LIMITED PARTNER ARTICLE SERIES
Fund of Funds Investing – Our View
As we consider our next potential venture fund investment, one aspect of due diligence that we particularly enjoy is a portfolio study of a team’s current and past funds. We want to understand how the team has shifted and improved the management of their portfolios fund over fund. What’s particularly of interest to understanding how a team improved their models, starting positions vs reserve allocations, their syndicates, kill switches, and how well they have stayed on thesis. We also look at – the what-happened-there, shake-your-head investments – and to comprehend what learnings were applied to the next fund. Our question is; did the team make the needed adjustments to their model to remove the blind spots?
Syndicate
One of the easiest measures of a fund’s outlook is to examine how the rest of the venture industry views the team. Syndicating partners are the lifeblood of every fund as they seek to fully fund their portfolio companies. The quality of the other participants with any venture fund’s deal is telling, it is a fixed measure of peer respect. It is important to see the progression of the syndicate network quality on a fund- over-fund basis.
It is standard practice for GP teams to create their own growth, opportunity, alignment and/or sidecar funds to support the outperforming companies in their venture funds. We are solidly on side with this practice; it maintains stability within the company and at the board. New investors with a lead position can create risk for the board and the organization as a whole when alignment has not been achieved. Alignment between investors and all board members is critical for stability as the company rockets toward an exit.
Detractors point to artificial valuations of new financing when the managers all operate under the same corporate umbrella; however, we have not seen any mismanaged process in this regard.
Good managers with a long-standing record of ethical behaviour do not
suddenly ignore best practices when engaging with a new fund.
Many funds in recent years have adopted “continuation” funds, which may or may not provide a liquidity event for the LPs of an aging fund and an entry point for LPs preferring more advanced- stage companies. This can be a highly effective model, assuming the GPs have rolled their carry into the new entity, most recent valuations have not been eroded to speed the deal, and existing LPs have been provided full transparency to the transaction. These can be particularly useful transactions. If the fund is at term or into extension years, we expect the GP to wrap it up and return capital. Standardized provisions and best practices for managing LP consent and rights are yet to fully emerge as part of the definitive agreements.
Thesis
When considering a fund in sequence, we’re always interested in understanding the evolution of the thesis and any deviations, the number of companies in the portfolio, and starting positions. Changes in a fund series’ thesis are often clear shifts as the team hones the more defined area of opportunity, which allows them to more quickly identify a term-sheet target and spend less time with those out of bounds.
Investing off-thesis once the fund has launched is just not worth it. If the off-thesis investment works, you won’t get extra LP kudos. And if it doesn’t work, the LPs won’t forget. Also, you’ve increased the risk of reputational damage by breaking the guidance of the Limited Partner Agreement (LPA). If you find something you just can’t leave alone, bring it to a syndicate partner and let them do it. If they are a great syndicate partner, they will return the favour.
Don’t do it – going off thesis isn’t worth it!
Venture commonly seeks investment where the prospective company’s capital requirements are “light” relative to growth potential. A capital-intensive deal, in our books, is not a venture deal unless you are in a fund size of stratospheric and well-syndicated proportions. Despite this being an industry mantra, there are always examples of funds that have taken on a company with enormous equity and debt requirements that end up tanking an otherwise well-performing fund. A little “off thesis” and a little “not venture” sets the stage for a big miss.
Pacing
Build the portfolio too quickly and you won’t have been sufficiently selective. Build the portfolio too slowly and some investments will not have time to mature within the term of the fund. While LPs generally allow for a 5-year commitment period, GPs that execute in 4 years create more breathing room for their companies to mature before they begin to seek exit opportunities. Additionally, there is little point in making a seed-stage investment in the last year of the commitment window as that puts unnecessary pressure on the fund and the company. At a minimum, your syndicate partners are similarly timed in their fund term for an exit and have a similar mindset regarding exit process, expectations and timing.
Reserve Allocations
Every fund manager evolves their approach in reserve allocation. Many first-time managers will grapple with the challenge, usually realizing too late that too little is held in reserve for the latter half of the fund term. This situation is unwelcome, but just as common as continuing to fund underperforming companies when the same capital would have been much better utilized in pressing the winners. The willingness of the GP to continue funding underperforming companies is one of the most significant causes of poor fund performance.
- First, exit-ability may be compromised with insufficient capital reserves. The company may have been sold earlier. Now, sophisticated buyers identify vulnerable companies and their opportunity to take advantage of the situation.
- Second, the ripple effect on syndicate partners is tangible.
- Third, difficult decisions will have to be made regarding support allocations of remaining portfolio companies with diminished capacity.
The inevitable downstream result of this error is obvious to all but those who have not participated previously. As the series continues, funds often move quickly to a smaller number of portfolio companies and increased reserve allocations as a percentage of committed capital.
When do you stop funding the underperformers?
