Part 1.2: LP Investment Processes & Restrictions
What’s Good for the LP is Good for the GP | Part 1: Know Your LP
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/.
Navigation
— 1: Know Your LP
— — 1.1: Understand Where Your VC Fund Fits in their Portfolio
— — 1.2: LP Investment Processes & Restrictions
— — — 1.2.a: Processes: How an LP Turns a Pitch Into a Commitment
— — — 1.2.b: Restrictions: LP Red Tape & What They Can’t Do
— —1.3: How to Be LP Friendly
— 2: LP Diligence Items That Actually Matter
— 3: The Art of Landing LP Commitments
1.2.a: Processes: How an LP Turns a Pitch Into a Commitment
Institutional investors have a reputation for moving slowly. While GPs are furiously trying to fill their raise, frustrations mount quickly when trying to grasp their standing in an LP’s investment process, and the only relief available is the occasional LP update given to candidate managers following overthought follow-up requests. To help ease GP anxiety, this topic addresses specifics surrounding the various steps and approvals needed to turn a GP’s pitch into an LP commitment and the ongoing manager re-evaluation processes that many LPs are bound by. If a venture GP is knowledgeable on the progression of the hiring pipeline, they can set reasonable expectations on close timing and be proactive in providing materials or support to the prospective investor when it’s appropriate (rather than waiting in painful ignorance or continually contemplating sending another “checking in” email).
How a New Manager is Approved
To create a baseline, let’s focus on how a venture manager is hired in the first place, assuming that this particular LP has never committed capital to this GP prior. Take a look at the chart below:
You’ll notice the hiring process displayed is somewhat formal and succinct, identifying the steps that most GPs are already familiar with and expect while undergoing diligence with an LP. According to the timeline shown, you could snag a contractual commitment in just over 3 months. Now, the venture managers who have undergone this level of fundraising before are probably side-eying this representation of the process pretty hard right about now, and they’re right to.
While this is the theoretical framework LPs often work to achieve, the reality of a GP’s path into a new LP’s venture sleeve is consistently longer and more complex, due to both multiple levels of internal (and external) decision-makers and the intervention of human behavior. This pushes the entire engagement timeline far past 3 months, often extending to around 4–6 months (or several years if you have yet to establish a positive relationship).
So what’s missing? First, the relationship-building process is absent entirely, and one of the most important aspects of securing an LP’s trust (and capital). This often begins an entire fund or two before a reputable allocator is comfortable enough to put their neck on the line to drag a potential manager hire through the diligence gamut. Second, the completion of one step does not necessarily trigger the beginning of the next. Even if an LP thoroughly enjoyed a manager’s initial pitch and believes in their strategy, there may not be any movement for several months if the LP is intentionally waiting for other developments in the portfolio, such as the inclusion of year-end valuations in NAV or the ‘firing’ of a long-underperforming manager taking up valuable portfolio real estate. Third, internal approval is time-dependent and can be tiered several times. Some LPs may require PMs that desire to push a new manager forward to schedule a manager review committee, where other asset class PMs must agree to some extent to the allocation, and likely have several revisions to the investment memo before they’ll hand that approval over. After that hurdle has passed, this may be repeated at a sub-committee level, appealing to a small group of internal and/or external advisors in a similar fashion. Of course, this is all assuming the LP has prior approval for allocations within a GP’s strategy from the Investment Committee beforehand — otherwise, an LP will have to hold off until next quarter-end to try and create flexibility in investment policies. Additionally, it’s worth noting that many of these steps are not sequential, with many being completed desperately out of order or being broken up and distributed over time.
It’s valuable to note that this process can be expedited heavily, with some steps being skipped completely at the LP’s discretion, provided that the LP has an existing commitment to other vehicles underneath the GP. However, this scenario wouldn’t exactly qualify as a new manager hire — there’s often significant nuance to these relationships, and this point is discussed further below in “Re-upping & Continuous Evaluation”.
Keep in mind that this investment decision process can vary widely among LPs, with some being much more agile than others. This isn’t to say that all LP “adjustments” to the ideological diligence process are in poor taste; more often than not, a portfolio manager is looking for the fastest, most efficient way to get GPs they trust into their VC allocation, and they correct for the inefficiencies specific to their organization. Many of the additional barriers and step duration are natural results of an LP’s increasing AUM and market conditions, so there’s a very high likelihood that a venture GP raising institutional capital will be targeting LPs with processes similar to that illustrated above. If you gain nothing else from this chart, at least reference it as a pseudo-commitment tracker when anxiety levels begin to rise.
