Do institutional Limited Partners back first time venture funds?

Follow me @samirkaji for my thoughts on the venture market, with a focus on the continued growth with the emerging manager landscape.

I recently posted this Twitter thread about the role institutional LP’s play within the emerging VC fund market (Side bar: I’m likely going to push more content through Twitter threads this year, with my Medium posts focused on the memorialization and elaboration of these threads).

In the tweet, I covered the recurring question I hear from newer fund managers to many newer fund to the realism of attracting institutional investors in a fund one offering, and what institutional investors typically look prior to making an allocation.

Here’s is the (modified) tweet thread about this topic:

1/While it’s accurate to say that institutional LP’s have and will continue to invest in Fund I offerings, it comes with a major caveat. Institutional LP’s generally lean in when at least one of the following is present:

1)the manager has a strong institutional track record from prior firms (if multiple GP’s, experience working together is essential)

2) The name brand operator (likely with a $B exit)

3) The manager is someone that is easily saleable to institutional partnerships or committees.

Simply being “differentiated” isn’t enough, particularly given the subjective nature of differentiation, and the difficulty to assess in early days.

2/That being said in pre-2015, these conditions were slightly more relaxed when many institutional firms (particularly fund of funds) were still in active emerging manager portfolio building mode. This is less true today as institutions are more focused on opportunistically adding names, while concurrently culling existing portfolios.

3/In our recent survey of emerging managers, we found that on average, institutional backing represented only 33% of capital in first time funds (the sample set included many managers that had prior institutional experience and had raised fund I prior to 2015).

4/The natural economic and risk misalignment inherently present between institutional LPs and first time funds cannot be ignored. Exceptions exist, but “proof of concept” LPs are rarely large institutional allocators. It takes as much (or more) time or more to diligence a $50MM fund where $10MM can be allocated versus a $500MM fund where $50MM can be deployed. A 3x on the former is far less meaningful than a 2x on the latter to an endowment or pension. Speaking of endowments, it is interesting to note that the average tenure of a CIO of an endowment is <5 years.

5/ If Fund I’s are off the table for most new GPs, will it be different with Fund II? With fund cycles at 18–30 months for sub-$100MM funds (over 2/3rds of new entrants), there usually isn’t enough time to establish the traction necessary to meet institutional hurdles.

6/More specifically, while mark-ups certainly help (especially when follow-on rounds are led by “brand” investors), it is difficult to differentiate only based on this metric. More important measures are clear execution of sourcing/winning in thesis area, evidence of strong firm infrastructure, astute portfolio construction/management, and enough portfolio hits to help delineate luck and skill. Of course, this is all difficult to prove in 2 years.

7/Similar to large VC funds that write seed checks, most institutional LPs that have written small checks into small funds often do so for optionality with designs to scale with the manager in subsequent funds. For example, as mentioned above, writing $5MM for a large endowment doesn’t move the needle even if the fund performs at top decile levels. Lowercase’s Twitter/Uber fund was the rare extreme outlier where a $2MM-$5MM would’ve moved the needle for any institution. Before committing, institutional LPs will usually need to be convinced in the scalability and durability of your model.

To further define scalability, being able to participate in “hot deals” at $100K-$250K doesn’t always neatly translate to making the jump to the larger checks that larger fund levels generally dictate. The larger the percentage of a round, the more powerful an investor’s value add, brand, and reputation need to be —this is often why institutional LP’s cite concerns about large jumps in sequential fund offerings.

For most first time funds raising $25MM or less (and this amount is largely driven by lack of institutional interest), the likely path is attracting institutional capital at Fund III, when it’s much more likely that meaningful proof points are present. However cultivating these institutional relationships early is critical, and between fundraising periods is often the best time to commence these relationships (i.e. a good time to turn attention to these relationships is post fund I raise). 
As with anything, there are always exceptions and the notes above are just meant to help craft and hone fundraising strategy for any manager operating in the early years.