I was chatting with a GP last week about the highlights and lowlights of having a multi-stage fund or just a VC fund as an LP via their fund-of-funds. The obvious synergies of access to downstream capital and branding, especially if the individual running the fund-of-funds is known for their institutional track record as an LP. As well as access to the GPs at those funds for mentorship reasons.
But the downsides also exist. You’re one of many of other GPs who have access to the same team. More often than not, there’s no institutional diligence. And the investment happens largely for strategic purposes. Same is true for multi-stage GPs investing through their own family office. But you also have to think through the tough conversations you need to have when you take checks from more than one of these funds. Assuming all else equal, and they write the same check size, when your portfolio companies are outperforming, do you pass them to Big Fund A or Big Fund B? Equally as true for any LP who wants co-investment opportunities. Family offices. Fund-of-funds. The classic question of: Do you like Mom or Dad more?
And there’s one more. Consider a multi-stage fund who’s an LP in your fund. You share one of your stellar portfolio companies with them, and they loved the deal so much they also invested. Not only invested, but led the following round at a much, much higher valuation. For the sake of this thought experiment, let’s say the Series A valuation is a solid nine figures. As such, they take a board seat. A year later, your portfolio company has the opportunity to exit for $800M. A phenomenal exit for everyone on the cap table, including yourself, your other co-investors, the founders, and the employees. And for you in particular, this would return meaningful multiples of your fund. But not your Series A lead, who is also your LP. The math isn’t inspiring for them. $800M would only be a shy 4-8X on their initial investment.
So, the Series A lead/your LP blocks the acquisition deal and pushes the founders to go for more. You push back on the motion as everyone else’s incentive, including the founders, is the same as yours. Whether the deal happens or not at this point is irrelevant. This Series A lead, who’s also your LP, ends up telling a number of other LPs that you’re difficult to work with. To the effect that they would also no longer re-up in your next vintage. And that makes your fundraise for the next fund even harder than you expected.
You’ve not only lost a $500-2M check (on average), but worse, you’re likely to have a tarnished reputation with prospective LPs. If they like you already, they may look beneath the surface. If they haven’t gotten to know you, they’ll likely surmise on limited information that the juice isn’t worth the squeeze.
Before you dismiss this as just a hypothetical case study, note that this is a true story.
As my buddy Thor once told me, “Capital formation is a design principle. Fundraising is a sales process. Without true design around a customer base and a product, you will fail eventually.”
Capital formation is thinking through the types of conversations you want to have when you’re in Fund n+1 and n+2, 5-6 years from now. As Adam Marchick once said, “The bulk of your conversations with an LP happen negative 6 months to time of investment. The most important conversations you have with an LP are Year 2 through 6 of your investment.” These are the conversations about extending recycling periods, early distributions, fund extensions, and so on. Many of which revolve around the return incentives of your LP base (if decisions are made by majority approval) or by LPAC approval. A family office who has no immediate liquidity needs might not want early distributions and wants you to hold out. Another who’s starting a new business line or pulling completely out of venture (because they were misinformed or set the wrong expectations initially) will want early liquidity and/or someone to buy their stake. An institution with a high leadership turnover rate will likely have a new CIO who’ll want to redo the whole portfolio. So what used to be obvious re-up decisions will need to be re-underwritten altogether.
So I’m not here to say, “Don’t take LP checks from fund-of-funds whose core business is being a VC.” I just want to remind you to consider the incentives of each LP you have on your cap table. Ideally, your LP base’s incentives are homogenous. Not only to themselves, but also to yours. Realistically, for the average emerging manager, it won’t be. But if you know it won’t be, prepare guardrails for future conversations. Don’t walk in blind.
Photo by Dan Meyers on Unsplash
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The views expressed on this blogpost are for informational purposes only. None of the views expressed herein constitute legal, investment, business, or tax advice. Any allusions or references to funds or companies are for illustrative purposes only, and should not be relied upon as investment recommendations. Consult a professional investment advisor prior to making any investment decisions.