Every Step You Take, LPs Will Be Watching You

By Tom Stein, January 1, 2003

People have been fudging their resumes for years, even though it can lead to embarrassment. Well, here’s a reason to make sure that your resume is 100% accurate: It may be scrutinized by an ex-cop hired by a potential limited partner when you go out to raise your next fund.

After years of doing due diligence on entrepreneurs, general partners are now getting a taste of what it feels like to be under the microscope. A growing number of LPs are hiring so-called business intelligence firms to perform hard-nosed “investigative” due diligence on venture capital firms-with some surprising results.

Outfits like Intelex Ltd. of Greenwich, Conn., Kroll Inc. of New York, and Decision Strategies LLC, which has five U.S. offices, are in the business of digging up crucial information that can help investors make more-informed decisions. They employ international databases, document searches and good old-fashioned legwork conducted by investigators around the globe to uncover everything from criminal records to unsavory business dealings. Matthew Cherry, president of Intelex, says it’s unusual for his firm to discover a single damning piece of data that will scare away investors. In one extreme case the firm discovered that a little-known VC fund/investment bank had fabricated its business address and claimed to be working out of a country that didn’t exist. The investors, naturally, walked away from the deal.

More typically, Intelex uncovers smaller issues that help LPs gain a better feel for the risk of a potential investment, and in some cases, the information helps them negotiate more favorable terms. For example, an LP was about to commit to a biotech fund, but Intelex discovered that just a single general partner in the fund had a solid track record in biotech. As a result, the LP was able to negotiate a key-man provision for that person.

Because of strict confidentiality agreements, the investigative firms decline to reveal the names of their clients. But at least one LP that says it has hired such a firm is the Canada Pension Plan, one of the largest public pension funds in North America.
Whereas one or two years ago Intelex had almost no LPs as clients, today is has more than a dozen. And while Kroll hasnt seen a huge influx of LP clients, it has seen increased interest. “We are seeing a change as more institutional investors come to us demanding greater transparency in their transactions,” says Peter Turecek, a managing director at Kroll. “These investors are more wary of things blowing up on them.” Turecek says he expects to see more LPs knocking on his door.

That’s a major change from a few short years ago, when LPs conducted almost no intensive due diligence. At that time, VCs could regularly raise millions of dollars with a single phone call to an LP. Today, the fundraising environment is dramatically different. LPs are taking their sweet time before making any commitments.

“The bar has gotten higher across the entire industry,” says Bart Schachter, a managing partner at Blueprint Ventures, an early-stage firm based in San Francisco. “Just as we are doing more due diligence on entrepreneurs and venture deals, the LPs are doing more due diligence on us.”

When Blueprint raised its first fund during the peak of the bubble, some investors handed over money without even requesting a meeting. LPs desperately wanted into venture capital at any cost. Now they’ve discovered that price was too high, and they’re moving far more deliberately. “Personally, we haven’t been subjected to investigative due diligence, but I’m not surprised to hear that more LPs are resorting to that,” says Schachter.

GPs shouldn’t assume that the due diligence being performed on them would be any less vigorous than the background checks that they run. Among the investigators Intelex employs are a former New York prosecutor who specialized in organized crime, an ex-Scotland Yard officer, former FBI agents, and several library science experts skilled at uncovering information in the public domain.

That kind of expertise doesn’t come cheap. Intelex typically charges about $3,500 to investigate a single general partner at a U.S. venture firm. The price goes up if the GP lives and works outside the States. Intelex will also scrutinize the working relationship between a VC firm and its portfolio companies for an additional $5,000. All told, the average cost of hiring Intelex is about $15,000.

There are several reasons why investors in venture capital, particularly public pension funds, are reaching out to investigative firms. At the top of the list is an increasing call for transparency at public pension funds. With venture returns plummeting, managers of these funds are under siege from stakeholders who want to understand the decision-making process behind each and every investment. The pressure is greater than ever for these managers to conduct thorough due diligence and not get caught in a compromising position.

One LP, speaking on condition of anonymity, says that he looks at investigative due diligence as a sort of insurance policy. If something goes wrong with one of his investments, he can go back to stakeholders and show them that he had the GPs in a fund thoroughly checked out. “We would only go with a business intelligence firm when we are in the final stages of our own due diligence or we are already very close to making an investment,” the LP says. “Honestly, we are not looking for a deep CIA background check or for someone to go rooting around the garbage. We just want a clearer picture of the people [to whom] we are giving stewardship of our money.”
Michael Flaherman, chairman of the California Public Employees’ Retirement System’s (CalPERS) investment committee, says that serious due diligence of GPs is long overdue. “LPs are more nervous these days,” he says “They are committing more of their time to due diligence.”

Brian Stewart, managing director of private markets for the University of Toronto Asset Management Corp., agrees with Flaherman’s assessment. “There was a lot of coattail investing, where LPs jumped into certain funds just because other people were, too,” he says. “There’s much less of that going on now. Though we have never hired an investigative firm to help us with our due diligence, that’s something that may make a lot of sense for investors.”

The changing face of venture capital is also prompting more due diligence. For much of the 1980s and 90s, venture capital was a clubby universe where everybody knew each other and trust was firmly established between LPs and GPs. Today, there are many new participants on both sides. Moreover, even brand-name funds may not be what they seem, because of the generational shift gripping many venture groups: Older VCs are quietly exiting the industry and some LPs still need to get comfortable with the younger partners taking their place.

Whether it’s a new fund or an established fund, “investors want to understand the issues around the partners of these funds and how they’ve conducted themselves in the past,” says Cherry of Intelex.

Increased due diligence is ruffling a few GP feathers. VCs who came of age during the bubble years still bristle at the notion of being subjected to the same kind of rigorous investigation they conduct on their own entrepreneurs. “We have gotten some push back from the GP community,” Cherry says. “When we first started doing this for LPs, I thought it would be the longstanding firms that would take the most offense and that the younger firms would be more accepting. In reality, it’s the other way around.” Maybe it’s because the more established funds have less to hide, he conjectures.

Even though much of the investigative work is being done behind the scenes, LPs are advised to let GPs know they are having them checked out. It makes it easier for the due diligence specialists to access certain information, like university transcripts. Also, it will save an LP from being confronted by a GP who finds out from a friend or associate that he’s being investigated.

Lucy Marcus, founder of Marcus Venture Consulting in London, is thrilled to see that venture firms are coming under more scrutiny. Over the last few years, she has spent more of her time helping LPs with their due diligence. She talks to countless industry sources to discover whether a particular GP plays fair and comports himself in a professional manner. She’s finding that a good reputation can be more important to an LP than whether a particular partner has made big returns.

“A certain level of decorum is returning to the industry because VCs now understand that their actions and behavior will have certain repercussions,” she says. “VCs who play by the rules and work well with others will be rewarded. But VCs who have a history of pushing around entrepreneurs or behaving in a litigious manner are not likely to win the trust of LPs in this market.”