Part 1.1: Understand Where Your VC Fund Fits in their Portfolio
What’s Good for the LP is Good for the GP | Part 1: Know Your LP
Series Introduction
There are currently a plethora of venture funds in the U.S. (477 funds closed in 2020, marking +13.3% annual growth over the last decade) raising record sums of capital in an effort to keep up with the high-valuation startup funding landscape we’ve become familiar with. Institutional Limited Partners (LPs) aren’t doing anything to slow this trend, either — an ongoing low interest rate environment has diversified asset managers looking for increased allocations to higher risk-return vehicles like those offered by private equity (PE) and venture capital (VC). As an LP, I was getting 2–3 new fundraising decks daily from private managers. So then, how can a venture General Partner (GP) ensure they can hold an allocator’s attention long enough to land that hallowed, substantial commitment?
As somebody who spent years in institutional finance allocating large sums to PE and VC funds regularly, I’m happy to tell you the answer is fairly obvious: get inside their head, learn what they like, and give it to them.
In this series, I intend to discuss the gritty details of how you can do that.
Part 1 focuses on getting inside of an institutional LP’s shoes on a daily basis to afford you the ability to understand how you can truly be “LP friendly” and best cater to their specific portfolio-wide mandates, approval processes, and restrictions while avoiding their pet peeves. Part 2 is reserved for the LP diligence process, breaking down what you can expect LPs to drill into, as well as the diligence items funds inaccurately think LPs care about. Part 3 is where I’ll translate these concepts into a framework for prioritizing a venture firm’s efforts while running the fundraising circuit and presenting to investors.
If you’d prefer the whole series in acute summary, heed the words of a trusted allocator and colleague:
“What’s good for the LP is good for the GP”
Although institutional investor preferences, processes, and priorities vary across the gamut, my time in the industry before converting to the GP side has already paid significant dividends in fundraising and building rapport with big investors holding big checks. If you’re interested in hearing more about what’s convinced my peers and me to write $10M+ checks to <2% of VC funds that knocked on our door, feel free to read on.
Don’t like reading or unnecessary visuals? You can catch my live commentary on this topic by listening to The GoingVC Podcast, where I guest host a miniseries that parallels this sequence at https://podcast.goingvc.com/whats-good-for-the-lp/.
1.1 Understand Where Your VC Fund Fits in their Portfolio
Knowing why an LP is looking to add venture to their portfolio is the first step-up in understanding how to best prepare and present your fund. If you know what they really want and why they want it, it’s much easier to give it to them.
Navigation
— 1: Know Your LP
— — 1.1: Understand Where Your VC Fund Fits in their Portfolio
— — — 1.1.a: Know VC’s Role in Their Broad Portfolio
— — — 1.1.b: Know Your Fund’s Role in Their Venture Bucket
— — — 1.1.c: Know What Your LP Likes & Give It to Them
— — 1.2: LP Investment Processes & Restrictions
— — 1.3: How to Be LP Friendly
— 2: LP Diligence Items That Actually Matter
— 3: The Art of Landing LP Commitments
1.1.a: Know VC’s Role in their Broad Portfolio
Where does your fund get categorized? Before narrowing your view to the venture side only, take a couple of steps back and consider the prospective LP’s entire asset base.
Know Who the Portfolio Beneficiaries Are
Understanding where an LP’s capital comes from (who the principals are) and its intended use should give you a pre-emptive idea of why they’re even considering adding a new venture manager.
· Are they an insurer and/or reinsurer? Property & Casualty or life insurance?
· Are they managing employee pension assets? (If so, then you have to further consider if these are defined-benefit or defined-contribution pensions)
· Are they a centralized hybrid manager allocating capital for more than a single purpose? (probably)
That last example is common for institutional LPs with $5B+ in assets under management (AUM), using a single investment team to manage capital across several trusts with contrasting mandates and return targets. Keep their underlying incentives and risk profile in mind as you prepare for impending discussions.
As a quick example, look at the following two hypothetical portfolios, both managed by the same LP with $15B in AUM, but held in different trusts:
The portfolio on the left funds a defined-benefit pension plan for a U.S.-based private company. On the right is a portfolio designed to fund that same company’s retiree medical trust (usually in the form of a VEBA allowing pre-tax employee contributions to be spent on post-retirement medical expenses on a tax-free basis).
