Finding the 10x Fund in Venture | AWM Insights #110
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Episode Summary
There are around 2,000 venture capital firms managing about 4,000 funds. It’s a small market in the grand scheme, but many aren’t worth investing in. The return difference between the top 25% and bottom 25% is staggering.
This is a game of professionals. It’s no different than elite athletes competing at the highest level in professional sports. The same separation of talent exists in the venture capital arena. Investors with the best access look for 5x or more in returns.
What else does it take besides capital to invest in venture? Are you an accredited investor or a qualified purchaser? Are you investing as an individual or an LLC? Are you making directs, allocating to funds, or even diversifying into a fund of funds strategy? Justin and Brandon give you the details on how the whole process works.
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Episode Highlights
(1:02) How do I find the next all-stars and Hall-of-Famers in venture capital?
(1:45) It is difficult to find the best-performing managers, funds, and even more so portfolio companies. And you are only rewarded if you can get into the best ones.
(2:18) There is persistence in the data. This means the best managers in VC are able to repeat their performance. This is NOT like the public markets and their managers.
(3:03) A different ecosystem in the venture space creates the opportunity to keep outperforming. Informational asymmetry and access to top-tier networks are the most significant drivers of persistent returns.
(3:32) Is a VC manager going to keep outperforming his competitors?
(3:55) Just getting access and an allocation to the small group of winners can be extremely difficult.
(4:50) If someone is banging down your door to invest in their fund, that’s a red flag. The best funds returns speak for themselves and don’t need to search for capital.
(6:40) When you finally decide to invest in a fund as a limited partner, what happens then?
(7:00) You must be an accredited investor and many of the top funds require you to be a qualified purchaser.
(7:16) Next, you need to read and sign a lot of documents including an operating agreement that establishes the role of the general partners.
(8:08) A lead investor or anchor investor is the person or group that takes the largest stake. They help negotiate and establish parts of the partnership agreement.
(9:16) How are you coming in to invest, are you an individual, trust, or LLC?
(10:12) What is a fund of funds structure? A fund that can get access and diversify into many different VC Funds.
(10:49) Trade-offs for fund of funds are possibly lower rates of return because the diversification caps your upside on the winners. The expenses also reduce returns to you the investor.
(11:40) Venture capital funds look to return 3x to their investors. To get that kind of return with the fees charged, VCs must find companies that can do greater than 10x before fees.
(13:56) Venture capital’s return profile is called a J-curve.
(15:32) In a perfect scenario, the venture investment turns into a hockey stick and goes mostly vertical before the exit.
(16:00) What are the fees in venture? Usually 2% of committed capital and a “carry” of 20% of profits on the exit.
(17:11) A $9M appreciation in a portfolio company would deliver $1.8 million to the VC and $7.2M to the investors. This is the carry and why so many smart, competitive people are in the space.
(18:22) The best VC firms can be selective with who they allow as limited partners.
(18:44) Just being a professional athlete is not enough to get an allocation to top VC funds. What else do you bring to the table to help achieve a successful outcome?
(19:04) If you’re an athlete can you provide a unique way to add value to venture firms?
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+ Read the Transcript
Brandon Averill (00:04): Well, Justin, we're back for another private markets chat here. We focused last week, a little bit on the entrepreneur, why they may want to go to a venture capitalist raise money, what it means to the company. A little bit about, Hey, how does a venture capitalist to actually take a look at these companies, figure out which ones to invest in. I think that's a good process for understanding the market. But for most people that are listening to this podcast, they really shouldn't be spending too much time diligencing companies trying to figure out which one's the next company that's going to blow up and a hundred X their money. At the end of the day, this is a game of professionals. We know that. We've talked about it. It would be silly, right, if I rolled out to Dodger Stadium tonight and tried to compete. So we want to leave it to the professionals, allow them to play the game that they're successful in.
Brandon Averill (00:58): And so let's talk a little bit today about how do I actually go find those professionals, right. How do I find the next all stars, the Hall of Famers of this game? Because what we do know is that persistence does exist at least in the private markets. And there are some data going back to 2020, there are probably 2000 venture capital firms out there. They're probably managing somewhere around 4,000 funds. So, it's a small market in the scheme of things, but it's also difficult. How do you go about figuring out which of those 2000 firms are actually worth investing in? So let's dig in there, Justin, we'll just kick it from the top.
Justin Dyer (01:39): Yeah. I'll jump right in then. And the short answer, and this makes a ton of sense, is it's a difficult proposition. There's a large absolute number of managers out there, that number you mentioned about 2000, that was through 2020. And it's only gotten bigger, venture capital, both in terms of number of funds and the amount of money in the space has continued to rise. There's a change, and we touched on this, I believe briefly last week, there's a change in the environment. Doesn't mean funds are shutting down overnight, but there's definitely a change in the fundraising environment. But getting back to the question specifically, and you even alluded to it, there is persistence in the data. Which let's unpack that a little bit. Versus the public markets, we've touched on this number of times so people that listen to the podcast on somewhat of regular basis have probably heard this, the performance data in the public markets doesn't tell us much about the future.
