LIMITED PARTNER ARTICLE SERIES
Fund of Funds Investing – Our View
OUR VIEWS ON EXITS & EXTENSION YEARS
We get many pitch decks about the raise of venture capital funds. Most of them display impressive stats to entice the reader to lean in. Gross Internal Rate of Return (IRR) and Total Value Paid-in Capital (TVPI) and Multiple of Invested Capital (MOIC) data are often emblazoned in large, bold font regarding the previous funds. Either they do not want us to miss these stats, or they assume we’ve lost our reading glasses yet again.
While we are sure both are often true, these stats are simply department store window displays promising incredible deals inside. DPI (Distributions to Paid-in Capital) is the magic. Of course, a strong DPI metric is typically only found in a mature or maturing fund, but it is surprising how many aging funds cannot point to distributions while other metrics might suggest success has already taken place. We recently inquired about the metrics not included in a deck and we were asked to sign an NDA prior to such disclosure. No.
We have managed several funds of our own and sold the last company within the portfolio of the small fund. The five-year fund (BridgeCo Capital) was built to invest in venture-backed companies whose current venture backers and portfolio management teams were aiming for an exit or sale within a 2-year period. We wrapped up the fund with five months to spare. In managing that fund we met with dozens of venture teams. We were targeting funds late in their term, which would theoretically create exit pressure for their remaining portfolio companies and allow us to ride along on a final financing for a last-in-first-out burst of quick returning capital. While that did occur with the particularly good teams with whom we partnered, we were quite surprised by the others’ lack of urgency and fixed commitment to an exit, even though they were remarkably close to the end of fund term. We quickly learned who was serious about generating exits and who was not. This was important information for us as potential downstream Limited Partners who expect DPI for our committed capital. We were able to cross a lot of funds off our list of prospects through that experience.
Venture funds have ten-year terms, yet it is rare to find a fund that wraps up within that period. Most require one, two or even three extension years afforded by the Limited Partner Agreement (LPA). Use of the extension years is bothersome only when they are used for the wrong (in our view) purpose. More disturbing is that it is common for GPs to seek a further LPA amendment to extend even further, until funds are old enough to ask mom for the car.
Our view is that on the fund’s 10th birthday, we sing, give a good pat on the back, and start cleaning up because the party’s over. The GP team should have made every effort to have exited by the fund’s termination, although we do recognize there are always a couple of leftover portfolio companies that require extension years. As an LP, we view term extensions as providing limited runway to complete liquidation processes. We do not ever agree with using extension years in anticipation of a portfolio company reverting course to become a winner. The pursuit of the hopium turn-around dream is aggravating.
We understand entirely why so many fund managers pursue this tactic. These tend to be underperforming funds that won’t pay the material carried to the GPs that they imagined when starting the fund so long ago. So, nearing the end of term, GPs look to what portfolio companies remain in hopes that they will soar to greatness in the extension years and create their payouts. The truth, though, is that it does not work. Those companies that are “six months from profitability/massive deal/inflection” so rarely get there while hurdles build, expenses accumulate, and dogs remain barking dogs. Extension years are created for exits and not for growth, so let us all admit it did not work out as planned and wrap it up.
At BridgeCo Capital, our last positions were sold in secondary transactions at less than favourable terms because we needed to remain true to our term. The fund was profitable and those last portfolio companies were so close to greatness/Covid19 recovery….You get the idea. Just pointing out our walking the talk moments.
All this brings us to a key condition that we seek in a team of fund managers: an exit mindset. We have had first conversations with teams who say they’ll never press for an exit or that “companies are bought, not sold,” and other nonsense. In those cases, there is no second conversation. If you are an LP, I would suggest you try this. Ask one of the GPs what the exit value expectation is for the near-term exit (2-3 years) companies for which they are responsible. Then ask the CEO of those companies the very same question and you may or may not be shocked to learn that those numbers are often not even close to being similar. That’s because the exit planning process has not ever been part of the discussion, even though the fund is mature. Exit planning should be part of the continual GP/CEO discussion agenda. Not discussing process, targets, planning and value expectations only leads to misalignment when it matters.
Certainly, significant blame for exit latency and a soft GP exit program lies at the feet of LPs. They get what they tolerate. Communicating a consistent message to GPs about exit expectations within fund term, beginning with due diligence, is rarely upheld over the term and is finally knee-capped by low resistance to probes for extension(s). Alternatively, LPs must adjust their own mindset as to what performance means if the invested capital is marginally or partially returned, but within the term. GPs will need to hear from their LPACs that their performance is judged heavily on this basis. Epic market stalls such as 2001 and 2008 come and go and that cannot be avoided. Extension grants can. LPs should be prepared to satisfy themselves with modest total fund return if they are able get back into the market. Recognizing that GPs do not wait until end of term to raise the next fund, LPs with consistent messaging and action to match will see rapid change.
