The Risks And Rewards Of Direct Investment For LPs The primary advantage of taking direct investments is cost savings, but it is not devoid of challenges

Yesterday, we wrote an article on how a lot of limited partners (LPs) are today moving into direct investments. And explained how it is a global phenomenon.

We also listed the factors leading to this trend. Here is a quick recap of the factors discussed.

• Traditional asset classes like debt have been giving lesser yields in the last 3-4 years
• There is an increased need to move to higher-yielding instruments
• The direct deals give LPs access to companies' cap-table, leading to better returns
• Comes with a zero management fee
• Gives LPs greater control over their capital
• Allows them to add greater value and play a more active role in the investee's business

However, direct investments also carry some disadvantages for LPs. In this article, we will be looking at the advantages and disadvantages of direct investment. But, for the uninitiated, her is what LPs and GPs mean.

Limited Partners or LPs pour capital into the venture capital fund and are not directly involved in the management of the fund. General Partners or GPs manage the VC fund and take all investment decisions.

"A crucial advantage is that co-investing alongside a fund manager allows the fund manager to negotiate the best terms for the investment on behalf of the LP. Achieving the same in a standalone direct investment scenario might be challenging for an LP unless it can meet the capital threshold for superior rights. The benefits of having an experienced negotiator on your side continue even at the exit stage, where small investors can sometimes get squeezed. At the same time, fund managers can often better protect their LPs' direct investments and negotiate favorable terms," said Anirudh A Damani, managing partner, Artha Venture Fund.

LPs are typically large institutions and High Networth Individuals (HNIs) who have plenty of money in hand and are looking to get good returns and they are charged a management fee by GPs.

"The primary advantage of taking direct investments is cost savings, as opposed to going through a fund. There is no management fee and carry sharing that needs to be done with the investment manager," Rajat Khurana, senior vice president–private markets, Lighthouse Canton India. However, he recommends investors who are exploring this asset class as first-time investors to ideally take the fund route due to some constraints. "Private market data is not public information. New and seasoned investors might struggle to build a healthy top of the funnel which may expose them to limited investment opportunities. Additionally, due to the lack of scale, the costs attached to conducting due diligence might be significantly higher as compared to a professionally managed fund," he said.

However, direct investment requires significant expertise, resources, and time from LPs to conduct due diligence, manage investments, and actively support portfolio companies and LPs may feel constrained due to a lack of in-house capabilities and limited exposure to private market transactions. "A direct investment portfolio may be less diversified than investing through funds, leading to higher concentration. Direct investment involves forgoing the expertise and guidance of professional fund managers, which may impact decision-making and risk management. Additionally, direct investments are often illiquid and have longer investment horizons, making it challenging to access funds quickly if needed," said Ankur Bansal, co-founder and director, BlackSoil Capital.

So, LPs taking direct positions have to deal with a serious workload, but if an LP is ready for this, the benefits of being more closely involved are strategically and financially more rewarding, if the company is executing to plan, according to Pranav Pai, founding partner and CIO, 3one4 Capital. "India's startup ecosystem has now completed a full cycle, and exits via large M&As and IPOs have been proven out. As a result, For many LPS, the strategic value of being involved with tomorrow's disruptors is also now clearly established. This is giving them a strategic purpose for engagement and investment earlier in their lifecycles," he said.

And, direct investments allow LPs to choose specific opportunities and customize their portfolio that aligns with their preferences and risk appetite. "This ensures transparency. As opposed to traditional fund structures, LPs can avoid certain fees in direct investments, resulting in lower costs and the potential to allocate more of their capital towards actual investments. Additionally, they can build long-term strategic relationships with specific companies and industries through direct investments," said Bansal.