Kill Switches
As important as it is to build a quality portfolio of companies, it is just as important to know when to stop funding them.This is a troublesome process for most teams to develop. In our view, the issues start when a single GP develops their own group of companies within the overall portfolio. Often, if a GP is the designated lead for an investment, it is easy for them to develop a bias for their companies and fight for further investment when others won’t. There is a reduction in this risk if an alternate GP is assigned to act as a second opinion in the management of the investment. Given the duration of involvement in most companies, this is almost always a necessity.
The GPs should start to ask, “would we invest now if we hadn’t already?”
Throwing the kill switch more often and earlier has been the redeeming quality for many improving funds. We appreciate when GPs clean out the dead wood and adjust for the lesson learned, but never speak of them again.
As each Partner develops their own group of companies or leads certain investments within the overall portfolio, it’s important to avoid emotional buying. It’s critical to establish mechanisms for balance within the partnership to review, set outlook, and prioritize when considering the total portfolio in relation to any single investment. It’s also equally important to disassociate reputational blame.
Unanimity of investment or follow-on decisions are common, underpinned by objective assessments of financial or operational metrics, scenario of returns through future rounds, or capital availability (either through syndicate or internally). An effective team will issue and uphold joint commitment to these markers when making life and death decisions. The quick, performed early, is a hallmark of fund-over-fund improvement. It’s an easy way to build confidence at the LP level.
Killing also means harvesting, or salvaging what remains, bringing the necessity of exit planning and skill to the forefront. Effective decision-making systems and discipline create a long runway for the process, which in turn maximizes the recovery of proceeds. We value teams that avoid simply dumping on a short fuse. This presumes that the fund is either the influential force at the table, or that its views and tactics are aligned with the other key investors. Teams that can create and maintain multi-investor alignment are preferred.
It is often said that the most exciting deal is the one VCs are
about to do. Excitement is high until it isn’t.
The majority of the portfolio will not live up to its aspiration. A team learning how long to lean in and support before leaning back and/or out requires at a minimum the experience of managing at least two prior funds. And it takes more than a mindset. It takes effort to write a decision process for moving forward or moving on and diligence to stick to it.
CEO Swaps
Before a decision to stop funding any portfolio company is made, there has to be a recognition that the company is underperforming.
The last option before cutting the funding of an early-stage company
may be swapping in a new CEO.
While this can work for a growth-stage company, it is often a waste of time for an early-stage company. Let’s also be honest here: if the CEO needs to be swapped out, we’ve made a poor investment decision. If everyone is clear about that, it is usually easier to make these tough decisions. If the CEO was bad enough that the board recognized a swap was needed, there is almost certainly a snowdrift of issues yet to be uncovered for a new incoming leader. It is usually a drag on internal rate of return (IRR) if the new CEO is also accompanied by a fresh round of financing.
The time for the turnaround and growth usually runs the extent of the fund’s term, leaving GPs to point at their great company in Year-13, asking LPs for “patience.” Only swap the CEO if no added capital is required. Otherwise, kill early and save the reserve cash and energy for the outperforming companies deserving of your work and our capital.
Value Add
A venture capitalist once admitted to us that while they often touted their value-add as their differentiator, in reality it was rather thin. Not surprisingly, the funds managed by this person’s team weren’t stout performers. The mantra that we repeat throughout this series of articles is “continual improvement, fund over fund.”
Improving value-add through every fund is critical to staying competitive for investee growth, loss reduction, and ultimately IRR.
Getting to value-add is a critical measure when we are considering an investment in a new GP team. If they point only to their past entrepreneurial exploits and
networks, we know we have to dig much deeper.
Great fund managers that have evolved over a series of funds have built out a machine of value construction that begins churning well before a term sheet is signed. Entrepreneurs with the greatest projections often have many options when it comes to financial partners, so it is in their best interest to partner with a fund manager that has experience and networks, but also has an arsenal of supportive resources.
These resources come in various forms. We have invested in funds that internally provide HR, marketing, sales, tech and M&A support. One of our funds even employs more technical talent than many of the technical companies in which they initially invest. These resources cost money, but the fund managers who efficiently create uncommonly high value also tend to generate the highest IRR.
Creating real value-add requires investment from the GP and it comes out of fees well before the broader value-add team is resolutely established. We watch how GPs allocate their fees for Fund I & II. Are they buying a larger home or are they re-investing in their own company so that the next fund will be a bigger success than the previous? Re-investing in their own company means building value-add, and it is the single most important marker in determining that the next fund stands a chance of outperforming the last.
The best GP teams are building value-add that is so powerful that no sophisticated entrepreneur would consider a competing term sheet. When we invest in a venture fund, it is because we are convinced that the portfolio companies will prosper much more efficiently with this team, their processes and their value-add, than with any other.
Summary
Great management of a portfolio requires these and many other skills that can be acquired only with fund management experience accumulated over successive funds. This is the basis of our refusal to participate with first-time fund managers. Many first-time funds are managed by great former entrepreneurs who lack specific experience in fund management. Notably, in the skills related to getting out. It is a relatively simple thing to invest in a company, but often difficult to get out.
Stay tuned for our next article about Exits.