LIMITED PARTNER ARTICLE SERIES
Our Views on Fund of Funds Investing – An Article Series
OUR VIEWS ON WHY WE DO NOT INVEST IN FIRST-TIME FUNDS
Intro
First-time fund managers are often active angel investors and/or successful entrepreneurs who assume they will be able to expertly guide portfolio CEOs to maximize on their opportunity. It’ s a compelling theory.
So why is it so difficult for those first-time fund managers to raise institutional capital? Certainly, 2020-22 saw a surge of capital that enabled many first-time funds to spring to life. Many of these funds are smaller with managers seeking larger successor funds. These new but smaller funds tend to attract capital from high-net-worth individuals and some portion of ecosystem building institutional capital. But building from there can be difficult, because it takes the participation of returns-driven institutional capital to get to the envisioned $200MM – $300MM fund size for a typical Series A fund.
First-time entrepreneurs often lament the lack of venture capital. Similarly, for first-time fund managers, availability of capital can also seem bleak. GPs seek to assemble a fund — they’ll put up their own cash and attract high-net-worth participants — but predictably run up against resistance from institutional investors capable of significant participation. This article explains our stance with respect to first- time fund managers and why we do not participate.
We expect this article to be the most contentious of our series, so let us reiterate: we are simply noting our view and obviously do not speak for all institutional LPs. These are not opinions lightly imagined. Rather, these points are our view because they are based on our earned experience and hard lessons learned, which have helped us to achieve tremendous returns as LPs. We could write 1,000 pages here, but we will blatantly make broad generalizations in the interest of brevity.
The table below is an over-simplified but honest representation of our view of the fund manager market. Not unlike how fund managers track companies for potential investment, we track fund managers. This table provides a quick illustration of that tracking.
Team Longevity
For us, a team that has not worked together for a substantial period is a significant risk. Business partnerships are often difficult and partnership failures are common. This alone poses enough risk to not consider a first-time fund. It is best when the GP is composed of team members that have worked together previously . But even with that in place, working together is different from investing together.
Entrepreneurial success and its ingredients are very different fundamentals, and being a great investor takes years to learn. A group of outperforming, Type A individuals thrown in a room to work together is often tumultuous. The recipe works if first-time fund managers have worked together at a larger fund prior to starting their own. It might be a first-time fund, but it won’t be the first time the team has made strategic decisions and invested together. This team has a much higher probability of succeeding. Funds that are pulling together their third fund have typically settled in and they have structure in place that allows them to operate as well as their better performing portfolio companies.
Team Upscaling
Every position at a fund is critical early in the fund series. Teams that hire up for both skills and experience will always outperform those who do not. A core founding team must be excellent in their own right; however, who they subsequently attract reveals the vibrancy of the GP. Hiring outperformers multiplies the probability of the success and succession of the fund.
A great example of attitude is typically in the second or third fund, when additional Partners or value-add talent are brought onboard. Were these run-of-the-mill executives or stars who had myriad opportunities from which to choose? Hiring up is a key indicator of future performance. It is equally important that the team continues to build in a manner that the performance of the fund is not unduly contingent upon a single Partner. The fund team should be so well augmented that the departure of a senior Partner will create little or no disruption within the organization.
Pre- & Post- Investment Processes
We have up-close and personal experience with many fund managers, and track many, many more. The best managers improve their processes. The worst managers point to their “nose for opportunity” or go off gut/intuition and have precious little process to follow as the team grows. Most live somewhere in the wide expanse between expert and underperforming but in the beginning, during the first fund, there is little in the data room to suggest that any process or policy exists at all. It takes many investment errors for fund managers to understand the need for process and policy. In the first fund, the venture manager is just too new to have all the sophistication of a fund manager with a series of successful funds.
Back-office Systems
The best GPs use their fee base to better their company, and that includes using the appropriate systems. These systems are often price prohibitive until fund size swells closer to a high- eight- figure total of committed capital. Outsourced services can be used until those functions are taken in-house. Teams that try to track it all out in a spreadsheet and have a neighbour accountant help at a friends’ rate won’t be taken seriously. Fund management and its reporting are complex, and every fund should immediately track and report as if they were already as large as their vision. When LPs considering investment in Fund IV are going through the data room of Funds I, II & III, they will be very impressed by the level of professionalism at even the earliest of days.
Value-Add
Entrepreneurs always have a desire to know an investor’s single most important investment criterion . GPs may ask the same of LPs. The truth is, it’s all important. By Fund IV (see table), managers should score very high on all aspects. However, if any returns-motivated LP were to participate in an earlier series fund, the value-add is not an area that can produce a low score at any time. Value-add must be material and robust.
LPs may provide allowance for fund- over- fund improvements in back-office systems, but if the team cannot demonstrate a differentiated value-add, there is no reason for that team to attract any capital from returns-motivated LPs. Too many teams point to (entrepreneurial?) operating experience and networks as the extent of their value-add. But that already exists at an absolute minimum in well-established, high-performing funds, so why would the LP take the risk of participating with an earlier series fund? It’s true that, in the earliest days of venture capital, entrepreneur experience and their accumulated networks were the full extent of value-add, but they’re now insufficient to compete in an ever-advancing industry. The best funds now support efforts related (but not limited) to technical development, marketing functions, sales, HR functions, scaling, finance, exit preparedness and optionality. The manner in which they support and accelerate companies has been elevated to such high art that many intelligent CEOs are looking well past term-sheet valuations as a determining factor.
