We are at a critical point in our economic future as the Coronavirus (COVID-19) has wreaked havoc across all aspects of our daily lives. As we enter a bear market, the venture capital and startup community must dive deeper not only into startup fundraising, as Sequoia’s Black Swan note points out, but with general partners (GPs) and their fundraising endeavors.
As most are aware, Plexo Capital invests as a limited partner (LP) into venture funds (synonymous with GPs) and also invests directly into companies. We wanted to share some thoughts on the impact GPs face as we enter this unpredictable time. This analysis will differ depending on where a GP is in the process (i.e., considering going to market, the middle of fundraising, or recently closing a fund).
That said, we encourage GPs to read the entire document as there may be items of interest for GPs that may not be in that particular point of the process (e.g., impact of portfolio construction changes for GPs in the market may also be of interest to GPs considering going to market).
Let’s take a look at some of these scenarios and provide context for our recommendations based on the dynamics we see in the market.
GPs Considering Going to Market
At Plexo Capital, we advise GPs to create a two-year timeline for the fundraising process once the Limited Partner Agreement (LPA) and the Data Room are complete. During this time, it is essential to remember that fundraising is a full-time job. GPs should plan to cover two years of living expenses during the fundraising period and will need to finance the GP fund commitment — typically 1–2% of the total fund. This can be a daunting proposition for GPs that haven’t benefited from a significant liquidity event or have considerable cash reserves especially when there is a pullback in the market.
In addition, we feel that it will be a challenging market for GPs to raise from both smaller LPs + institutional LPs.
Smaller LPs are (or will soon) feel increased (or perceived) financial pressure
For smaller LPs (e.g., individual investors, high net worth individuals, smaller family offices, etc.), we suspect that there will be a reduction in the willingness to take a meeting or make commitments given their overall portfolios have declined due to the slide in the public markets.These smaller investors may have not incurred any realized losses; however, they may feel “poorer” seeing the value of their portfolio decline over the past month. In other cases, some individual investors may have been thinking about harvesting capital gains to place into VC funds and are likely revisiting those plans.
Institutional LPs are slowing down in general for market clarity
Conferences and annual general meetings cancelled and rescheduled will impact the ability to meet with prospective GPs with a particular emphasis around institutional LPs with firm wide travel bans implemented. Anecdotally, we are hearing that many institutional LPs are focused on their existing GPs and taking their time thinking about new commitments as they wait to see more clarity from the market.
Plexo Capital Recommendation: GPs that are considering going out to market should revisit their plans. They can always choose to defer until there is market clarity and certainty.
GPs in the Middle of Fundraising — Impact of Increased Timeline + Shortfall in Fund Target
For emerging managers (women and people of color in particular), it has historically been challenging to raise a fund. It will only become more difficult with current circumstances. GPs currently in the market should prepare scenarios for an extended timeline for fundraising, as well as, a shortfall in their target to be raised to understand the impact on: 1) the available management fees, 2) the coverage of upfront expenses, and 3) the portfolio construction model.
A decrease in management fees resulting from a smaller fund size will impact operating plans
GPs should model their operating plans for several scenarios that are below their target fund size and create a minimum viable fund size (or MVFS, which is a term we learned from Beezer Clarkson from Sapphire Ventures). The MVFS should reflect the minimum fund size that can fund a realistic operating plan to execute the GP’s model, which includes the minimum salary that is acceptable for the GP.
Upfront expenses will need to be covered longer as first close/capital calls are extended
The GP needs to think about the costs incurred during the fundraising period prior to an initial close and capital called. Most LPAs allow for some threshold of fund formation expenses, although these costs are usually borne by the GP and not reimbursed until the first close is complete and capital called. An extension of the timeline for fundraising means that the GP might need to float these costs for an extended period of time.
Portfolio construction models will be impacted if a smaller fund is raised
If a lower amount is raised, the GP needs to consider the impact on the portfolio construction model. Typically, a GP designs a model based on a target amount raised leading to:
- Desired number of portfolio companies
- Percent of deals where the GP will lead
- Average check size
- Target ownership level
- Percent allocated for reserves
The combination of all of these variables leads portfolio construction to generate a risk/reward + diversification profile that the GP believes will be attractive to their LPs. If the final amount of the raise is significantly lower, the GP should think about the impact of the smaller fund size and how the model should be changed to still provide a desirable risk/reward profile to LPs while still allowing the GP to execute on their model and thesis.
