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General VC Questions

What is the Monte Carlo Simulation and how does it help to model the probability of success during due diligence?

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Mar 21, 2024
I often see various Excel-generated models being included in data rooms.  These models are referred to as a "sensitivity analysis" of various sorts and typically display probability outputs.  I do not understand the significance and how the models work to assist with due diligence.  Could you please help to explain the signifance and use of appropriate models during the due diligence process?
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Accepted Answer
Mar 21, 2024
Fund managers often show various scenarios for how the fund may perform relative to the investment strategy. As an LP, it’s critical to understand the assumptions behind those projections, because models are rarely 100% accurate. For example, if the fund is pre-seed, the risk of the individual portfolio company failure is high. Therefore, to counter the risk, the manager often has to make more investments with lower check sizes and at lower valuations. The calculus for the LP is: Are the assumptions that are the basis of this manager’s strategy realistic and do they generate a high probability that the fund will make several investments that can return the fund individually? 

In a Montecarlo simulation, LPs can use these assumptions as levers. For example, a lever could be the ownership % of the investment and its effect on performance. The next level in the DD process can be to think critically if the manager can realistically get that level of ownership based on their strategy, brand, deal flow, etc... Great companies command big valuations and therefore it’s hard for investors to command great ownership. On the other hand, if the company sells too much of the cap table too early, it will struggle to raise additional capital and therefore the investment will perform poorly. A Montecarlo simulation allows for a greater level of fidelity to test various assumptions and to test if the manager's strategy is grounded in reality. 

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