest a certain amount of money which makes them entitled to a share or the returns in the business. The manager of the fund uses fund from the capital pool to invest in a number of startups and small businesses during the period of this investment.  Some of the role the fund managers’ play is to use venture capital management techniques to grow these portfolio companies with a goal to increasing their value and mapping out exit strategies at an appropriate time. When this is done and if the startup or small business generates a return at the end, the returns are shared among the venture capitalists. Risk management techniques aim to evaluate the level of risk involved in the investment and provide a good exit strategy that minimizes losses in case there are. An ideal risk assessment procedure in venture capital funds is one that is devoid of bias. No matter how little, any form of bias when measuring the risks involved in a venture capital investment should be avoided.  In the venture capital industry, the main risks that venture capitalists or venture capital firms face are:

  • Capital risk

Not only do venture capitalists face long-term risks of losing the value of the capital they invested, they also risk recording losses as a result of liquidity constraints. Some of the factors that can have effects on the long-term capital risk are equity market exposure and manager quality.

All across the venture capital industry, the capability of managers to generate cash and produce value from their portfolio companies differs generally. This makes the selection of managers a very important part of venture capital funds. It is also essential for Venture capitalists to track changes in the quality of personnel and any other changes that can have adverse effects on the quality of management.

  • Liquidity risk

In order to fund their commitments, venture capitalist can sell the shares they have in a venture capital investment. However, this can be unreliable because the secondary market for venture capital investments is usually smaller and ineffective when compared to other markets. This feature exposes venture capitalists to the risk of asset liquidity. Also, the prices of the secondary market are often determined by some factors that are usually beyond the value of the venture resulting in prices discounts.

  • Funding risk

In a venture capital fund, the venture capitalist is faced with funding risk as a result of the random timing of cash flows during the period of the investment. Venture capital fund managers are tasked with the role of calling all or most of the invested funds during the period of the fund’s investment. The investors are usually given very short time notices to meet their commitments and the ones who are not able to do so are obligated by force to do away with a considerable percentage of the money accrued to him in the venture. However, the fund manager and the venture capitalist can negotiate in order to make decisions on the capital call obligation and on the amount of the fund.

  • Market risk

The control techniques applied to the risks in a venture capital carries greater challenges because it is an illiquid asset class. The basic goal is to define how the fluctuations in the market affect the value. When evaluating assets, there are 2 main methods. One method of evaluating the market involves determining its current market value or an approximation of the value it might be. The other method is the current worth of the future cash flow already estimated from the asset. Arbitrage and liquidity present in the market forces these two methods of asset valuation into alignment; other dysfunctionalities that are present in the market like the absence of liquidity cause them to diverge. This is more pronounced in venture capital transactions. In venture capital investments, fair value estimations are usually based on the notion of an orderly transaction. This notion assumes that there is no form of compulsion that binds either or a buyer or a seller when a transaction is undergoing.  The two parties involved are both reasonably knowledgeable and versatile, and they are capable of performing diligently when making investment decisions.

In this kind of illiquid asset class, a good assessment of how capable the partner is in carrying out an orderly transaction is necessary for guaranteeing that the market risk is accounted for accurately. If the partner is successfully able to carry out an orderly transaction and the current worth of the future cash flow estimate is lesser than the price, the sale will be recorded. The discounts usually found in secondary markets are as a result of a decline in the value of the fund. Most times, they arise as a result of the incapability of some partners to carry out orderly transactions as a result of the unavailability of liquidity.

Addressing Venture Capital Risks

There is a strong case for adequate risk management and control techniques in the venture capital industry – in particular, liquidity risk – for over-commitments. Over-committing investors sign more commitments on an average than they have resources available. The reason for over-committing is to get the most out of investments in venture capital funds but is also accompanied with a greater risk of not having sufficient cash available when funds call for capital. It is uncontroversial that proper risk management needs to be put in place in such situations. However, it is often argued that certain large institutional venture capitalists have more than sufficient liquidity so they do not need to spend time and effort on venture capital risk management. Clearly, such investors are not exposed to liquidity risks; however, they are still exposed to the risk of not meeting the target return for the resources dedicated to private equity. Therefore, this view needs to be challenged, especially with regard to capital risk. One could dispute that in a big venture capital firm’s portfolio, undrawn commitments are “lent” to other events where they don’t realize a venture capital like return, but they have as such not been cancelled and thus carry opportunity costs, particularly if they are not invested in higher yielding and less liquid assets. Where this is the case, premature and unplanned liquidations of such positions will, on the other hand, usually depress returns and need to be reflected; otherwise, the associated costs are overlooked. Even if they do not over-commit, investors with a marginal allocation have to “over-allocate” to venture capital as they otherwise will not make an adequate return on the resources dedicated to the asset class.

The profits or returns of investing in a high-return investment like the venture capital industry can be dampened by losses which can usually be averted or minimized by proper risk management approaches and control techniques. Venture capitalists take these risks into consideration and devote a lot of time in devising risk management techniques that are effective.

Key Takeaways

  • Investing in startups requires a lot of risk management techniques, unlike mature companies who produce cash flow, sales and profits that can be used in estimating the reliable value of a company.
  • Venture capitalists take on an enormous amount of risks when investing in a startup or an entrepreneur. Some of the risks are liquidity risk, market risk, funding risk and capital risk
  • In the venture capital industry, both the entrepreneur and the venture capitalist are susceptible to a significant amount of risks and a good knowledge of capital allocation, risk management, and effective investment is mandatory for a thorough understanding of the risks involved in the venture capital industry.
  • The risk management approach to be applied when deciding internal capital allocation and investment decisions should also have a high standard because it enhances good corporate governance where which policies to be implemented when investing are set to account for both the risks involved and the returns to be expected.
  • Risk management techniques aim to evaluate the level of risk involved in the investment and provide a good exit strategy that minimizes losses in case there are, and an ideal risk assessment procedure in venture capital funds is one that is devoid of bias.
  • There is a strong case for adequate risk management and control techniques in the venture capital industry, investors sign more commitments on an average than they have resources available. The reason for this is to get the most out of their investments but is also accompanied with a greater risk of not having sufficient cash available when funds call for capital.
  • As one of the major differentiating characteristics of the venture capital industry, venture capitalists are aware of the risk that not all the companies in their portfolio will make headway, they try to reduce the effects of the companies in their portfolio that fail by offsetting them with fast moving ones.