Plexo Capital Recommendations:
Know your minimum viable fund size (MVFS)
Prepare a few scenarios that include closing funds below target to understand the effect on the lower available management fees and the impact on the operating plan. If a lower amount is closed, the GP will also need to look for the opportunity to reduce costs from the operating plan to compensate for the lower management fee available.
It will take longer to close funds and even have a first close and the first capital call
GPs should prepare for an extended timeline for fundraising, along with a longer time to a first close. In addition, it will likely take longer for the first close and the associated first capital call, which can be used to reimburse the GP’s out of pocket expenses.
Identify how the portfolio construction model changes under a smaller fund
Understand the changes that need to be made to the portfolio construction model in the event a smaller fund is raised. The available levers may need to be moved in order to compensate for a smaller fund, so know the important levers for your thesis and risk/reward profile. Also, please see the recommendation on reserve planning in the “Recently Raised a Fund” section with guidance on thinking about reserves.
GPs in the Middle of Fundraising — Prioritizing LPs for a Close
For GPs in the middle of fundraising, it will be helpful to think of prospective LPs in potential close priority order, especially institutional LPs. Those LPs most likely to proceed are those where the GP has passed the investment committee (IC) and the LP is working on the documents (although caution is still advised until the documents are completed). The next category of prospective LPs would be those who have done all their diligence and have met with the GP in person but might not have gone to IC (or the commensurate approval process if a family office). Those LPs most in danger are those that the GP has not met with in person.
Plexo Capital Recommendations:
Prospective LPs that have approved should be prioritized for a first close
Initiate a conversation with those prospective LPs that have gone through IC (or the commensurate approval process), and see if they can come together at the same date for a meaningful close, which may be under the threshold stated in the LPA for the first close (in which case, the LPA might need to be amended/modified). If not, talk to the lawyers of the prospective LPs about moving to rolling closes (again, the LPA might need to be amended/modified).
Understand what it will take to move prospective LPs that are close across the finish line
Talk with these prospective LPs to see better understand the outstanding items in their process, and what can be done to move them across the finish line. Make sure to ask what the new timeline might look like with the current situation. Be mindful that the process will likely extend out significantly if the LP needs to meet with the team in person. Try to move to online (think Zoom) meetings, but the reality is that everything will likely slow down as most processes will continue to favor meeting in person (especially for institutional LPs).
Identify changes to strategy and how to communicate to prospective LPs
The best opportunity for GPs is to communicate with prospective LPs transparently. We recommend that the GP use this time to think about how the current environment necessitates changes to the fundraising strategy, operating plan and portfolio construction model. Then, think about a communication plan to prospective LPs.
Recently Closed a Fund
GPs that have recently closed funds are in an enviable position. They will have dry powder and will likely benefit from lower valuations, less competition for deals, and the benefit of time diversity investing into a cohort of companies in this new environment.
Plexo Capital Recommendations:
Virtual meetings will be the new normal for some period of time
Trust permeates throughout the venture capital ecosystem. Now more than ever, we need to continue to connect and build business relationships. With social distancing as the new normal, video technology such as Zoom allows as a middle ground between an in-person meeting and a faceless phone call. Shift all of your meetings to video conference calls to continue conversations during this time.
Over-communicate to your LP base with regard to changes in your plan and portfolio
The current situation is changing minute by minute, and everyone is trying to understand the impact on the economy. Now is the time to over-communicate with entrepreneurs and LPs. Reaching out to the entrepreneurs in the portfolio and providing guidance around the market can be helpful. Help them understand how they should be thinking about expenses, runway, and fundraising. For LPs, now is the time to reach out to them with a portfolio update and identify any risks. Also, LPs will want to know how the GP is spending their time and thoughts around new investments in this environment. Do not wait for the normal cadence of a quarterly letter or marketing note and strive to send something out as soon as possible.
