One of my favorite things to do is collabing with friends on content. Especially on topics not covered well or ever publicly, but should. My buddy Ben is one of those rare souls I never hesitate to collab with. Be it through the podcast or our first joint piece together on underwriting the risks of investing in emerging managers below.
You can find the same blogpost here on his Substack. Separately, one of my favorite blogposts Ben wrote happens to be the one where he lays out how he communicates with GPs. A practice I’d love for the broader industry to adopt at some point.
Nevertheless, without further ado…
Ben and I were messaging in Whatsapp the other day debating the risks of investing in a particular early-stage venture fund. After going back and forth laying out our thinking we had the bright idea to create a short post laying out which ones were important to us and to give a chance for other allocators to weigh in. This post is the result of that idea plus about 300 more Whatsapp messages. We hope you enjoy it, and take the opportunity to debate with us.
As an allocator, risk is the one word you can never run away from. You have to define it, price it against the relevant upside and recognize that it is always there, lurking in every opportunity.
As we are not traditional allocators, and instead choose to back the riskiest sub section of the riskiest sub section of asset classes: early stage emerging venture capital managers, evaluating risk is probably the single most important part of our job.
All day, we talk with people who want to raise a venture fund, to go invest in companies changing the world, to fund innovators — to fund individuals and ideas that can’t be reduced to a single sentence, who will redefine life as we know it, and to many, will seem crazy. In short, we back people who can’t stand the fact that someone else might be able to make the world a better place better than them.
But, when you’re doing a job that is about mitigating risk, and you’re also trying to invest in world changing technology, by definition you’re taking a risk on approach.You have to have a pretty nuanced and thorough view on the topic.
So, as you might’ve guessed after we said the word “risk” 7 times before you found yourself here, this is our piece on how to define the risk of investing in venture capital emerging managers. Hopefully, you get to learn a little more about how we think:
Operational Risk:
This risk can be summarized as the things unrelated to investing, which can impact the ultimate DPI number.
Operating a fund is a distinctly different animal than other businesses. There are easy mistakes that drive the amount of investible capital down, liability up, and make DPI harder and harder to reach. Picking the right legal team (shout out to Sam at Pilsbury for setting the standard here), admin, bank account, and setting the right internal spending policies are all crucial.
The smaller the team, the more operationally inexperienced people are, the greater this risk. Do they know how to structure capital calls? Do they have an information and cybersecurity policy set up? If applicable, do they know how to warehouse their prior deals? How about QSBS structures? Do they know that SAFEs don’t kickstart the QSBS countdown and only priced rounds do?
If the GP(s) are planning to hire an associate or an operations person, do they know how to set that individual up for success? Or are they merely outsourcing what they don’t want to do? In fact, there are a surprising number of investors who spin out of their prior shop who realize the operational complexity for the first time. And without a good back office team, the investible capital can slowly be eaten away. As one of our mutual friends, Ashby Monk once said, “The difference between net and gross return is your investment in the organization.”
Vintage Risk:
This can be summarized as: in the next 2-4 years, can this person actually get into the best deals in their area?
We often see angel investing track records shown as a proxy for fund investing track record. However, these are two totally different functions/ . Returns from part time angel investing is a result of choosing the best deals where you have allocation. However, funds have fixed deployments and timelines. This means you HAVE to allocate, you can’t just wait until a deal you like is offered to you. It’s like switching from a gatherer mindset to a hunter mindset. You have to go out and find the very best deals, or else you’re going to go hungry.
Win-Rate Risk:
Most emerging GPs start in one of two areas:
- Operator angel
- Spinout/career VC
Yes, there are others, and you can cross-apply a similar framework for them, but for the purpose of this piece, we’ll focus on these two.
As an angel, everyone loves you. You’re a small check. Everyone else who’s participating wins their ownership targets. The lead. The 1-2 sub-anchors. And there’s often still room for others. But as you now have a fund, even a small one writing $100-250K checks, you will eventually want to invest in a round that has capacity constraints You are now asking a founder to make a choice: Do they want your check or are others more valuable than you are in the longer term?
Additionally, with how the markets are changing now, large multi-stage funds are taking as much ownership as they can to make their economic models work. There is an uncanny valley appearing, with everyone between the lead investor and really small, strategic angel checks getting squeezed out of the round. And as an emerging fund manager, you now have to not only win the favor of the founders but also not draw the ire of the lead.
As a spinout, the question looms: Was a GP successful because of the team/brand at her last firm? Or was the firm successful because of her? Here, deal attribution really matters. Not only who got the deal over the finish line, but also who was most valuable – customer introductions, talent, hiring needs, downstream capital introductions, syndicating valuable supporters on the cap table, etc. – post-investment. Even better, if it was pre-investment.
It’s also worth noting that win-rate risk exists both at the time of the initial check, as well as the pro-rata check. And as such, should be evaluated separate from each other. The initial check is what we talked about above. The follow-on check is a function of are you valuable even after the initial investment was made.
