Gatekeeping, pattern matching…are LPs judging first-time fund managers wrong?
LPs need to change how they evaluate emerging fund managers — the future of VC depends on it.
Being a fund manager is a lot like being a startup founder. Cold emails, pitch decks, tons of meetings, back and forth communications, and sometimes at the end of all that, there’s a signed agreement and the wire is sent.
Just half of running a venture capital firm is deploying capital into startup founders. But no one really talks about the other half: raising the capital for the fund. As it turns out, there's not a lot to go off of as an emerging fund manager. Not knowing exactly what limited partners are looking for proves to be difficult for emerging fund managers, and this difficulty even trickles down to the founders. So why aren’t we talking about it more?
In the last few years, the spotlight was on the ins and outs of startups raising funding from a venture capital firm and how/why VCs were allocating their funds to certain startups. But we’ve left out an important piece of the puzzle; limited partners, or the funders of the funds.
The ambiguity surrounding LPs and raising a VC fund keeps emerging fund managers up at night. There’s no clear set of standards to follow, and often, LPs have conflicting opinions. And with what little feedback fund managers receive from LPs, it’s clear that their decision-making is not suited for the new era of VC.
The current methods LPs are using to pick fund managers are flawed. Pattern matching, when an investor uses an experience from the past to influence current investment decisions, is inherently bad because the past is antiquated and biased, as Samir Kaji mentions above. Gatekeeping is another problematic trend in venture. Intentionally or not, limited partners turn away new, and underrepresented fund managers. The problem goes down to the VCs and funds themselves.
We’ve got to change this, at the very least for the sake of the founders we are investing in.
As emerging fund managers ourselves, my partner Brandon Brooks and I have experienced the patterns and gatekeeping first hand. We’ve been asked, “Why aren’t you picking the best founders?” and have been told, “We have $100M to allocate but only $2M in the diversity bucket.” This goes to show us that these LPs have no idea about the statistics which show historically ignored founders outperform.
We’re no stranger to “no” or being passed on. We know what it’s like to be rejected. Below is a tweet of reasons why, and how conflicting they are across LPs.
What Twitter Had to Say
After so many internal discussions, Brandon took his thoughts to Twitter, and a lot of people weighed in. We were flooded with responses from people who wanted to join in on the conversation or just listen because they’ve experienced the same when raising funds of their own.
Because of the overwhelming response from Brandon’s tweet and our goal to bring transparency and change into VC, we hosted a Twitter Space on Thursday, January 19 to open up and encourage the conversation.
This spirited Twitter Space lasted two hours, and each minute was filled with honest opinions and experiences from GPs and LPs. Over 1,000 people tuned in to hear our featured speakers chime in on the topic, including
- Del Johnson: A VC, Angel, Micro-Fund Manager, Distributed Scout, and Editor, Del Johnson is immersed in the world of startups and venture capital.
- Zécca Lehn: GP of Responsibly VC, a pre-seed fund investing in sustainability and social good.
- Trish DiGirolomo: Trish is an Endowment Investments Manager, Operator and Fractional CFO, and is enthusiastic about all things Private Markets.
Brandon kicked off the conversation by defining a few terms to make the space open and accessible to everyone.
A glossary of terms, if you will.
Venture capital is just one section of the larger category, private markets, which are investments in privately owned companies. In venture capital, limited partners put money into the fund and the general partner(s), also known as GPs, take that money and put it into startups. To further explain, here’s a chart breakdown of each that we published in a previous article.
Limited partners can take many forms.
- High net worth individuals (HNWs) are individuals who are accredited investors that have at least $1 million in liquid assets or income above $200,000 ($300,000 joint income if they’re married), according to Rule 501 of Regulation D of the Securities Act of 1933.
- Institutional investors invest on behalf of other people (Investopedia). Think companies or organizations like pensions, endowments, commercial banks, hedge funds, and insurance companies.
- Family offices manage investments and assets of very wealthy families.
It’s important to note that each LP has different thought processes and approaches to choosing funds and fund managers.
Now that we’ve covered limited partners, let’s dive into how general partners raise capital from limited partners, and how venture capital funds are structured. Two common venture fund types are 506(c) and 506(b).
- 506(c) funds are opted for because you can engage in solicitation, or raise publicly. Investors in 506(c) funds must also be accredited investors.
- 506(b) funds are not allowed to advertise or raise in public. No more than 35-accredited investors can own securities in the fund.
Rolling funds, investment vehicle that is structured as a series of limited partnerships, are typically 506(c) funds. In a rolling fund, managers can share deal flow with investors each quarter, as described by Rolling Fund News.
Staying True to Your Fund
After the brief introduction, we dove into the discussion. I started off by covering the conflicting opinions that emerging fund managers get when raising money from LPs. The moral of the story, every LP wants different things out of an emerging fund manager. But as a general partner, you have to stay true to your firm’s thesis because…
a) you don’t want the wrong type of people investing in you
b) the ones you want will find you
c) you should not sacrifice or change your mission and values for anyone
I opened the floor up to Del Johnson, who has done tons of research on the back office operations of LPs and venture capitalists. Even from studying this deeply, there still isn’t a lot of information out there.
“If you think there’s little information out there about how venture capitalists evaluate startup founders, there’s many many times less information about how limited partners evaluate VCs.” — Del Johnson
This fact hurts every part of venture capital — the LPs, fund managers, and even the founders. There’s a long history of limited partners pattern matching or doing things the same way as the ones before them did. But this doesn’t work when it comes to venture capital.