Justin Dyer (02:36): If we find a manager that's done well in one year, an active manager, that's done well last year let's say, does not mean... There's no real strong, predictive correlation looking forward in that past performance. It's one of the main reasons you see in on a lot of the compliance disclosures, past performance is no guarantee for future success or something along those lines. It's a different, not similar, it's a different environment or different ecosystem within venture. We've touched on some of the reasons why that's the case in the private markets, right. Informational asymmetry, just access and network things of that nature really, really helps support it. But one of the big things that we can lean on is there is some persistence, like you said, in performance. So that allows us to look and see, Hey, is this manager we're having a discussion with even worth continuing to do diligence on because of what their past success has been. It's a factor. It's not the only factor, but it's a nice indicator of whether or not it makes sense to continue a conversation and consider making an investment in them.
Brandon Averill (03:49): Yeah. And I think that's kind of the tricky thing, right. When there's persistence of performance, we know there's a small group of winners every year in this market. It naturally becomes a lot more difficult to get access to those winners, right/ and so we were just up in the bay area a couple weeks ago. I think we referenced this on the podcast last week or the week before, but being up there and hearing one of these top fund managers, top venture capitalist, general partners, talk about this phenomenon, basically, they more than doubled, we're talking billions, more than doubled the size of their fund. And they did so with 20 fewer, what are called LPs, limited partners, who are the actual investors, people probably listening to this podcast in those funds. And I think the point here is that with success, right, it becomes a lot more difficult to get access.
Brandon Averill (04:42): And so he made the point, kind of jokingly, but if somebody's banging down your door for you to invest in their venture capital fund, it doesn't mean it's a complete no, but it should be a red flag, right. Those funds that have continued to persist are going to be the most sought after. And so they typically aren't out there soliciting your business too often. Doesn't mean it can't happen. We've developed really good relationships with some people, but usually it comes from a relationship that you already have within the space. And so I think when you're taking a look at this and trying to look at funds, keep that in the back of your mind. I think similarly with companies, right. I think this kind of neat anecdote, I was on the phone with a very top tier venture capitalist a couple days ago. And I mentioned a company to him that we thought, still think, is really interesting. We've actually used their service and pretty compelling overall. And I mentioned the company, he's like, "Oh yeah, let me look." And he looked at the file and they've talked to them 20 times in the last year. So there's no way that capacity wise, we're hopping on the phone with that one company. They're not even going to invest. This is just like a random company and they've talked to them 20 times.
Justin Dyer (06:01): They eat, sleep and drink this
Brandon Averill (06:02): Yeah. It's pretty back to the professionals doing the professionals game. Right. So talk a little bit, Justin, about structure. Okay. I've found a fund that I think are venture capitalists. I was like, "I believe in you, I believe in it. You've had your persistence, the track record speaks for itself." When I come in as a limited partner, what happens? How much money... If I'm giving them a certain dollar amount, what am I getting in return for that? What do I have to pay? Talk about some of the logistics for me.
Justin Dyer (06:31): Yeah. We'll keep that as high level as possible, but generally speaking, there's going to be a fund commitment minimum. So, that's essentially the amount you're saying I'm going to invest over the life of the fund. Generally speaking, there's also a... Well, there is a regulatory requirement from the SEC that you have to be at a minimum, an accredited investor. A lot of the top, top funds require you to be what's called a qualified purchaser, which just is a higher barrier to entry if you will. And so once you get past that, you make your commitment. You attest to basically being a qualified individual to make the investment. You're going to have to sign a bunch of legal documents and read through them, hopefully first and foremost, if you have an attorney as well, that can help you out even better.
Justin Dyer (07:24): The good thing is a lot of the documents are relatively standard. There are certain areas that change and change in pretty similar and or predictable ways. But they're big meaty documents. It's essentially an operating agreement for a limited partnership. So Brandon, you've mentioned being an LP, being a limited partner, the venture capital manager serves as what's called the general partner. All of this is spelled out in the limited partnership agreement. It spells out what their powers are, how distributions are handled, et cetera, et cetera, et cetera. I mean, these things can be 50, 60, 70, 80 pages long at times. Typically there will be a lead investor or what's called most frequently, an anchor investor in the venture fund. That's somebody who's taking a good portion of the investment. Maybe it's a 10% stake or 20% stake, or sometimes it even fluctuates. And they say, "Hey, we will take X amount out of the gate. And then we will adjust based on future commitments that you get from other investors." And it will be a percentage of that.
Justin Dyer (08:37): So there's a lot of nuance there. And I am starting to get a little bit in the weeds, but the structure itself, it's a limited partnership. You're essentially buying an interest in the limited partnership. Some of the documents that are involved, or I mentioned a limited partnership agreement, LPA, is what they call it for short. There's something called a PPM, private placement memorandum. And then a subscription agreement or the sub docs. And that's really where you go and you attest to being a qualified purchaser, or an accredited investor, and the shape or the form of your entity that you are coming in as an investor with. It could be an individual. It could be a trust. It could be another limited partnership agreement, or an LLC that's coming into invest, et cetera, et cetera. So there's a lot of nuance and variation within that.
