Social Impact

Investment Structure

Demystifying venture capital for healthcare professionals.

I am using my social distancing time to help a colleague assess the feasibility of a new Social Impact fund for early stage startups.

The timing aligned with the start of an online program about venture capital sponsored by TechStars/Kauffman Fellows that I had enrolled in. Having a specific project to apply the learnings to always makes the content more meaningful.

It didn’t take long for me to discover some parallels to a legal structure commonly used in healthcare. Understanding the parallels will make venture capital more relatable.

Structure

Healthcare companies already have experience with the basic legal structure Venture Funds use. It’s the same structure commonly used in joint ventures with physician partnerships.

Venture firms use the General Partner [GP] – Limited Partner [LP] structure to manage their funds. The firm acts as the GP which is the active partner in the fund and the investors [Pension Funds, Endowments, Foundations and Family Offices] are the LPs that have a passive role. The main role of the LPs is to provide the money to fund the investments made by the GP.

Knowing that it’s a legal structure that many of us already have experience with demystifies the complexity of it.

Expectations

Many entrepreneurs have 10X seared in their minds as the required or targeted return. However, the goal of venture funds is to return at least 3-5% more than the public markets in order to compensate investors for the increased risk. For the 10 years ending June 2019, the S&P 500 returned 14.7% and the Dow Jones returned 15.03%.

That’s on par with the expectation of healthcare joint ventures as well. However, projections are usually done to estimate the return of a healthcare joint venture and to benchmark actual performance rather than using the stock market performance.

Problems

The main problem with the GP/LP structure in both cases is that the expectation is not met but the fees paid to the GP are the same regardless of outcome.  In other words, LPs pay proportionately more when a smaller pot of money is returned.

That generally doesn’t make anyone happy. Disappointed LPs eventually sever the financial relationship.

Timing

Timing is one of the big differences. LPs in a healthcare joint venture have more engagement in day-to-day operations. Even if the GPs aren’t sharing all the financial data in real time, the LPs often have a sense of the business and know when something is off. Changes can be made at the end of the contract term or sooner if termination for cause is warranted.

Conversely, the LPs in a Venture Fund often get limited insight into the financial performance of the fund because they have no involvement in the management or operations of the portfolio companies. The actual results are revealed at the end of the fund which is 10-13 years after the initial commitment. Consequently, LPs may have invested in multiple funds with the Venture Firm before they get any insight into actual performance.

Interestingly, the solution for VCs is one that I’ve used in healthcare joint ventures to establish trust with the LPs. Experts are recommending more transparency and standardization in financial reporting.

With that said, I think there are some additional challenges for establishing appropriate benchmarks with public funds. It’s not an apples to apples comparison.