An LPs Perspective
We then turned to Trish DiGirolomo, who works at an endowment fund, to share what she looks for in funds. Here’s the questions VCs want the answer to from an LP’s perspective:
- Why are you different?
- Why are you the person to drive outsized return?
- How is it repeatable?
- Why are you capable?
- Awareness of who you’re talking to?
- Build relationships early?
Trish also noted that it’s important to know the ins and outs of your portfolio’s construction and how your fund works related to the LP. And understanding it is not enough, you need to communicate it to the LP. Another takeaway from Trish is that a “no” now is not a “no” forever. Some institutional investors prefer investing in Fund 1 or 2, and might ask that you contact them when you are at that stage.
Trish also shared the most important question that she asks EVERY fund manager she talks to: “What do you have to believe in order for us to invest in you?”
Do trusts and relationships influence LP decisions?
Next, the conversation transitioned into dependence on trust and relationships LPs have when choosing which LPs to invest in. Jay Kapoor, a seed and early stage VC and VSC Ventures, brings up the topic of trust and its importance to his early fundraising efforts. He believes that trust can be built in a variety of ways, via Twitter or an affinity relationship.
While I understood the idea of building trust, I chimed in that one of the best ways to see change and move away from pattern matching, referencing the tweet by Samir Kaji. I also emphasized reaching as many LPs as possible aside from traditional institutional LPs, so that more emerging LPs can join our fund.
This led into a conversation about the importance of community when fundraising, instead of relying on networks (that don’t exist for all of us).
Del entered the chat saying that LPs often rely on trust because they are uneducated and are under a time-constraint. He brings up the real problem that venture capital has: is that the things that LPs say venture capitalists need to have are actually bad and are based on assumptions. It can often lead fund managers to distort their thesis and mission, which ultimately hurts everyone involved and brings in less value.
“There is no actual financial reason why LPs need to establish personal relationships with VCs. It’s a financial transaction.”
Del also shares a study from the Swiss Institute of Finance that found when LPs have a prior existing relationship with a GP, it increases the likelihood that they will invest in that fund by 30% and this often led to less returns and lower performing funds.
This is exactly why Overlooked Ventures exists. My partner Brandon Brooks and I want to make an impact on the people receiving the funding and we know we have to start somewhere to break the cycle.
Emerging fund managers flipping the table
Emerging fund managers are changing the game, for venture and startups. Back in September, Brandon and I spoke at a meeting of the US Department of Treasury, where we educated professionals from state agencies across the country. I wrote this article back, uncovering the issues in the allocation of capital into VC funds, and why LPs should reconsider who they’re writing checks to.
From the article: “Institutional investors and limited partners should consider backing emerging fund managers because it leads to stronger funds and higher returns…EFMs bring a fresh perspective to venture, and it’s working in their favor.” The proof is in the data. Cambridge Associates, Prequin and PitchBook all came to the same conclusion: investors who back emerging fund managers get better returns.
Despite the numbers, 78% of capital raised goes to experienced general partners. How do we change this behavior?
We need to make a new playbook. Look, people are getting the same information from the same places and so how do they expect anything to change? Here are a few things we do at Overlooked Ventures.
- Educate those in power
- Ban warm intros
- Eliminate GP Commit
- Decline deal-flow requests from matching tools and networks
Just as importantly, how should LPs evaluate first time fund builders, according to the fund builders themselves?
- Do they have unique insights and access to deals you might not see?
Frank Rotman is one of our LPs and co-founder of QED Investors, a fintech VC fund that just raised a $1B fund 7. Frank recently shared on Venture Unlocked podcast what he would be looking for if he were running an endowment fund. He said,
“I would be seeking alpha in the earliest stages in the ecosystem with the managers that can find non-consensus investment opportunities.”
Frank openly shares that the biggest alpha is in early-stage funds, early-stage managers, and those who find unique and different opportunities. He invested in OV because we embody everything about that.
2. Is there an intimate understanding of the fund manager’s portfolio construction?
Not just WHAT markets they’re investing in. But what does the portfolio construction look like in terms of number of deals, check sizes for each, target ownership, follow on reserves. These are things that LPs should be asking to managers.
3. What does their community look like? Can the community they’ve built help their portfolio companies in someway?
We started OV as a community before it was even a venture firm. And let’s be honest, community if very important for early fund managers. Advisors and people to go to when you are just starting out. Also community in terms of the people to help your founders if they are just getting started.
Something we just started doing at Overlooked Ventures is a new monthly gathering with our portfolio company founders where we are getting together (virtually for now) to help each other conquer challenges. It started because I used to attend gatherings in Columbus called Startup Cafe where founders, investors, mentors, and business execs would get together casually once a month over coffee, discuss a theme, and connect each other or solve roadblocks. Being the only woman there, I was always quiet and just took notes. Now I’m bringing that idea to our portfolio company to ensure that they have a safe and inclusive space to ask questions and get real candid answers. We bring experts to the meetings to help these founders with different things.
Our next one is all about the importance of media relations and brand awareness for a pre-seed startup. Our guest is a Forbes reporter and PR specialist who will field questions from our founders. Things like this can really help founders with funding know how and when to allocate marketing spend and how to do more self-made media.
We’re entering a new era of VC, and limited partners need to catch up. Emerging fund managers and diverse VCs are ready to deploy capital into overlooked founders. When will you join us?
You can listen to the full recording of the OV VC Chat / How LPs judge 1st time funds here.