To some LPs, this may seem to create a disincentive to maximize efforts as end of term approaches in a modestly performing fund. If in the best judgement of the LPAC an extension is unlikely to generate meaningful carry to the team, it is time to just flush the portfolio anyway. A wildly underperforming fund is unlikely to return LP capital, and a marginal fund will not make the effort worthwhile. LPACs should hold separate meetings to discuss proforma exit scenarios beginning in year 7 and then annually thereafter based on information feed-ins from the manager, as necessary. In this way, adequate LP alignment and preparation for extension-year discussions will have been seeded. Hopefully, those conclusions are fed back to the manager routinely so a thumbs down at end of term is not a surprise.
The necessary background work can be difficult. Institutional LPs are tasked with the oversight of dozens of fund allocations. Depending on the information quality, systems for aggregating and analyzing, and degree of portfolio insight provided by the General Partner beyond LPAC meetings, the ability to gauge “exit-ability” can be challenging.
All the above assumes LPs are nearly like-minded in this approach. Splintered LPACs will diffuse the effort. Beyond just an assessment of the GP, LPs will be forced to consider the structure and makeup of the LPAC. Locking arms with other LPs, or the influence of some subset, may not be worth it either. A note to GPs on feedback loop: . LPs need to get better at coordinating themselves on governance issues when they arise, and in providing feedback to the GP. Too often, a designate is cajoled into the duty of gathering LP feedback after in-camera or other form of interaction. Feedback is important and should be embraced as a valued mechanism to advance the relationship if the LP discussion yields it.
This means, however, that the meeting cannot be a dump of company portfolio news ferreted out of the package just before the meeting. It also means that swamped LPAC nominees need to steer conversation toward the future rather than dwell on past customer misses or failed financings in portfolio review. What remediation steps are being planned or implemented? What are prospects for exits, and why? Is there a path to 0.5x or 1.0x DPI —and when and how? The interest does not seek promises but only to reinforce expectations that should be set in due diligence, particularly on exit philosophy and fund term. If consistently done, this engages GPs and LPs in meaningful dialogue. Far too often the onus for quality interaction is left to the GPs and results in a missed opportunity. Importantly, LPs become more familiar with the rationale and reasons behind fund and portfolio decisions that can create more buy-in under pressing circumstances and advance mindshare or commitment to the successor fund.
As we consider our own cash return models from our own direct investments, we make adjustments reflective of many elements, but alignment is our leading measure. Our alignment with the portfolio company management and the other board members is critical if we are to expect any semblance of order as the team prepares for a liquidity event. Where alignment does not exist or has been lost, our view is that selling off in a secondary or even taking a loss is usually the best course of action as it will be better to expend energy elsewhere. Any fund manager can create a portfolio of investments. Great fund managers have a complete model for value-add that produces measurable impact for their investees. The best fund managers also have a complete process for exit planning and getting out in time.
Just as GPs need alignment with their investees, GPs and LPs need to be aligned. While there are generally few occasions for the GPs and LPs to be significantly at odds, lack of alignment on exits and liquidity is the most troublesome. Discussions regarding exits and exit philosophy need to be undertaken before any LP completes a subscription agreement. This simple conversation held prior to fund term extension due diligence can save a lot of work now and aggravation later.
Warren Bergen began his work at AVAC Ltd. in 2011 and was promoted to President of the organization in 2015. He established AVAC’s BridgeCo Capital Fund I with Mark Carlson in 2017. Warren is a member or observer member of the Limited Partner Advisory Committee for several venture capital funds. Warren is a Partner of Accelerate Fund I, L.P., an early-stage technology fund and serves on several boards including Alberta Machine Intelligence Institute(AMII).
Mark Carlson began his work at AVAC Ltd. in 2009 and was promoted to Managing Director of the organization in 2015. He previously worked with several funds and co-founded BridgeCo Capital with Warren Bergen in 2017. Mark is a Partner in Accelerate Fund I, L.P. and is a member or observer member of the Limited Partner Advisory Committee for several venture capital funds. More broadly, Mark has managed the full cycle of venture transactions including serving as a Director on numerous boards and has completed 50 marathons.
Our team brings venture capital and entrepreneurial experience valued by our investment partners and portfolio companies. Collectively, we are entrepreneurs, investors, science and technology experts, company builders, and business drivers. Our management team is fully immersed in the entrepreneurial and venture profession across all technology domains. AVAC is invested venture capital funds managed by Inovia Capital, Finistere Ventures, Georgian Partners, Yaletown Partners Inc.