Friday Aug 10, 2012 by Jo Tango - Partner, Kepha Partners
This is the second post in a blog series on trust.
Last week, I wrote that VC is a “trust business” and I highlighted why trust between an entrepreneur and a VC is important (called “When Entrepreneurs and VCs Break Up” and is here). This week, I’d like to write about trust between a VC firm and its investors.
In 2006, I left a venture capital firm, where I had been a partner for 8 years, to start a new VC firm. To get funded, I met with a lot of institutional investors, called “Limited Partners” or “LPs.” That inaugural fundraising was very interesting. Unaffiliated with an existing firm, many LPs were very up front and shared their thoughts about VC.
A few were very happy with some of their VC managers. But, most were not. I paraphrase one LP who said: the VC industry is guilty until proven otherwise.
For example, one of our major investors has many VCs in their portfolio, but now supports only two: Kepha and a VC firm in China. A major foundation has cut their VC roster from 30+ firms to just five. A leading university endowment has dropped most of their VCs and instead is thinking of bypassing VC firms and investing directly in innovation. More stories like this abound.
Common frustrations I heard from LPs during our inaugural fundraising included:
I think part of the frustration comes from the nature of a VC fund. You see, when a LP invests in a fund, it is empowering a VC with a 10 year-long open checkbook. Funds last a decade and a VC has tremendous freedom with how he invests it. There are limits usually on how much a fund can put into a single investment, but for the most part, the VC has tremendous latitude.
Moreover, if a fund isn’t doing well, the LP has limited recourse. One option is that they can renege on their investment commitment to the VC fund, but this usually triggers a “default” clause whereby that LP will give up 50% of the dollars they’ve invested to-date. These dollars are then allocated to the remaining LPs. So, in practice, I’ve never heard of a LP defaulting.
A second option is to sell their investment in what is called the secondary market. Other institutional investors will bid for that LP’s investment and assume the obligation for the remaining unfunded dollars. Unfortunately, buyers usually bid with a discount to fair market value. So, if a LP has $100 invested in a VC and wants to sell it, bids can come in at $50 or less.
Third, fund documents usually include a “no fault divorce” clause, where a group of the LPs can together vote to hire a new manager to take over the investments. However, the clause often requires 80% or more of the LPs dollars to vote “yes” on replacing a manager, and that is a high number. And, many LPs wonder how easy and practical it is to find, hire and retain a new VC firm to manage a portfolio they don’t know well. So, in practice, these divorces almost never happen.
So, you see, the typical LP is very leery about having his money locked up for 10 years. They must trust that VC. And, trust takes time. Broken trust takes even longer to re-forge.
So, how does all this affect Kepha? We believe transparency is the answer. It helps us earn trust with a LP.
We are a new firm. We have a lot to prove. We know we are one of the new kids on the block with nothing to brag about. But, I’m glad that some of our investors have told us that we have the most honest reporting in the business.
So, trust is important between a VC and an investor. Investors sign up for a 10-year checkbook. It is tough to tell your investors the bad news, but it is the right thing to do. In the end, the bad news will be discovered anyways.
Next week, I’ll write about the other side of this trust factor: why a VC must trust a LP, or not take their money.
Jo Tango is a Partner with Kepha Partners in Waltham, MA. You can find this blog post, as well as additional content on his blog, which is located here. You can also follow Jo on Twitter (@jtangovc) by clicking here.