You’ll notice that the defined-benefit plan is heavily diversified across asset classes and that PE and VC are grouped together as per common practice. Even combined, PE/VC only accounts for 15% of the DB trust. If you dove deeper, you’d likely see VC comprising ~40% of that bucket (30%-45% is common), which is only 6.0% of the trust and 5.3% of the LP’s total managed capital. Venture is a small line item in the LP Investment Committee (IC) meeting agenda.
The second portfolio, the retiree medical trust, makes this even more daunting as there’s a complete absence of early-stage VC altogether. In this example, the investor’s IC implemented a no-tolerance policy for early venture allocations in the medical pension post-2008, citing excessive volatility and poor liquidity matching. The takeaway for venture teams here? Rather than assume, research and ask LPs about their structuring and restrictions before prepping the bank for a large check from each trust.
Learn to Sleuth
As you work through this thought process, you can find more information about the LP’s asset base by looking through their SEC filings (if public), searching Pitchbook and other private databases (which can also lead you to their current GP relationships, some of which you may be able to squeeze information from), and of course, from their public-facing website (in fact, some benefit administrators don’t lock down the highly insightful employee-facing portals, allowing anybody able to locate them to peruse benefit handbooks and mandates).
Of course, as you begin building your own rapport with these LPs, you should begin asking pointed questions about their portfolio allocation, and there’s usually little worth hiding while in talks with a potential incoming GP. After researching likely investment rationales and what asset classes are represented in their portfolio, you should have a decent understanding of why, and how, this LP allocates to VC.
1.1.b: Know Your Fund’s Role in their Venture Bucket
After knowing where VC fits in the wider portfolio, drill to the next layer down (and sometimes even deeper) to ensure you have a solid grasp of how your specific strategy is being labeled.
Let’s continue using the hypothetical LP above. The extended visual below demonstrates how this investment team has decided to group responsibility across multiple sub-asset classes, and how they consider each sub-allocation relative to one another:
From this breakdown, we can extract a few meaningful implications.
1. Only 1–2 PMs are responsible for 6–7 strategies, several of which are significantly different than venture.
2. Late & Multi-stage VC are grouped together, so they’re likely judged against the same set of criteria. If you’re a multi-stage GP, your fund will be compared to late-stage vehicles which tend to exhibit earlier DPI.
3. Although venture as a whole boasts 40% of the PE/VC portfolio, only 25% is set aside for early-stage commitments.
Remember that an LP’s current asset allocation/sub-allocation distribution is not incredibly useful by itself. Probe a prospective LP for details on each strategy's policy midpoints, ceilings, and floors, then use these targets to calculate the delta. If you know the magnitude and direction an LP is trying to take their portfolio, you’ll have a better understanding of how (and when) your fund can fill that need.
Learn Your Label…
Big institutional LPs will typically have ICs that determine asset class mandates, sub-committees that decide on cross-strategy mandates within an asset class, and internal portfolio managers calling the shots on investment decisions for everything else. The influence from all of these decision-making layers results in investment labeling, sub-labeling, and cross-labeling across the portfolio.
Potential buckets a venture manager could be placed into are based on investment stage/multi-stage, geography, vertical preference, lead/syndicate, generalist/thesis-driven/opportunistic, and emerging/established, among several others. Use an understanding of an LP’s categorical standards to identify who you’ll spend time building relationships with and which aspects of your fund to focus on.
As an example, many venture allocators prefer sector-focused funds over generalists when adding to their early-stage sleeve due to niche expertise. However, vertical-specific experience matters less for later-stage funds as deals become more financial in nature. This is meant only as a quick nod to an LP’s perspective — these categorizations and how investors consider each will be covered in detail in Part 2: LP Diligence Items That Actually Matter.
…Then Reframe It
Remember that stack of fundraising decks lining investor desks and inboxes? Without a good reason to do otherwise, portfolio managers will race to find the first reason they can disqualify a prospective GP.
This means a prospective LP may see your fundraising deck and send it straight to the trash bin because they don’t have authority to invest in international venture managers, while the GP’s wondering why they haven’t gotten a response to the improved presentation highlighting the profitable acquisition of a portco by a European parent. Don’t bet on the PM to do significant diligence on your behalf while labeling a GP early in the relationship. Don’t lie, but frame your strategy in the most suitable, LP-tailored lighting possible.