Fund Thesis
We invest in funds seeking companies that solve problems within enterprise solutions. While “enterprise solutions” may sound fairly generic, we are interested only if we believe the team we choose to back is uniquely and best suited to capitalize on the investable opportunities within any particular sector within that spectrum.
We often hear from GPs pursuing a thesis that outlines a large funding gap within a defined market and/or geography.In our experience, the team has often not done their math. For a single fund to establish a portfolio of companies, the market must be witnessing a very substantial population of companies seeking capital within that sector. If only one other fund is pursuing a similar thesis in the same sector/geography, holding all else equal, the market must be witnessing twice the number of companies seeking capital. And with every other fund pursuing the same thesis, the required market of deals must increase in the same manner.
Here’s what often happens. A strong cycle produces impressive exits within a particular sector, so several new funds spring up to go after that market — but there’s now 10 funds pursuing a sector that has only 3,000 companies . The “A” deals get done, but then so do the “B” deals (and many “C” deals as well). The “funding gap” usually does not exist. Again, this is just our view. We expect some to feel very differently.
We have, however, seen many fund managers refine their thesis over the course of the series. While some thesis alterations reflect market shifts, more often they happen when a GP recognizes exactly where in the market they can be efficient versus competing funds. In the best funds, the refinement of a thesis over the series of funds always draws closer to the core of the value-add of the fund team.
Performance Metrics
There are thousands of first-time funds in market, fewer second funds, even fewer third funds, and so on. Fund teams need time to bolster all the criteria that have been discussed in this article, and more. As a result, teams are afforded less than upper- quartile metrics at first. Then, if the team can demonstrate what mistakes were made and what has been learned and thereafter codified into standard process, some LPs may entertain the potential of a second or third commitment.
It is not a coincidence that fund teams that work on team upscaling, pre & post-investment processes, back-office systems, value-add, investment thesis, syndicate networks and exit agility tend to produce fund- over-fund improvements in performance metrics. We have on occasion been confronted with “Hey, we just produced great returns on Fund I” and the idea that we should therefore drop our investment policy limitations against funds early in a series. While first-time funds can produce great returns, it is much easier for us to choose from teams that have produced fund-over-fund improvements in all these critical areas, because it illustrates their commitment to long-term success. A first-time fund producing great returns may have simply been the benefactor of a frothy market condition that made most funds look good. Or the first-time fund may have benefited from a grouping of investee companies that were close to them personally, but they have not built out a deal flow engine that ensures they get continuous high-level prospects over the longer term.
Syndicate Network
Clues about the professionalism of the fund manager can be garnered by the company they keep. In poker terms, the ability to attract co-investors of a high calibre is a significant tell about the cards they hold. That bit of evidence is further bolstered when those high-calibre funds repeat the association with additional co-investments. Fund managers need to build out syndicate networks with trustworthy, like-minded professionals. Bringing new fund managers onto the board of the investee introduces a certain amount of risk. That risk is mitigated if the onboarding GP is well-known to the incumbent GP. Investors that collaborate, work and exit well together enjoy a mutually beneficial arrangement. It would behoove any GP to seek to expand and upgrade their syndicate network, fund-over-fund.
Exit Philosophy
Exit philosophy is so important to us that it is generally our first question when speaking with GPs soliciting our commitment. A fund with a 10-year commitment requires strong alignment between GPs and LPs if the relationship is to survive and attract subsequent commitments. It is therefore in everyone’s best interests that the exit philosophy be aligned right from the start. We can all agree on all manner of fund management, but if we’re at the end of extension years and the GP is seeking extensions to those extensions because portfolio companies still remain, we’re not aligned. Our view is that the purpose of extension years is to clean up what didn’t get done during the 10-year term of the fund, not to try to give breathing room to portfolio companies that might turn around. The dogs should be cleaned out prior to any extensions. We discuss this a lot with GPs to ensure we’re aligned before we ever consider a new commitment. Because we feel it is so important, “Our View on Exits” is a standalone article in this series.
Summary
There are several significant misperceptions about fund management. The first is that when prospective fund managers see companies without funding, they initially believe that signifies a funding gap. In reality, they may be seeing lesser deals that should never get funded and not a gap at all. A second misperception, held by many prospective and new fund managers, is that they already have what it takes to be a sophisticated fund manager. For example, when a new fund is managed by former entrepreneurs who believe that their entrepreneurial experience is the basis by which their fund will be successful, which of course is only one of many requirements.
We’ve listed only a few differentiating requirements in this article, but these are the basic areas that need constant improvement over the fund series. No one starts Fund I with the sophistication of Fund IV. It takes years of experience and several funds to build out the infrastructure and skills required of an upper-quartile fund manager. Fund managers need those first funds to get it all put together. In our view, there is no shortcut.