Here’s a question I got from a GP recently, which to be fair, took me much longer than I initially intended to respond to.
To the GP who sent this to me, and I know you’re reading this, thank you. It’s a great question. And one I’ve heard frustrate many a good GP out there.
So I’m going to include below what I wrote to that GP — word for word. So apologizing ahead of time for typos and grammatical errors.
Ok, this is an awesome question! Took some time here so I could better process my answer for you. Apologize for the delay and ramble ahead of time.
So I think there are 2 questions here: (a) how do you stand out as a GP who actually has deal flow when everyone claims they do, and (b) in a broader scope, how do LPs diligence deal flow?
I’ll start with the former.
(a) How can you prove to LPs you have deal flow that’s different/better than others?
So first off, most people say the same thing: “I get deal flow from founders in my network and co-investors.” But if everyone says that than even if it’s true, how does yours look any different? The truth is most LPs don’t know either. And in some ways, it might be easier to guide LPs how to think, that not only helps them diligence your fund, but also makes them a better LP, period. Keep in mind, most LPs cover a wide variety of asset classes and venture, much less emerging managers, is the smallest of the smallest chunk. And so they don’t have the incentive or the experience to really dedicate all their time to try to figure out how to better underwrite venture.
It’s similar to a question a friend of mine recently asked me. My friend is someone who eats to live (as opposed to lives to eat. Yes, those people exist in the world). And recently he found himself in love with someone who loves to eat, and by function of that, lives to eat. And so he asked me, despite having eaten at a bunch of restaurants, “how do I know which fine dining restaurant to bring his girlfriend to for their 6-month anniversary?” And I gave him a whole list of things I look for when it comes to picking restaurants. For instance, reading Google and Yelp reviews, but specifically the 3 and 4-star ones, not the 5- or 1-star ones because they’re so biased. And on top of that, I gave him recs of date-ish things to do pre- and post-dinner as well based on proximity to the restaurant. I also told him in the reservation to ask for a 10-15 minute kitchen tour after the dinner as an extra special experience. And after giving him all of that, he stares blankly at me. Not because he didn’t hear or understand what I told him, but because, really, he was just looking for a name. One name. He would then book it, and move on with his life. Because food, for him, was and is not his focus area. He had other “more important” things to focus on in his life and in the relationship.
Similarly, most LPs are the same when they look at venture. They do it because they need to think about total portfolio allocation or the David Swenson model, but they don’t do it because they love it or that they believe in it. And so they need to know a name, and that’s all they need.
So to get off my preamble, assuming that an LP has committed in their mind to spend time and do the work in emerging manager land, then you proceed with the next step. And unfortunately, most won’t. And that’s okay. They’re just not the right fit for you now.
So, the next step is really to guide them. One thing I’ve found to be helpful (if you have it) is to take your strongest few co-investors that you think you have the best relationship with, and ask the LP, “Let’s take X firm. What are the best investments they made in the last 12 months, say by revenue growth or headcount growth? And I will tell you if I saw them before they made their investment and who shared it with me.”
Conversely, you should look at who else you know well in their existing portfolio, and have them vouch for you and the type of deals you see. Also potentially more importantly, the kind of person you are. The strongest co-signs are often GPs in their existing portfolio and institutional LPs that specialize in venture that they’re really close to.
Another thing I’ve seen a GP do (paraphrasing here): “I’m going to give you a list of folks who send me deals, short list, and I can give you a longer one if you’d like. And I haven’t told them you’re going to call, so please use your best judgment when asking for their time. But ask them how many other VCs they passed the last 5 deals they shared with VCs to? If they’re doing their job right, they’ll likely pass to more than one. But see if my name comes up. If it doesn’t, you have your answer. If it does, you have your answer.”
Going a step further, and I don’t think I’ve seen any GP do this yet, but I feel like it should be more of a thing: Take all the deals you’ve gotten from your “network” (i.e. founders, investors, etc), and segment them by, who sent you a deal because:
- You co-invested with them in the past
- You invested in them
- You didn’t invest in them (compliment to an investor to get strong deal flow from someone they passed on) – anti-portfolio, but keep in mind this only matters, if the people you receive it from are successful founders in the eyes of an LP, maybe you asterisk these
- You had no prior economic relationship with them
- You used to work with them
- They’re a fan of you/your content/etc
- I’m sure there are other segmentations, but you get the gist.
And in addition to that, when you pass on a deal that someone refers, categorize the deal into why it’s a pass:
- Not a strong founder
- Too expensive, but good founder
- Good founder, but not in sector/thesis
- Not raising at the time
And all the above you would show to an investor and I think should be a good snapshot as to the quality of your deals. Then if you’re comfortable with them, challenge them to try the same exercise with other investors. Part of proving something to an LP is to help them become a better investor, period. Whether they invest or not.
(b) How do LPs diligence deal flow?
The simple answer is: they do references. In terms of how many, I’ve heard everything from 3 to 40. The highest end being Cendana. Most institutions
For those that do 5 or less, primarily either use an oCIO/RIA (i.e. Cambridge, Stepstone, Hamilton Lane, some kind of MFO, etc.) or they primarily bet on firms that are hard to get but also won’t get them fired, largely because they don’t just have the time/resources/team members to specifically underwrite emerging managers in venture. Because of the optimization of “I need to see ‘everything’” and I don’t have the time to go deep and assuming they choose to do (in some parts) their own work, they:
(i) talk to a lot of spinouts ‘cause easier to reference and draft a memo to get buy in
(ii) talk on stage at conferences with the perception that they are open for business, which they technically are, but very selective
(iii) have you go through really long ODDs and DDQs in front of a (large) panel of stakeholders and decision makers in the organization. Ranges for 3 to 20-something people all listening to you answering questions. At that point, it’s your word against your word, but a committee will nitpick on everything. The upside is that it’s easier to share something you do that you’re 1 in 5 or 1 in 10 who do (as opposed to FoFs and venture-focused MFOs or institutions who need you to be 1 in 100 or 1 in 1000). The downside is you need to appeal to a larger group of people, and it takes more time outside of meetings (up to 350 question ODD).
But I digress. For the purpose of your question of your question and what I believe your frustration might be, I’m going to focus on diligencing deal flow when you’re not in the room. Assuming it’s an LP who is actually intentional about diligence AND is open-minded enough to not bring too many of their own biases in…
- On-list
- Founders: sticking to the facts. How did you meet the GP? What did you talk about in the first meeting? How long did they take before they committed? What questions were asked? Did other VCs ask the same questions? How competitive was the round? If you offered any special terms, why and who else did you offer it to? Did they all take it? Have you introed any other founders or people to the GP? Has the GP provided you value post-investment?
- Co-investors: Who gives you the best quality of deals? Intro to meeting ratio? Meeting to diligence ratio? Meeting to commitment ratio? How does this GP stack rank against other relationships/other verticals? Did the emerging GP intro you to the deal you’re co-investors in?
- LPs: How many other firms of a similar strategy did you talk to? What were the sourcing strategies for the other firms? Compare and contrast.
- Former employers/misc: deal flow isn’t really diligenced here. The best thing these folks can attest to is your character + network.
- Off-list (a lot of off-list is done with people who, in the words of an LP, “owe you [the LP] more favors than they owe the GP”)
- Founders: Rank your favorite investors on the cap table. Who are your top 3? Why? If you were to start a new co, who would you take with you again?
- Co-investors: How much signal is a deal if that GP sends it to you? Compare with other GPs. Why?
- LPs: Have you gotten co-investments from the GP? How is their level of communication post-investment?
- Others: Same as above.
