The quick 1x DPI or the key to long-term success in Venture Capital
A year into Fund of Funds (FoF) has given me a great overview of VC funds strategies and of what investors (or Limited Partners, LPs) are looking for when they decide to commit to the 6 to 12 years journey of a fund. A cornerstone corporate LP would likely want to source partnerships, Series A+ dealflow or M&As while a public entity LP would prefer to help the local startup ecosystem thrive.
4 to 5 years into the fund period is when the next generation fund would start to be fundraised. Would the LPs also be part of that second journey?
Likely yes if they notice that their main target is being accomplished.
But how to make sure LPs continue to renew their support, with the growing offering of funds?
“The response to losses is stronger than the response to corresponding gains”.
Implying from Kahneman’s definition of loss aversion, ultimately and regardless of what was internally discussed to approve a fund commitment, any LP’s biggest worry would be losing money, i.e. not getting back what they invested, or the “1 time” gross return on investment, which, in fund terms, is the “1x DPI” (Distributed to Paid-In). The psychological “negative” impact of a 0.8x “perceived” final return on investment would weigh more than the “positive” impact of a 2x one. (-0.2x beats +1x).
“Cash is king”
especially with adverse macroeconomic conditions and during Venture Capital turbulence periods. A 6x TVPI (Total Value to Paid-In) is certainly a nice paper number, and it could do a great job at camouflaging issues that
- top performing portfolio companies could have — like team or runway issues.
- fund shares could have — like a huge liquidation preference on top.
The trick could work to lure LPs for months, till they start getting anxious for the cash they invested.
Quick conversion of paper numbers (RVPI) to cash (DPI) is key.
So let’s say a fund returned half of what an LP invested (0.5x DPI) in 5.5 years, 1x cumulative in 6 years and is aiming at more than 3x (current TVPI) cumulative in the 10 years of the fund life, how would the LP react?
The LP will likely:
- reinvest the 0.5x at the first closing of the next fund (in year 6), as the chances of losing money are greatly reduced.
- reinvest the remaining 0,5x in the last closing — if not deciding to increase commitment, as their “biggest worry” would have been surpassed and the potential upcoming incomes would be seen as upside.
There are many ways to structure the fund thesis to accelerate the J-Curve and reach that quick 1x DPI objective.
The quick 1x stipulates a high internal rate of return, and in my opinion it is what aligns the most the interests of LPs, GPs (General Partners or Managers), and rest of the VC team altogether. Some parameters:
- follow-ons or reserve allocation — low.
- investing at reasonable valuations — paying more than 10x ARR? $15M Seed post-money? Nope.
- exit strategy per business model — yes, 12x secondaries could do better than 100x IPOs for B2C portfolio companies of Seed funds. Keep unicorns for dreams.
- fund size — $200M+ seed fund? $1b+ growth fund? No thanks, with luck they’d reach 1x in 8 years.
- recycling policy — It has almost been 5 years and the LP hasn’t seen a penny, why are the funds proceeds being reinvested in follow-ons that are extending the runway of overvalued companies that nobody wants to finance?
BONUS: why are GPs and team interests also aligned at 1x DPI?
- they will soon start earning their long-awaited bonus — from the carried interest after the hurdle rate,
- while they can comfortably raise the next generation(s) of funds,
- which shall positively impact the rest of the team
Where it doesn’t happen:
Focus on getting the first 1x asap. The remaining 1x, 2x or 9x can wait for 5 or 12 years.
