If you’re a venture capital fund, limited partners (LPs) are the life blood of your business. They give you capital to manage over a long time horizon in exchange for a return that (hopefully) exceeds traditional liquid asset classes. They are your customers. But like any customer base, LPs can churn — usually at the time when you need them the most.
So, just like early stage enterprise software companies must pay attention to the makeup of their customer base, first time venture funds need to think about constructing an LP base for the long-term. It’s certainly easy to disregard this practice while investment in venture capital is at an all-time high — but this is exactly the right time to do it.
I know what you’re saying — as a first time fund, you just want to get the fund closed. But, if you are fortunate to have excess demand, or you are raising your second or third fund, or the industry is enjoying frothy times, paying attention to LP construction will reap huge dividends down the road.
So, what does paying attention to LP construction really mean? Assuming you have some leverage, here are some basic concepts:
1. Don’t let any LP be more than 20% of your fund. At or above this level, an LP will likely drive special terms, insist on control provisions, and may inhibit other LPs from investing. Ideally, your largest LPs are 7–10% of your fund.
2. Prioritize LPs that have their own internal source of capital. That is, LPs that are managing their OWN money. You have enough risk in your own fundraise — be careful how much risk you take on from your LPs’ fundraising efforts.
3. Focus on LPs that have demonstrated a long-term commitment to the venture capital asset class. For example, fund of funds (FoFs) are typically formed to invest in venture capital, so their bias is to keep investing in your fund as long as you are performing. Alternatively, be wary of LPs that are “new to venture”. At this stage in the market, there are a lot of tourists.
If you can successfully navigate those three items, then you’re ready to take the next big step — building a diversified LP base that can withstand the peaks and valleys of the VC industry. The simple analogy is an enterprise software company that sells across many vertical industries in order to insulate itself from the economic cycles of any particular industry. Believe it or not, LPs do not act like a single herd — different types of LPs will move in or out of venture capital at different times.
Let’s look at a “vertical” segmentation of LP categories:
1. Fund of funds are “indirect” funds set up to pool third party capital and charge fees in exchange for providing access to top venture capital funds. As a result, FoFs have traditionally been the largest and most consistent investors in venture capital over the last thirty years. However, as more third party investors gain direct access to venture funds, the FoF fee structure has come under pressure. FoFs are adapting their business models, but expect some shakeout here. The top FoFs (with the best VC access and a long-term view) are great business partners — target 20–40% of your fund for this type of LP.
2. University endowments are highly sought after LPs because of the fine institutions they represent. They have been investors in venture capital since the 1980s. However, they can also be finicky investors and “market timers” as was seen during the early 2000s when many universities trimmed their list of venture managers. Seek out university endowments that have stayed with their (performing) managers through peaks and valleys. Target 10% of your fund with these LPs.
3. Public pensions are large pools of government capital that have a limited allocation to alternative assets like private equity and venture capital. Because of their size, public pensions may need to write a big check into your fund, so pay attention to #1 above. I personally like these funds because they often accrue to the benefit of teachers, police officers, and firemen. But these funds can be regulated by investment committees that may have a short term view based on regional economies, so they can be “market timers”. Target 10–20% of your fund for these sources.
4. Sovereign wealth funds are investment vehicles set up by foreign countries to invest in U.S. venture capital. They are large pools of internally managed capital that are new to venture capital and eager to invest in our startup ecosystem — but they haven’t yet demonstrated a long-term commitment to our asset class. I believe this LP segment is here to stay and will generally be consistent investors given the massive size of their capital bases. Pay attention to the pending FIRRMA legislation and its impact on this segment. Target 10–15%.
5. Private pensions are the corporation version of public pensions. They have been investors in venture for 20–30 years, but are obviously not a growing segment. They are typically supportive investors, but will likely not scale if your fund size grows. Target 5%.
6. Corporate investors usually have a strategic reason for investing in venture funds. They can be helpful with portfolio companies but also pose some confidentiality risks. Make sure to assess their longer term commitment to the venture capital asset class and be discreet with company level disclosures. Target 3–5%.
7. Family offices are wealthy families that have earmarked a percentage of their asset allocation to venture capital. They are typically smaller investors but can be a very stable segment. Target 3–5% of the fund for this category.
8. Individuals will also invest in venture funds. It’s a good idea to set a minimum investment threshold and limit the number of individuals because they take just as much management as larger LPs and typically have a smaller appetite for the illiquidity of venture funds.
Ok, this all sounds great, but what if you’ve already raised your first fund and established a mix of LPs? How do you effectively rebalance LP percentages without antagonizing your most valuable customers?
First, build a pipeline of prospective new LPs in segments that you’d like to add if existing LPs churn (some churn is typical and healthy). Second, if your fund is changing in size, take the opportunity to rebalance LPs by adjusting them in different proportions.
As a venture capital fund, you should always be talking to prospective new LPs, especially in between formal fundraising efforts. Having a strong pipeline will give you the confidence to execute on this long term strategy.
— Barry Eggers, Partner @ Lightspeed