In 2020/2021, I invested in four Emerging Manager VC funds (each <$10M in size) and learned valuable lessons while meeting with 50 General Partners (GPs). As an active angel investor, I sought insight, deal flow, and potential co-investments. However, I didn't fully grasp the fundamentals of starting, running, and managing a successful fund.
It's easy to write a check, but it's crucial to understand what you're investing in. While I met fund managers and understood their thesis at a high level, I admittedly didn't delve into the details of their Limited Partnership Agreement (LPA). Although nothing bad or nefarious happened, I strongly recommend that any potential Limited Partner (LP) considering a fund investment should understand how it actually operates, just as an investor should know how notes, SAFEs, and priced rounds work.
Key Factors to Evaluate
Here's a comprehensive guide on what you, as an LP, should evaluate when considering an investment in an emerging venture capital fund:
1. Capital Contributions
Understanding your capital commitment is crucial:
Commitment Size: How much capital are you committing to the fund? This could range from smaller allocations in micro-funds to larger commitments in more established pools.
Capital Call Schedule: How often will the GP call capital? Is it in stages as the fund finds investments, or are they asking for upfront contributions? A clear understanding helps you manage cash flow expectations.
Management fees significantly affect your returns:
Standard Fee: Most funds charge around 2%, though this can vary depending on fund size and strategy.
Fee Schedule: How are these fees applied? Is the fee front-loaded in the first few years when most investments are made, or is there a drop in fees as the fund matures? Sometimes fees taper off after the investment period, reducing operational costs as investments begin to exit.
Carry, or carried interest, is the share of profits that the GP earns after the fund's returns exceed a set benchmark:
Typical Carry: Most funds offer 20% carry, though some emerging managers may offer more favorable terms, like 15% carry, to attract investors.
Hurdle Rate: Look for any hurdle rates, such as an 8% preferred return that the fund must achieve before the GP receives carry. This ensures that LPs see a baseline return before profits are shared.
4. Investment Strategy & Deployment
How a fund deploys capital and its overall investment strategy are crucial considerations:
Percentage Deployed Before Next Fund: Emerging managers typically need to deploy a large portion (usually 75%-90%) of their capital before raising another fund. This ensures focused and diligent capital management.
Number of Investments: Is the fund concentrated with 10-20 bets, or more diversified with 30-40 investments? Understanding the fund's approach to diversification helps you gauge the risk profile.
Follow-On Strategy: Ask about the fund's follow-on investment strategy. Emerging managers may reserve 20%-30% of the fund for follow-on rounds, ensuring they can support their best-performing companies as they scale.
5. Lifecycle and Recycling Provisions
Understanding the fund's timeline and how proceeds will be managed is essential:
Fund Term: Most funds run on a 10-year cycle, with a few years dedicated to investing and the rest focused on supporting existing companies and making exits. Will the fund have any extensions if necessary?
Recycling of Distributions: Some funds offer recycling provisions, allowing them to reinvest early distributions back into new opportunities. This can maximize the potential value of your initial commitment.
6. Liquidity & Distribution Preferences
LPs should understand how and when they'll see returns:
Cash vs. Stock Distributions: While most funds aim to return capital in cash, some may also distribute stock from portfolio company exits. Consider whether you're comfortable receiving stock and how quickly it can be liquidated.
Clawback Clauses: A clawback ensures that if the GP is overpaid in carry early on, they repay LPs to maintain fairness. This protects LPs in case of later underperformance by the fund.
The amount of capital the GP personally invests in the fund is an important factor:
GP Skin in the Game: A GP committing 1%-2% of the fund shows confidence in their ability to deliver returns. Some GPs may offer even higher commitments to align their incentives with LPs.
8. Governance & Control
Consider your level of involvement in governance, especially with an emerging manager:
Advisory Committee: Many LPs participate in advisory committees, which oversee key decisions like conflicts of interest or extension of fund terms. Understand your rights and obligations as an advisory committee member.
Key Man Provisions: Emerging managers may rely heavily on one or two key individuals. A key man clause ensures the fund is paused if these individuals are unable to continue managing the fund.
9. Risk and Diversification
Emerging managers often have specialized strategies, so it's important to understand where and how they plan to invest:
Sector & Geographic Focus: Does the fund have a clear focus, such as SaaS, deep tech, or fintech? Are they concentrated in specific geographies? Emerging managers often have a unique edge in niche markets, so understanding their focus helps you assess alignment with your investment goals.
Stage Focus: Are they targeting early-stage startups or late-stage growth companies? Early-stage funds may have more potential upside but could come with higher risks.
10. Reporting & Transparency
How often and how clearly the fund communicates its progress is vital:
Reporting Frequency: Most funds provide quarterly updates. Some emerging managers offer more frequent communication, especially in the early years, as they establish credibility.
Valuation Methodology: LPs should look at how the fund values its portfolio companies. Transparent and conservative valuation methods provide a clearer picture of fund performance.
11. Co-Investment Opportunities
Emerging managers often offer co-investment rights, giving you access to top deals:
Co-Investment: This can be an attractive opportunity for LPs to double down on the fund's best-performing companies. Make sure to discuss the terms of any co-investment rights.
Why Invest in Emerging Managers?
Because they’re awesome and the foundation of the entire tech, startup world!
Access to Untapped Markets: Emerging managers often have their fingers on the pulse of new, innovative sectors and geographies. They may offer access to opportunities that established funds overlook.
Personalized Attention: You can often expect more direct engagement with the GP and potentially more influence over the direction of the fund.
Attractive Terms: Emerging managers sometimes offer more favorable fees, carry structures, and co-investment rights to attract LPs and build a track record.
By thoroughly evaluating these factors, potential LPs can make informed decisions when considering investments in emerging venture capital funds. Remember, due diligence is key to successful fund investing.
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Trace Cohen@Trace_Cohen
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