Diving Into Your Track Record — So…You Want to Raise A VC Fund?
How will institutional LPs analyze your track record?
The debut article in this series of posts for emerging managers emphasized the importance for managers to build a differentiated proposition that would provide them access to the best tech founders. In the analogy to startups drawn in that post, the secret sauce is your product moat. It is unique, it cannot be easily replicated and as a result, will often be the foundational core upon which institutional LPs such as ourselves will base their investment decision.
After buying into your fund’s moat, LPs will look to understand whether — in startup parlance — you can “execute against the strategy”. In other words, are there strong indications that you can actually make money for investors even with your moat? Delivering returns in venture involves not just access to great founders (check!), but also, among other key attributes, the ability to identify a great founder and company when you see one, to determine the appropriate exposure relative to your fund size, to enter at the right price and then manage that investment accordingly until its exit (As an aside, execution will of course also be dependent on other factors such as your team composition and dynamic; a crucial topic that will be discussed in another post).
Presenting Your Track Record
Institutional LPs will therefore analyze your investment track record closely. That may make fundraising more challenging for first-time investors as institutions generally prefer first-timers practice on someone else’s dime as they build their track record. Just to put that in perspective, institutions feel that they are taking a fair amount of risk investing in emerging managers as it is. Venture is a higher risk investment and coupled with the inherent illiquidity, institutions just need to be very sure that the expected return justifies the risk. Investing in someone with a proven track record (perhaps at another venture fund) can provide that comfort, even if it might be a first-time fund manager. Partnering with experienced investors is one way for first-time investors to get started as a venture capitalist and as mentioned above, I will revisit the team element in another post.
What will LPs look at specifically when it comes to an investment track record? First off the bat, regardless of performance, ideally the investment strategy you are pitching is similar to that of your prior investment experience. For instance, if your experience has been in late-stage tech investing and you now wish to start a seed-stage fund, you will need to justify why you have the chops for early-stage as the skillset of a successful seed investor differs substantially from late-stage investing.
Next up, we look at the amount of dollars deployed. Remember that your prior track record acts as a guide for LPs when assessing your new fund as to whether you can execute. The nearer the amount of your aggregate invested dollars to date to that of your new fund size, the easier it is for LPs to size up whether you have the potential to deliver similar returns. Managers who have not deployed meaningful dollars in the past may therefore want to raise a more modest amount of capital to right-size their new fund relative to past experience. There is no magic number here in terms of total past deployment, although one measure might be the amount a partner in a similar-sized fund and strategy to what you are pitching would be expected to deploy over a fund cycle — say a 3-year investment period in new investments and a few years of follow-ons.
With regards actual track record, what does great performance look like? The key to success in venture is understanding that venture returns are distributed according to a power law, meaning that a very small percentage of the highest performers account for the greatest percentage of distribution. Thus, in a typical early-stage portfolio, the most unlikely outcomes will drive performance whereas the smallest impact investments will account for the bulk of actual outcomes. (It explains why LPs are so fixated on understanding a manager’s access to the best founders, and it also has implications for selection and portfolio management). The average dispersion of manager returns in venture capital is thus widest relative to other asset classes, as it is only the top quartile of managers who can provide LPs with returns and the top decile who can deliver outperformance. Therefore, to justify the investment into a venture manager, LPs will generally underwrite commitments to a 3x net cash on cash multiple and a 20%+ net IRR — “net” referring to returns being net of management fees and GP carried — and will want to believe there is potential to significantly exceed that number. Specifically, emerging managers’ ability to provide top decile returns is enhanced by their typically smaller fund size, which allow meaningful exits to provide strong impact, and we have seen emerging managers deliver 5x and even 10x fund returns. Of course, this doesn’t mean your pre-fund I performance mirror these figures, but this should be a helpful guidepost for past performance as well as what you believe you can do in your new fund.
Specifically, the performance figures LPs will look for are the amount invested, active value and realized value, both on an individual company basis as well as in the aggregate.