Remote Diligence
The COVID-19 pandemic brought significant hardship, but I’d be a pessimist if I didn’t acknowledge the positive outcomes that came with a widely unavoidable work-at-home environment. These impacts have created non-temporary shifts in how an institutional investor is willing to conduct diligence, leaving GPs open to benefit new channels for fundraising (as long as they can outperform the increased competition from other GPs raising virtually).
Case in point: An unnamed LP I spoke with recently detailed their inability to invest in any manager they haven’t met with in person, citing higher investment committee (IC) reluctance to approve any request without “completing absolute diligence”. In 2020, as less than 2% of staff worked in-office and all meetings were held over a webcam, attitudes changed — primarily since a restriction on remote investing meant capital would just be sitting there, dragging on the portfolio. This would only get worse as time went on, with current manager distributions accumulating and commitments rolling off until the portfolio was heavily over-weighted in less volatile, less restricted asset classes. Now, 20% of this LP’s committed capital is allocated to new managers hired without any representative sitting in the same room as the GP. Further, the current sentiment among their team indicates a strong probability of not only continuing to re-up commitments to new funds raised by previously hired GPs, but also to give similar consideration to virtual-only managers new to the investor.
A quick word of advice to remote venture GPs (but applicable to all): Make sure all your fund’s information on private databases like Pitchbook and Prequin are accurate (or omitted, at the very least). I know many venture managers that don’t shell out the significant overhead that comes with a Pitchbook subscription, but many institutional investors do. You don’t need an account to correct mistakes for your profile — just submit a change request by email. LPs are using these places consistently during early diligence and complete, accurate data could very well increase your chances of a second look. Additionally, many of these investors use recurring top-down scans for emerging managers, and a lack of crucial information may filter you right out of their pipeline. How do you know if it’s right or wrong without a subscription? Ask a trusted LP or a privileged peer to print off your firm’s summary report, or request one straight from the source. These companies are paid for their difficult-to-obtain private data and would be happy to oblige.
This newly sanctioned remote hiring process comes with its own caveats, of course: LPs are conducting more thorough diligence, doing higher volumes of reference calls, and expecting incredibly high recommendations from peer LPs and other managers. On top of these high standards, LPs are now able to be even pickier in manager selection. Remember that an LP wants to feel special to any hired manager and be comfortable knowing that they’ll be treated well, without having to be a supermajority investor. Remember, polite faces and decks with footnotes.
Any GP anticipating a fundraising process with institutional LPs needs to take advantage of this immensely wider pool of potential LPs sooner rather than later, understanding that competition for commitments is only going to continue rising and becoming more diverse as LPs put more thought into pitch decks emailed from far and wide.
Re-upping & Continuous Evaluation
Human nature typically leads most of us to do as little work as possible to reach a target outcome, and large LPs are no different. If a GP has been hired in the past and has been performing modestly within expectations, you can bet that an LP’s historic commitments to Fund II and Fund III will be followed by an even bigger commitment to Fund IV. A VC portfolio manager isn’t trying to make work for themselves, and while it’s difficult to get that first name brand commitment, it’s almost just as challenging to lose that investor’s loyalty in future funds (although not unheard of).
Not only is it far simpler to gain a re-upped commitment over a first-time check, but it’s also much quicker. Given a lack of material adverse changes in the GP, the diligence process can be shortened significantly — internal LP diligence memos are already templated — and the LP’s portfolio managers, subcommittees, and IC are already familiar with and comfortable allocating capital with that GP. There can be a surprising lack of concern among portfolio managers regarding over-concentration in a particular venture GP, with some allocators going so far as to actually implement formal policies for expedited diligence and relaxed performance benchmarks for those GPs that have passed the IC in the past. Trust has been built, and based on an LP’s individual AUM growth, a GP could expect increases in subsequent commitments ranging from ~1.2x-2.5x.
