Series on Trust: The LP and the VC

This is the second post in a blog series on trust.

Last week, I wrote that VC is a “trust business” and I highlighted why trust between an entrepreneur and a VC is important (called “When Entrepreneurs and VCs Break Up” and is here). This week, I’d like to write about trust between a VC firm and its investors.

In 2006, I left a venture capital firm, where I had been a partner for 8 years, to start a new VC firm. To get funded, I met with a lot of institutional investors, called “Limited Partners” or “LPs.” That inaugural fundraising was very interesting. Unaffiliated with an existing firm, many LPs were very up front and shared their thoughts about VC.

A few were very happy with some of their VC managers. But, most were not. I paraphrase one LP who said: the VC industry is guilty until proven otherwise.

For example, one of our major investors has many VCs in their portfolio, but now supports only two: Kepha and a VC firm in China. A major foundation has cut their VC roster from 30+ firms to just five. A leading university endowment has dropped most of their VCs and instead is thinking of bypassing VC firms and investing directly in innovation. More stories like this abound.

Common frustrations I heard from LPs during our inaugural fundraising included:

  • “Scope creep”: VC were expanding their efforts into new areas or geographies where they had no prior expertise. Some were doing well, but most were not. Some LPs felt that they received portfolio exposure to areas for which they had not signed up.
  • “Inconsistent strategies”: LPs keep all presentations that a VC firm pitches, includes ones from decades ago. So, they can easily call up the old documents and compare the new one to prior versions. If there are inconsistencies, the LPs know
  • “Lack of transparency”: Some LPs were very frustrated with the lack of detail on the management companies (more on that here). Others didn’t like how VC quarterly reports to their investors often say the bare minimum
  • “The stiff price of success”: One investor told us that when a firm has a successful hit, it often then raises a very large subsequent fund (for reasons on why this may be challenging, click here). The LP feared that VCs would drift away from early stage strategies that created success in the first place
  • “Complicated stories”: One of our investors recently commented about another VC firm.  He said they had “a lot of baggage” and it was unclear if LPs would re-up with their next fund.  In other words, it was a complicated story.  LPs cover a lot of ground: public stocks, bonds, hedge funds, real estate, natural resources, leveraged buy-outs, and venture capital (all of which include both domestic and international).  As of May, in VC alone, there are 369 VC firms officially fundraising.  That figure likely excludes firms that are “pre-marketing” a new fund (informal discussions that start a dialogue).  When you include real estate, growth equity, buyouts and VC together, there are over 1,900 private equity firms fundraising right now.  So, complicated stories are hard to assess amid this sea of firms.  As one LP told me, “We just don’t have the time to research everybody, so we just pass on most.”

I think part of the frustration comes from the nature of a VC fund. You see, when a LP invests in a fund, it is empowering a VC with a 10 year-long open checkbook. Funds last a decade and a VC has tremendous freedom with how he invests it. There are limits usually on how much a fund can put into a single investment, but for the most part, the VC has tremendous latitude.

Moreover, if a fund isn’t doing well, the LP has limited recourse. One option is that they can renege on their investment commitment to the VC fund, but this usually triggers a “default” clause whereby that LP will give up 50% of the dollars they’ve invested to-date. These dollars are then allocated to the remaining LPs. So, in practice, I’ve never heard of a LP defaulting.

A second option is to sell their investment in what is called the secondary market. Other institutional investors will bid for that LP’s investment and assume the obligation for the remaining unfunded dollars. Unfortunately, buyers usually bid with a discount to fair market value. So, if a LP has $100 invested in a VC and wants to sell it, bids can come in at $50 or less.

Third, fund documents usually include a “no fault divorce” clause, where a group of the LPs can together vote to hire a new manager to take over the investments. However, the clause often requires 80% or more of the LPs dollars to vote “yes” on replacing a manager, and that is a high number. And, many LPs wonder how easy and practical it is to find, hire and retain a new VC firm to manage a portfolio they don’t know well. So, in practice, these divorces almost never happen.

So, you see, the typical LP is very leery about having his money locked up for 10 years. They must trust that VC. And, trust takes time. Broken trust takes even longer to re-forge.

So, how does all this affect Kepha? We believe transparency is the answer. It helps us earn trust with a LP.

We are a new firm. We have a lot to prove. We know we are one of the new kids on the block with nothing to brag about. But, I’m glad that some of our investors have told us that we have the most honest reporting in the business.

So, trust is important between a VC and an investor. Investors sign up for a 10-year checkbook. It is tough to tell your investors the bad news, but it is the right thing to do. In the end, the bad news will be discovered anyways.

Next week, I’ll write about the other side of this trust factor: why a VC must trust a LP, or not take their money.

3 thoughts on “Series on Trust: The LP and the VC

  1. Jo,

    I enjoy your blog.

    Here’s a funny story from a friend who runs a large endowment. They are an LP in a handful of blue chip vc funds.

    He was visiting one of these funds and asked a question. The reply was, “That’s a great question. Let me show you this video with Lance Armstrong to answer it.” And the partner played a fluff video about excellence in which Armstrong pitched the firm. My buddy was blown away by the arrogance; couldn’t the guy just engage in a discussion?

    My friend has a laundry list of complaints, so I asked him why he keeps investing. His answer surprised me. He said “I am measured against my peer endowments. They all invest in these same funds. Usually results are so-so, but every once in a while there is a Google, and returns are so high they move the annual result for the endowment in a big way. If I’m not in when that happens, my comps will look terrible. So I have to be in.”

    Mike Travis

    1. Hi Mike, thanks for the note and anecdote.

      I think your LP friend raises an important point: in the investments business, you have to be “in it to win it.” VC firms raise money episodically, and if a LP chooses to pass on that fund, it is unlikely they’ll be invited back into future ones. These funds aren’t like stocks, that you can buy and sell on a daily basis.

      So, all the more reason that the LP needs to trust the VC before investing. Thanks for writing….

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