When funds present their performance, those metrics are typically referred to as PI (paid-in or cost), DPI (distributed or returned capital to LPs as a ratio of paid-in), RVPI (residual or active value as a ratio of paid-in) and TVPI (total value as a ratio of paid-in, = DPI+ RVPI). TVPI and DPI are the key figures here. Funds will also present an IRR figure which is the rate of capital gain factoring in time and based on a specific set of cash inflows and outflows).
LPs will look very favorably on investors who have shown strong realizations in their past performance as it indicates they can not only invest in, but also exit, venture investments. However, even if most of the value is still active and you are yet to see your first exit, as long as the underlying assets can justify their recent valuations with some meaningful upside, your pitch can still be strong. This is generally done by providing a picture of the underlying company business performance. Showing your ownership percentages on a fully diluted basis in the companies will also be expected.
Looking for Pattern Recognition
Within your track record, attention will hone in on the value drivers of performance. Here, LPs are looking to detect a broader pattern of strong access and investment judgment. While the power law of distribution i.e. that strong performance is likely driven by only one or two investments, is well understood by LPs who invest in venture, they need to gain comfort that you can repeat that type of performance consistently.
To further confirm such possible pattern recognition, LPs will also pay attention to the time series of your investments. Maintaining strong performance over a sustained period of time is clearly advantageous. Moreover, assessing investments against a broader macro backdrop is also insightful to us. For instance, we place a lot of weight on managers who have been around the block, so to speak, and have invested through both good times and bad times. Managers who have been through down markets, even if their performance suffered, will probably know what to look out for when the next downturn comes and hopefully navigate their investments to safer ground, to the extent they can (more about reserves management another time!). Institutional LPs with an emerging manager allocation such as ourselves are well aware, however, that we have been in a bull market for over a decade now and as a result, many newer managers will not have the downturn experience. That doesn’t rule these managers out. It just means we will spend more time trying to understand how they behave under pressure, perhaps in a particularly difficult company financing round or board meeting, which we learn via reference calls we make with co-investors and founders.
Be Upfront and Transparent!
One thing is certain, though. Be as upfront and transparent as you can! For managers presenting a prior fund track record, show net performance (adjusts for fees and carried) as opposed to gross performance (and for those with an angel track record, presenting a pro-forma track record on a net basis would be a welcome gesture!). Showing net performance makes is easier for LPs to understand your true performance and also to benchmark against industry figures such as Cambridge Associates’ quarterly benchmark research. A simple approach is to prepare the actual cash flows for LPs and let them do the IRR calculation. Second, generally accepted practice is to not markup company valuations until an external event occurs, such as a completed financing round led by a third party or, of course, an exit event, has occurred. Such things can often easily be cross-checked by prospective LPs given the possibility they have existing exposure to the same underlying companies through other managers.
Which brings us to deal attribution. Attribution can be a sensitive topic and is generally most relevant to managers who previously worked at other venture funds. It answers the question of how critical you were in making that specific investment happen at the fund. Did you personally source the deal from external channels or were you staffed with the deal internally given your particular domain expertise, for instance? Perhaps a junior associate found the opportunity and brought it to you for you to lead. That is also fine as it may still not have occurred without your involvement, but the point is LPs need to believe that once you no longer carry the business card of <your prior fund employer>, your personal network is strong enough to attract the best founders to your new fund.
These nuances can often be easily verified from calls LPs make within their GP network or they may even already know the back story from their exposure to co-investors in that company. I recall recently seeing pitch decks from two emerging managers in the space of a couple of months who had both stepped out of the same larger firm. On the track record slide, both put the same company logo! That certainly raised eyebrows and can often taint our view from the start. I am sure there were good explanations for it, as one may have sourced the deal and the other possibly led it, but bottom line, it pays to be upfront and as clear as possible about attribution in particular, and your track record in general.
There are of course other parts to “execution” that we will cover in future posts, but nailing down your unique value prop together with clear presentation of your past investment performance is a great place to start!