I’ve seen the same deck revised ever so slightly for specific geographies or by allocator type and recommend all venture managers, from newly minted to established, adopt this approach. One of the first steps in landing a large commitment is simply not giving the investor any reason to say no.
Strategy History
I’d be remiss to not emphasize the value of learning the history behind an LP’s venture strategy. Whenever possible, probe the LP audience to discover subtleties in portfolio construction and the drivers of significant mandate adjustments.
· When did they start allocating to venture capital?
· If they go deeper than solely hiring GPs, why did they get authority to participate in co-invests or build a direct strategy?
· What other assets are grouped into the same bucket as VC and when were they melded?
· How has the VC policy midpoint allocation % changed over the last 5–10 years?
· How is LP capital passed between decision layers (like asset classes) in order to act on capital calls?
Many managers use liquid assets like fixed income ETFs to fund scheduled contributions. Others enforce policies that require cash or cash-like securities to be held to ensure calls are met, which causes a heavy drag on portfolio yield and exerts pressure on GPs to invest capital early.
While every LP’s specific IC temperament is different, here’s another anecdote revved up for illustration:
In 2005, a hypothetical IC finally approves an insistent Chief Investment Officer’s (CIO) request to begin allocating to VC to mitigate some of their heavy concentration in traditional assets. Just as this newly established venture portfolio begins rising from their J-curve, the global financial crisis collapses their overweight mortgage-backed security (MBS) allocation. A flight-to-safety drives the IC to immediately place a hold on new venture commitments that doesn’t subside until 2011, when they allow minor VC commits to “test the water”.
In 2021, this history has left significant bias within the company’s top-floor decision-makers, and while the venture portfolio has grown back to a healthy size, PMs know not to waste their time proposing the addition of any VC manager that hasn’t achieved top-quintile returns for several consecutive funds. GPs should spend time discovering the LP-specific obstacles they’re up against.
Check Size & Self-Selection
is one of the most rudimentary but often overlooked reasons I’ve turned down a venture manager in the past. As a GP, consider the prospective LP’s size and target commitment relative to your current raise soft cap. For many institutional investors, pacing and portfolio mandates naturally restrict the universe of investable GPs to hefty funds that can allow for bigger allocations.
As a PM for a large pension in the US, if I’m targeting $200M in annual early stage commitments and already have $175M signed across several vintages, I’m probably not going to spend any time evaluating funds raising less than $100M or over $1B. I need to put $15M-$20M into each commitment, and my check size needs to provide ownership that is…
1) 25% or less of the fund’s LP base (preferably less), which a small fund can’t accommodate, and
2) Large enough to allow for a seat on the Limited Partner Advisory Committee (LPAC) or otherwise ensure my voice isn’t drowned by larger investors.
Of course, there are generally exceptions to hard-and-fast rules like the example above, both by stage and track record length. For a Seed fund or emerging manager, it’s reasonable to assume this same LP would only seek a $3M-$5M allocation. This gives the LP time to dip their toes in and test the relationship, giving them an ‘in’ on the next raise if all goes well. For PMs, engaging with a prospective GP comes down to striking a balance between the extent of diligence required to commit and the fund’s relative contribution to the overall portfolio. It’s got to be worth their time.
Understanding what your prospective LP values and their intended commitment size is an easy way to highlight strong candidates for early fundraising efforts and bookmark others for later and larger funds.
1.1.c: Know What Your LP Likes & Give it to Them
Focus is Critical, but Keep Your Head Out of the Sand
PMs you speak to will often be responsible for more than just the VC portfolio — personally, I’d finish rolling out an impact analysis on our non-IG investment post-LIBOR transition before priming my headspace to thoroughly interrogate an early-stage venture team over lunch, all the while knowing I’d have to shift gears again at the office to convince the IC we needed to ease mezzanine allocation limits.
This multi-hat role inherits a necessary, but distracting, scatterbrained train of thought that GPs can help compensate for in a live discussion. I’m not necessarily saying some LPs need handholding, in fact, most hold a strong pulse on both private and public markets. However, be prepared to share your thoughts on the macro environment in relation to the allocator’s total jurisdiction. They won’t expect a venture manager to be an expert on infrastructure, but demonstrating awareness goes a long way towards gaining trust.
