Friday Aug 17, 2012 by Jo Tango - Partner, Kepha Partners
I’ve been writing a blog series about trust. I started with a post on how VC is a “trust business” and I highlighted why trust between an entrepreneur and a VC is important (more here for a post on “When Entrepreneurs and VCs Break Up”).
Last week, I wrote about why investors (called “LPs”) in VC firms find trust as a must-have before they invest (more here on “The LP and the VC”).
Today, I’d like to write that trust goes both ways: the VC must trust his investors–or shouldn’t take their money.
It’s very important that a VC’s investors have a long term horizon and can tolerate the ups and downs that exist in a VC portfolio. Here’s why:
Why does all this matter? Well, when a VC closes a new investor, he is doing so not just for the current fund, but with the hope that the LP will commit to future funds. So, there is a real opportunity cost to a bad fit.
This dynamic is further complicated when a fund is over-subscribed. Which LPs does the VC firm pick for the fund? If you say no to someone who has done a lot of work, it’s very difficult to re-build a relationship for the next fund. But, if a LP comes into one fund but drops out of the next, all LPs talk and this could taint the next fundraising. So, these are delicate decisions.
Unfortunately, in today’s market, the situation is more complicated. There is a lot of turnover at LP entities. I’ve heard that up to 40% of LP personnel are switching jobs. For example, many great LPs work at public pension funds and, usually, at relatively low salaries. Once a LP has a great personal track record, he may be tempted to switch firms to receive a significant pay increase.
So, the VC may spend years building a personal and trusted relationship with a LP, only to find that person gone. Someone else takes over the relationship with that VC. Since this new LP didn’t make the original investment in the VC, he may not be emotionally committed. It’s pretty tough to “speed date” to a good relationship with someone.
Moreover, the LP that is taking over faces a tough situation. If the VC succeeds, the other LP will get the credit for it. If the VC fails, the new LP can always blame his former colleague for it. So, there is little personal upside and much downside.
This dynamic unfortunately encourages VC firms to generate more demand than their fund can accommodate, and then cut back LPs’ allocations. So, if you’re raising a $200MM fund, you try to generate $600MM of demand. If each LP is asking for $20MM, you cut each back to $10MM. You thereby diversify your LP base. If a few LPs drop out for the next fund, it’s manageable.
(Note: At Kepha, we do the opposite. We like having a small group of LPs, as we think we can better build a trusting relationship with each of them).
So, trust goes both ways between a LP and a VC. Funds are 10-year long entities. It’s important that both parties sign the documents with the intent of being true long-term partners.
Next week, I’ll write about trust within a VC partnership.
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.