The Whys of LP Direct Investment
Brett Munster
One of the biggest surprises for me over the past year and a half has been the demand from LPs for direct deals. At AITV, we have done a number of them. While not all of our LPs are interested in this strategy, many are, and I have come to learn that it can be great tool but it can also be challenging.
When you think about it, it makes sense that LPs would want to invest directly into early stage companies. Some LPs invest in VC because it allows them to see additional deal flow and boost returns by investing in well-performing companies. Even if many of these investors wanted to do this themselves, most do not have the same level of deal flow, the domain expertise to properly vet the deals, or the resources needed to run a full due diligence process efficiently in a way that is not a strain on the entrepreneur. Our LPs that participate in direct deals lean on us for all of that. And when executed properly, direct deals can lead to outsized returns for both the fund and the LPs.
However, there are some challenges that direct deals present to both the GPs and LPs. This mostly revolves around alignment, which is explained well in this article that Winter Mead of Sapphire Ventures wrote. For the record, that article is 100% correct on potential for misalignment but we are well aware of these potential pitfalls, have talked through them with our investors, and have developed a structure with which we are all comfortable. The direct deals are not a main strategy, but a supplement to the core fund strategy.
We make sure we open our direct investment opportunities up to all our LPs but many have told us what they are looking for (sector, stage, etc) so it is pretty easy for us to identify which deals will likely be a fit for certain LPs. The biggest issue usually revolves around fees and we charge lower fees on these direct deals.
The companies we invest in tend to like this structure as well because it helps fill out the round with fewer investors on the cap table. All of our direct deals are put into legal entities we manage so the company only has one line on its cap table.
From conversations I have had, it seems that the appetite for direct deals has grown over the years. Maybe it is just a product of the times because everyone is wanting to get involved with all the growth in private stage valuations. When market turns will there still be as much demand? I don’t know. It could just be a fad given the climate we are in or maybe it’s a long term trend, only time will tell. But personally, I like that we have LPs that are engaged. It helps develop a closer, better-aligned relationship when done properly.
