Governance and Compliance in Venture Capital Funds

Governance and compliance are fundamental aspects of a successful venture capital (VC) fund. For Limited Partners (LPs), grasping governance frameworks and compliance strategies is vital for achieving transparency, minimising risks, and protecting their investments. Compliance is essential for safeguarding investor interests and upholding the integrity of the VC landscape.

This article forms part of a comprehensive 10-part series titled Insider Secrets: What LPs Must Know to Invest in VC Funds in India, where essential insights for navigating this asset class confidently are explored. An AMA session is scheduled for February 13 at 5:30 PM to address critical questions often overlooked by LPs and reveal information aspiring VCs seldom receive internally. Registration for the event can be done here.

Understanding Governance and Compliance

Governance encompasses the frameworks, policies, and processes that dictate how a VC fund operates and how investment decisions are made. Robust governance guarantees that the fund functions with integrity, aligns with LP interests, and follows best practices.

Key Components of Governance in VC Funds

Fund Structure and Decision-Making

Typically, VC funds exist as Limited Liability Partnerships (LLPs) or Limited Partnerships (LPs). General Partners (GPs) manage investments on behalf of LPs, and investment stratagems are scrutinised by an investment committee to ensure strategic conformity.

Transparency and Reporting

Regular financial reports and performance summaries inform LPs of fund activities. LPs should verify that reporting standards meet international best practices.

Risk and Conflict Management

Funds must implement methods to identify and resolve conflicts of interest. LPs must evaluate if GPs are motivated to act in the best interests of investors.

Best Practices for LP Governance

To ensure sound governance, LPs should:

• Ensure Clear Investment Mandates: Review fund documentation to verify a well-defined and adhered-to investment thesis.
• Assess Investment Committee Independence: An independent and varied investment committee mitigates bias and enhances decision-making quality.
• Monitor GP Accountability: Evaluate how GPs are incentivised and whether their interests align with long-term fund performance.

The Role of Compliance in VC Funds

Compliance is crucial for safeguarding investor interests and preserving the integrity of the VC ecosystem. LPs should be familiar with critical regulatory frameworks governing VC funds and understand their implications on fund operations.

Key Regulatory Authorities and Guidelines

Securities and Exchange Board of India (SEBI)

SEBI regulates Alternative Investment Funds (AIFs) under the AIF Regulations framework, ensuring transparency, investor protection, and equitable governance practices.

Financial Action Task Force (FATF) Guidelines

FATF establishes regulations for anti-money laundering (AML) and counter-terrorism financing (CFT). LPs should verify that funds comply with AML policies.

Fund-Specific Compliance Requirements

Funds must comply with KYC (Know Your Customer) standards, and all required regulatory filings and audits should meet AIF regulations.

Due Diligence for LPs Regarding Compliance

LPs should conduct thorough diligence to:

• Verify Fund Registration and Licensing: Confirm whether the fund is registered with SEBI or relevant regulatory authorities.
• Review Compliance History: Assess if the fund has faced past compliance violations or regulatory investigations.
• Evaluate Fund Policies on Ethics and Governance: Ethical standards should be clearly articulated in fund documents to prevent misconduct.

Addressing Governance Risks

While many VC funds demonstrate integrity, LPs must remain cautious regarding governance lapses that could threaten their investments. Common governance warning signs include:

• Lack of Transparency: Absence of clear financial reporting or vague disclosures, along with failure to regularly update LPs about fund performance.
• Excessive Management Fees and GP Misalignment: Management fees significantly above industry standards, along with GPs prioritising short-term gains at the expense of LP interests.
• Conflicts of Interest and Unethical Conduct: GPs maintaining personal interests in portfolio companies without full disclosure, alongside side agreements that disadvantage LPs.
• High Turnover Among Key Fund Personnel: Frequent alterations in the investment committee or management team and lack of seasoned leadership in fund operations.

Strategies for LPs to Mitigate Governance Risks

To safeguard their interests, LPs should:

• Conduct comprehensive pre-investment due diligence on the governance structures of funds.
• Regularly engage with fund managers to oversee compliance and transparency.
• Request periodic governance audits to ensure adherence to ethical and regulatory benchmarks.

This article has been co-authored by Anup Jain and Rajeev Suri, Founder Partners at BlueGreen Ventures.