Identify Commitment Risks with LPs
GPs need to also think about the composition of their LP base. If a fund has closed, GPs need to over-communicate with their LPs during this period of uncertainty. There is a higher risk of defaults in a down market, and GPs should try to remain proactive in identifying any potential challenges that LPs may have to meet their capital call commitments. This especially holds true with emerging managers as the composition of their LP base typically includes a large portion of individual investors. Another item to pay attention to is the use of credit lines to fund investments and both delay capital calls and smooth out the cadence of those calls. While we do support the use of credit lines, it is important to note that it could hide or delay surfacing an issue of a potential default of an LP. It will be helpful to give LPs more transparency into the future capital call cadence, so LPs can know what to expect and can plan accordingly or surface any potential issues as early as possible.
Reread your LPA to understand guidelines/remedies around topics like LP defaults
As we mentioned in the recommendation on understanding the risks with LPs, it is important to understand what remedies are in place in the LPA for a potential default from an LP. GPs should consult with the counsel on fund formation for guidance and clarification on any questions.
We recommend GPs prioritize understanding:
- How much time can be given to a defaulting LP to remedy the situation and fulfill their capital call based on their commitment.
- What happens in the scenario if an LP is just not able to meet their capital call.
Most LPAs have a provision for a penalty that will require the defaulting LP to forfeit a percentage of their capital account (up to 100%) or leave it to the discretion of the GP. It is likely the LPA will provide what can be done with an existing position of the defaulting LP and may include a right of first refusal to offer the defaulting LP’s pro rata ownership to existing LPs. The GP may also be able to go to the open market for an outside firm or entity to purchase the defaulting LP’s ownership. Please be mindful that the behavior of the GP during a default should be extremely thoughtful as it could reflect how prospective LPs view the GP.
Revisit reserve models to: 1/ focus on existing portfolio + 2/ think ahead to dilutive future rounds
1/ GPs should be in close contact with their portfolio companies to gain transparency into cash burn and re-assess business models to understand if there is a framework to reduce burn without restricting growth (or at least minimize the reduction in growth). Next, GPs should work with the entrepreneurs to identify when a round needs to be raised based on those cash needs. We will likely see scenarios where inside rounds are beneficial to extend the runway for companies. With additional runway, entrepreneurs have time for their revised models to be implemented. The goal is to have enough time to reach a point in the market where there is more clarity such that companies can begin the process of raising an outside round with more confidence. This information should be used to inform the GP’s reserve math as more inside rounds will likely need to happen. Reserve math is hard enough as it stands and will likely be even more difficult in this market given the level of uncertainty.
2/ Another dynamic to keep in mind is the likely reduction in valuations for future rounds. As a result, it is also prudent for GPs to revisit the reserve strategy to model the impact on lower valuations in future rounds that will decrease ownership to an amount below the threshold of optimal dilution per the GP’s prior portfolio construction model. Together with the aforementioned analysis on the need for inside rounds, the GP can understand how reserves might need to be modified, which can lead to cascading impacts in other areas of the model.
Remain open for business but understand the benefit of time diversity
It is important for GPs to remain open for business. That said, we know it is highly likely that the pendulum will swing to lower valuations and less competitive rounds over time. This means that there is benefit to having a cohort of companies that reflect this new reality of lower valuations, new frameworks for growth, longer timelines between rounds/liquidity events, etc.
It is important to revisit deals currently in process that may reflect the “old mindset” that the market exhibited even just a few months (if not weeks) ago. We had noticed anecdotes that the market was starting to change, especially in the consumer space in the aftermath of some high profile events around valuations and terms. However, we also know that it might take some time for entrepreneurs to accept the new realities of the market especially given that we have a number of entrepreneurs that have only known the dynamics of a bull market throughout their professional and entrepreneurial careers.
These are unprecedented times for our fellow global citizens, and we strongly encourage the health and safety of our respective communities first and foremost. With regard to business, we need to understand that we are all in uncharted territory and need to remain as calm as possible and patient. Ultimately, we will get through this, and we will return to some sense of normalcy, although there will likely be some elements that reflect a new normal. We are here to help not only our GPs, but we want to help the overall community as well. Please feel free to reach out with any questions or concerns. We would also like to thank the following individuals that helped with feedback and advice:
Elizabeth “Beezer” Clarkson, Managing Partner, Sapphire Ventures
Lindel Eakman, Managing Director, Foundry Group
Jaclyn Freeman Hester, Principal, Foundry Group
Samir Kaji, Senior Managing Director, First Republic Bank
Thanks for your time, and please let us know if we can help with other specific questions.
The Plexo Capital Team