A primary rationale for existing manager preference is due to the consideration that any manager in an LP’s current portfolio is constantly undergoing continuous evaluation. That is, the team of analysts, portfolio managers, and various committees are keeping an eye on those GPs they’ve entrusted with large sums and are likely updating internal diligence memoranda on a recurring basis. A formal review process may be as often as quarterly, or as sparingly as once every two years, with the frequency varying with perceived risk. Understand that whenever this reapproval process does come around, those responsible for an LP’s venture portfolio will have to speak to what your fund has done since the last memo — don’t force them to make excuses on your behalf.
1.2.b: Restrictions: LP Red Tape & What They Can’t Do
Varying Mandates
As mentioned previously, you’ll run into LPs managing assets for more than one purpose, typically held in different trusts, with different beneficiaries and restrictive mandates.
It’s common for GPs to build their fundraising strategy around a targeted list of LP archetypes, using rough calculations based on portfolio AUM and venture allocation target midpoints to estimate the anticipated check size from each. However, the multitude of variables that drive each year’s updated target commitment pacing by strategy (such as the market value and timing of managers rolling off the portfolio, decisions on re-hiring a manager in their next fund, portfolio growth, and allocation policy changes) make any detailed forecasts of check size nearly meaningless. Don’t solely base your check size expectations on an LP’s venture AUM against their targets. You’ll end up overestimating what they’re able to commit or underestimating how much they have to commit.
Picture this: You’re an early-stage GP in the diligence process with a potential LP who manages assets across multiple trusts. Your calculations point you towards a glorious $15M commitment. Your hopes are dashed when the LP returns a $10M indication, revealing that, unlike their pension trust, the large retiree medical trust is disallowed from early-stage VC illiquidity. On the flip side, if you’re lucky enough to be restricting maximum commitments for new investors, expect that LPs will still want a sizable allocation for each trust with which they’re approved to do so (often because of cross-portfolio requirements to ensure equal stewardship among jurisdictions). Remember which prospective investors would provide the most valuable relationships and prioritize early.
Be ready to question an LP early regarding multiple commitment values by trust and/or strategy.
Side note for the Fund-of-funds (FoF) managers out there: When LPs have a secondary, smaller portfolio lagging due to its inability to meet minimum commitment sizes, institutions often turn to FoFs to maintain target commitment pacing. Be sure to set up a hunting blind here.
Side Letters
If you’re just beginning to explore commitments with more established LPs, know that there will almost always be a side letter specific to each investor and each commitment.
These are often short, 4–6 page documents executed alongside a fund subscription, detailing an LP’s specific regulatory requirements and contractual preferences for engaging in a partnership via investment. While a GP should read these thoroughly and be prompt in communicating concerns back-and-forth before signing, these are often not as malicious as they could be.
Generally, the side letter would include items like a Most Favored Nation clause to protect an LP’s rights, assurances of partnership requirements under any applicable regulatory body (such as LPs managing an ERISA trust), confirmations that the LP won’t be responsible for any “matchmaker” fees from placement agents used by the GP, various disclosure requirements, and discussions regarding governing law and legal proceedings.
While on the allocator side, we would include a conditional side letter for effectively every manager commitment, usually just to ensure mutual understanding and adherence of our ERISA status, as well as to help the GP stay in line with the special rules associated with an ERISA partner investor.
Short note on ERISA guidance: LPs managing private pension plan assets in the US are almost guaranteed to be required to follow taxation, disclosure, and investment standards observed under the Employee Retirement Income Security Act of 1974, or ERISA. Although an ERISA LP is more restricted than others regarding what they can invest in, they should not be avoided by GPs looking to take their strategy to the next level — this is where large and reliable anchor commitments can be found, and it’s not particularly difficult to make your fund investable for an ERISA partner.
The key rules of thumb for GPs in extreme brevity: 1) Don’t hold “Plan Assets” within the partnership, and 2) Keep the sum of all ERISA LP capital commitments under 25% or structure yourself as a VCOC. Perhaps most importantly, under most fund documents, a withdrawal right for ERISA investors will be triggered if the fund is deemed to hold “Plan Assets”. Details on what qualifies as “Plan Assets” and more information on ERISA governance can be found on the U.S. Department of Labor’s website.
To Be Continued
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 1.3: How to Be LP Friendly” publishing soon: In the next part of this ongoing publication, I’ll discuss the day-to-day life of LPs, how to communicate with prospective and current investors without triggering their pet peeves, and other simple pointers 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.