Help LPs Help You — How LPs are Evaluated
What can you showcase as a venture manager that actually matters to the LP? How are they evaluated? Competition between an LP’s various asset classes can be fierce, and PMs are often able to increase their respective portfolio size at the cost of other asset classes if their hired GP’s stats work in their favor during the tactical asset allocation meeting. Outcome: +1.5% to VC. Take that, international equities.
Below, you’ll find a highlight reel of the things PMs are considering during diligence, but likely not discussing with you. If you know what standards your PM is being held to by el Jefe, you can make it easier for them to get approval for a commitment, and maybe even help them look good.
· IRR: A lot of GPs tout their IRR, assuming that the LP will just buy into that. What these GPs may not realize is that many LP ICs actually gauge performance across all PE/VC strategies using the same benchmark and return methodology. Some ICs care more about time-weighted returns on a manager level, some strictly apply PME, and some just take annualized returns over/under the S&P 500 + X%. Ultimately, those ICs make or break the LP’s ability to allocate to venture, and it’s more or less about knowing the preferences of the board or kingpin investor.
· J-Curve: Not all ICs are built equal, and some voting members have a stronger grasp on private market mechanics than others. Every quarter, there’s a PM somewhere trying to explain the effects of the J-curve on their VC portfolio, begging to avoid a reduced commitment target. While it’s obvious to GPs at this level that institutional LPs care about hasty returns and high DPI, what may be less obvious is how the early years of a commitment weigh on an LP due to their specific IC-mandated formula for reporting fund performance. Is it net time-weighted return, IRR, or another method that may or may not adjust for J-curve effects? Who knows, maybe the IC is very knowledgeable of the J-curve and cares more about a GP taking their time before harvest? Find out what conditions your LP representative is working under and cater to those, if at all possible.
· RVPI: This one’s easy. Institutional LPs are actually pretty meticulous and love numbers. Understand that during diligence and during a commitment, LPs are evaluating each and every portfolio valuation that rolls up into RVPI and TVPI. Having an independent party support your portfolio values helps ease this concern for LPs, as does including a footnote explaining such, but ultimately, solid RVPI will not save a GP from inexcusable DPI.
· Frequent Re-evaluation: In my own experience, PE and VC managers hired are subject to an increased frequency of check-ins and investment memo approvals than traditional asset classes. Remember that your LP doesn’t want to tell their reporting sub-committee a new set of stories to excuse the problem portfolios of a GP every 3–6 months or so.
· Co-invest/Direct Investments: I covered this already, but we’ll hit it again briefly. Some LPs can do co-invest or direct venture investments. If your prospective LP is one of the lucky few (and they have a strong preference to do so), detail your team’s current or future ability to bring those opportunities to the LP’s door early in discussions.
The points above are just a quick snapshot, but this topic will be the focal point for Part 2: LP Diligence Items That Actually Matter.
One LP’s decision to hire you to manage their capital may be dependent on a fruitful pool of co-invest opportunities, while another LP may be unimpressed by those opportunities if their IC still hasn’t given the green flag for that kind of concentration. Knowing what your audience likes is an easy way to prioritize those precious minutes in front of your next investor.
To Be Continued
If you made it this far without getting distracted or hyperventilating from rising anxiety, then I look forward to making a commitment to your fund myself (as you obviously have intelligent people on deck). Thank you for reading, and if you’re a masochist you can listen to The GoingVC Podcast, where I guest host a miniseries that parallels this sequence at https://podcast.goingvc.com/whats-good-for-the-lp/.
If you have any questions, comments, ideas, or otherwise, reach out to me here, LinkedIn or Twitter. To see more of my content, such as published theses, my live venture deals watchlist, or other ramblings, you can find everything at linktr.ee/caigreeff.
COMING UP — “Part 1.2: Investment Processes & Restrictions” publishing soon: In the next part of this ongoing publication, I’ll lay out specific LP investment processes, unique restrictive mandates, and a simple guide on how to be LP friendly as a venture GP.
Disclaimer: Statements and opinions expressed are solely my own and do not necessarily reflect the views of any current or former employer. Examples referenced herein come from a wide pool of experiences that are not attributable to any particular organization.
