Cup of Zhou

Five years ago, I wrote a piece about the third leg of the race. From my time as a competitive swimmer, the lesson our coach always had for us was if you’re swimming anything more than two laps, the most important part of every race is the third leg. Everyone’s tired. Everyone’s gasping for air. Yet everyone wants to win. The question is who wants it more. And by the time you get to a decently high level, everyone’s athleticism is about the same. All that matters is the mentality you have on that third segment of four of each race.

We often say, that starting a company or a fund is a marathon, not a sprint. True in a lot of ways. But also, it’s a series of sprints within a marathon.

We put out an episode last week with the amazing Ben Choi, which I really can’t stop recommending. Just because I learn something new every time I talk with Ben, and this time especially so. But that’s my own bias, and I get it. But more interestingly, he said something that I couldn’t get out of my mind since we recorded. “The first three funds—not just the first two, the first three—are that ‘working-out’ process. Most pragmatically, there’s very little performance to be seen by Fund III. So it’s actually Fund IV for us to hold up the manager as no longer emerging and now needs to earn its own place in the portfolio.” The timestamp is at 16:21 if you’re curious.

And it got me thinking… is Fund III that third leg of the race?

When most GPs raise Fund III, they’re usually four, maybe five years, out from their Fund I. And that’s assuming they started deploying as soon as they raised their fund. And within five years, not that much changes. Usually, that’s two funding rounds after your first investments. But lemons ripen early, so only a small, small subset move to Series A or B. Most have raised one or less subsequent round since the GP committed capital.

Even accounting for two funding rounds later, that’s usually too early to consider selling into the next round. And if one does (unless it’s a heavily diversified portfolio and the GP has no information rights, and somehow is so far removed from the company that no one at the company talks to the GP anymore), then there’s signaling risk. Because:

1. No matter what portfolio strategy you run, not staying in touch with your best performing companies is a cardinal sin. Not only can you not use those companies as references (which LPs do look for), you also can’t say your deal flow increased meaningfully over time. No senior executive or early employee knows who you are. So if they leave the company and start their own, they wouldn’t pitch you. Your network doesn’t get better over time. See my gratitude essay for more depth here.
2. Not having any information rights and/or visibility is another problem. Do the founders not trust you? Do you have major investor’s rights? How are you managing follow-on investment decision making—whether that’s through reserves or SPVs? Are the blind leading the blind?
3. And if you do run a diversified portfolio, where optically selling early may not be as reputationally harmful to the company, you are losing out on the power law. And for a diversified portfolio, say a 50-company portfolio. You need a 50X on an individual investment to return the fund. 150X if you want to 3X the fund. As opposed to a concentrated 20-company portfolio, where you only need 20X to return the fund and 60X to 3X. As such, selling too early meaningfully caps your upside for an asset class that is one of the few power law-driven ones. As Jamie Rhode once said, “If you’re compounding at 25% for 12 years, that turns into a 14.9X. If you’re compounding at 14%, that’s a 5. And the public market which is 11% gets you a 3.5X. […] If the asset is compounding at a venture-like CAGR, don’t sell out early because you’re missing out on a huge part of that ultimate multiple. For us, we’re taxable investors. I have to go pay taxes on that asset you sold out of early and go find another asset compounding at 25%.” Taking it a step further, assuming 12-year fund cycles, and 25% IRR, “the last 20% of time produces 46% of that return.” And that’s just the last three years of a fund, much less sooner.
4. Finally, any early DPI you do get up to Fund I t+5 years is negligible. Anything under 0.5X, and for some LPs, anything sub-1X, isn’t any more inspiring to invest in than if you had absolutely no DPI.

Yet despite all of the above, the only thing you can prove to LPs are the inputs. Not the outputs. You can prove that you invested in the same number of companies as you promised. You can prove that you’re pacing in the same manner as you promised. And you can prove that founders take the same check size and offer the same ownership to you as you promised. And that is always good. As you raise from friends and family and early believers in Fund I, Fund III’s raise usually inches towards smaller institutions, but larger checks than you likely had in Fund I.

1. Fund-of-funds care about legibility. Logos. Outliers. Realistically, if you didn’t have any before Fund I, the likelihood of you having any while raising Fund III is slim. They need to tell a story to their LPs. A story of access and getting in on gems that no one else has heard of, but if everyone knew, they’d fight to get in.
2. Any person you pitch to who has any string of three to four letters (or is hired to be a professional manager) attached to their name (i.e. MBA, CAIA, CFA, CPA, etc.) has a job. For many, their incentive unless their track record speaks for itself (likely not, given how long venture funds take to fully return capital) is to “not get fired for buying IBM.” Some of their year-end bonuses are attached to that. Some lack the bandwidth and the team members to fully immerse themselves in the true craft of emerging manager investing. Many times, the incentive structure is outside of their immediate hands. For every bet they make that isn’t obvious, they risk career suicide. At least within that institution.

I’m obviously generalizing. While this may be true for 90%+ of LPs who fit in these categories, there are obviously outliers. Never judge a book by its cover. But it’s often helpful to set your expectations realistically.

As such, despite not much changing from your investment side, from the eyes of most LPs, you are graduating to larger and larger LP checks. Usually because of the need to provide more proof points towards the ultimate fund strategy you would like to deploy when you’re ‘established.’ But to each new set of LPs, prior to an institutional 8-year track record, you’re still new. On top of that, as your fund size likely grows a bit in size from Fund I, to some LPs, you are drifting from your initial strategy by no longer being participatory and now leading and co-leading. You also might have added a new partner, like Ben talks about in the afore-mentioned episode. And a new strategy and a new team requires new proof points related to on-thesis investments. So, Fund III is where you begin to need to whether the storm. For some, that may start from Fund II. Altos Ventures took four years to raise their Fund II. Many others I know struggled to do the same. But if you really want to be in VC long term, this is the third leg of the race.

And this is when a lot of GPs start tapping out. Will you?

Photo by Victoire Joncheray 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.