Yes, pro rata or right of first refusal is usually a legal right, but if you’ve been in venture long enough, you’ll know those rights aren’t enough. Large and/or downstream investors will almost always force you to give up your pro rata. And it’s the GP’s job to provide immense value, make sure the founders know and are willing to fight for you, and be able to prove to later-stage investors that you can still be valuable later.1
Team Risk:
This can be summarized as: is this the right GP(s) for the right strategy?
Do these GPs really get the space? Does their past make this thesis painfully obvious? We’re looking for deep specialized expertise and a strategy that actually fits. If they’re concentrating, can they actually get into the best deals? That means founders need to want them in the round. Beyond that, do they have the right skillset from sourcing to closing? Red flags pop up when a team is running concentrated without the ability to win allocation, doesn’t really understand why founders win, or just lacks the diligence ability.
The other dimension of this risk is whether the GP is solo or part of a team. While it’s easy to see the risk involved from the perspective of a solo GP (e.g. what if this person gets hit by a bus?), teams may introduce more risk. With each N increase in a team, you are introducing N2 amount of process before making an investment. You are also introducing interpersonal dynamics around investment decision making. Also, the key-person risk doesn’t necessarily go down either. What happens if a team of two that compliment each other breaks up? Did adding that second person really do anything to lower the risk? We have seen teams work, and Solo GPs work well. The key is to not rely on maxims here that one is better than the other.
Sector Risk
This can be summarized as: do we think this sector has enough high density talent to support a VC strategy?
Exceptional outcomes need exceptional people. It’s not enough for a sector to just be “hot.” We need to see high-density talent flocking to it. That means tracking where the very best minds are going – whether that’s looking at top colleges, prior professional successes, or other ways to measure talent. If the talent pool isn’t there, you simply won’t find the people capable of building the companies that drive fund returns.
Downstream Capital/Graduation Rate Risk:
Related to sector risk, but worth explicitly defining, is there immediate downstream capital for a fund’s portfolio companies? Many hard industries – for instance, life sciences, hardware, energy, just to name a few – don’t have obvious players who would immediately lead the next round. In these specific instances strategics tend to be the biggest players, but they are more opportunistic..
The GP needs to actively spend time helping larger, later-stage investors understand the value of their sector and their portfolio companies or inject enough capital in their portfolio companies until they become obvious for everyone else. In these cases, it helps to know that the GPs are actively strengthening relationships with larger pools of capital, and specific partners , as well as having decision makers involved either as individual LPs or via their fund of funds.
The loss ratio in venture is much higher than other asset classes2. It’s not surprising that 50% of the portfolio dies. But being able to graduate at least a third of your portfolio to the next stage is the bare minimum. We do want to caveat that this is the bare minimum. Anything north of 50% is great, excluding the 2020-early 2022 vintages, where everything was getting funded.
Market Size Risk
This can be summarized as: is the focus of the GP big enough to generate multiple billion dollar+ outcomes.
We’re looking for funds that can 5x. That means the company outcomes need to be massive. So, you need to be in a space with room to grow. Are there enough potential buyers to support huge valuations? Is there enough investor demand to keep fueling that growth? Think about it this way: you could be the best fax machine investor in the world, but even if every business had one, the market’s just too small to generate those billion-dollar exits needed for fund-level returns.
Decade Risk:
This can be summarized as: does this fund have the staying power to be an exceptional team a decade from now.
It all comes down to the “why.” Why are these GPs doing this? Do they see themselves building something generational? They don’t need to be the next Founders Fund, but what’s incentivizing them to stick around for the long haul and keep pushing for those top-tier returns?
Are they getting rich on fees or carry? Are they aware how fees can compound in the future? What will keep them going 2 years from now? 5 years from now? 10 years from now?
When they’re financially successful already, why bother? What has historically kept them motivated?
Financial Security Risk:
Will they struggle to put dinner on the dinner table with their current fund size? Does that mean they’ll be distracted from doing their absolute best on delivering the best returns for us, the LPs and supporting the best founders to win?
We never want someone distracted from doing their life’s work. If they’re all in, we want to make sure they can go all in. Now and into the future.
Similarly, is this a part-time hustle? Do they have a main gig? What is their current list of priorities?
In Conclusion
The goal here isn’t that every GP has to address every risk. There are some, where we as LPs can help mitigate. There are others that are outside of our control. The goal is to figure out what the risks3 are, how the GP is controlling for them and what the ultimate upside is, before we write a check.
- This is one area where we use different heuristics:
– David’s rough litmus test is that a GP who wants to grow their fund to a firm must be able to prove value to a portfolio company for at least 4 years after the initial check.
– Ben’s take is looking at the super power, or one thing that GP can deliver to a founder better than anyone else in the near term.
All this to say, the real work begins after the investment. ↩︎ - Loss ratio is a topic that is sensitive in venture. It matters more the later you go, and anything under like 90% can still lead to a tremendous seed fund. We decided to include it here as it is a risk, just take it with a grain of salt as you read the next few lines. ↩︎
- And we’ve now said the word “risk” 30 times. Oops, 31. ↩︎
Photo by Valery Fedotov on Unsplash
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