Justin Dyer (09:32): I will say, and we can get into this maybe a little bit too, is that there there's different goals or mandates of the fund itself. So one of the most common that we're kind of talking around here is a venture capital fund. That's taking capital from limited partnerships, investing it directly in companies. They will often very frequently make a small portion of the fund capital available for other funds. Maybe that could be a whole nother episode, but won't get into that too much now, or it could be what's called a pure fund of funds type structure where the venture capitalist is pooling money together to go into funds.
Justin Dyer (10:17): The benefit there is your really diversifying exposure. So one of the reasons we alluded at the outset is, most people shouldn't be trying to pick funds themselves is because it's hard to get proper diversification. And with venture, a lot of companies go to zero you're trying to find a needle in the haystack. It's called a power law distribution where a very small number actually hit it big. It's very difficult. So spreading your risk out accordingly makes a lot of sense. You're able to do so even more within a fund to fund structure. And there's trade offs too, right, there's higher fees, maybe lower rates of return, excuse me, but higher certainty and predictability on future returns.
Brandon Averill (10:59): I think that's a great point. I mean, you brought up structure, so I'm the limited partner, I'm coming in and I'm saying, "Okay, I'm going to give you my million dollars," which would probably be at a very low end, but I'm going to give you my million dollars and I'm going to tie this money up. I think it's important to note, right. You're going to tie your money up probably for 10 years. And there's usually a couple extensions. So I'm willing to forego this money for 10 years. I'm not going to be able to get it back. How can I start to formulate what I would expect back in that, right. And how should I evaluate that? And there's a benchmark out there that most people point to, right, successful venture funds are going to return you three X. So three times your money, anything above that, you're starting to really talk about your superstar firms.
Brandon Averill (11:47): But when I think through tat, that's how you start to look at, okay, this is my expectations for this money, right. And I want to make sure that I'm on the same page with the venture capitalists that I'm talking to. That that is what's going to end up happening. I think, digging in, how does that functionally happen, right. I think this is something that a lot of limited partners need to know is, okay, I want that three X return, you referred to it, but the power law distribution that venture capitalist is going in doing due diligence on companies. They're going to invest in a handful of companies and they probably want, you're going to hear this often, they want those companies they're investing in to have the potential to actually return the fund. Right. And so they want these companies to be explosive.
Brandon Averill (12:36): And there's probably going to be very few companies that actually do carry the fund. There's the famous examples of, I think it was Excel investing in Facebook and it just like... I mean, it returned like 10 funds, right. And makes it a heck of a lot easier to invest out of that. And I think they had tons of more successful winners in that specific fund and put them on the map. But talk a little bit more, even, I think getting in the weeds here of like, how do we actually take a look and what should we expect? Okay, we expect that on a fund level. Is that going to show up right from the beginning? Am I expecting year one to see a two X, a three X, and then it's going to stay that way all the way through the 10 years? Or how does it actually play out to me?
Justin Dyer (13:20): No, it doesn't play out that way.
Brandon Averill (13:22): Leading question, right?
Justin Dyer (13:23): There you go. Yeah. Right. Leading question. But there's a term, I'm not sure if we've mentioned it in this series that we've been diving into the private markets, and a lot of this fund specific structure and these topics that we're talking about also applies to private equity. I just want to mention that. As we dig into that in future episodes, this is a good just placeholder, I guess, to mark. But the common return dynamics, or you can think about it as a growth curve, it's called a J curve. So it really is quite simply, it looks like a J. So when you start out in venture, you are deploying... You're committing capital. Well guess what? The venture fund itself has operational expenses and they charge a management fee, we'll touch briefly on fees and expenses to expect. But they charge that out of the gate.
Justin Dyer (14:14): There's also the fund setup expenses. That's also paid for from the fund itself. And so that starts to pull from the fund immediately. That is an immediate drag. And hopefully it doesn't last too long. And as they start deploying capital, those investments, because they're private, they're not traded on the market each and every day, you don't get an updated valuation the day after, the minute after you've made that investment. And so there's a period of time where you deploy capital, expenses are coming out of the fund, the investments are held at cost. And guess what? The net asset value or the value of the fund, quite simply is less than what the total was, right. They raised the 50 million fund, let's say. And well, first of all, they're not going to call that all immediately, but the percentage of it that they do call, they start pulling expenses on. And there's an immediate mark down within the first year or so. It's not all that uncommon to see this first part of the J curve show up in returns. And then hopefully sooner than later, if it's a good venture fund, it starts to go back above zero and then skyrockets up. Itturns into kind of more that hockey stick type return in a perfect scenario.
Brandon Averill (15:36): No, I think that's great. And you hit on fees. I think quickly just to touch on that. I mean, there's the famous, like two and 20, right. That's probably the starting point for a lot of people. You see really successful funds take even more. So maybe dig in, explain, I mean, what is two and 20 first off?
Justin Dyer (15:54): So the two we'll start there, because that's basically what I was just hitting on it. It's management expenses. It's the fee that is charged to keep the lights on and pay some basic level of salary for the team that's running the firm. That's typically a percentage of committed capital. So as the fund starts to increase, you're not getting increased management fees as well as, as you alluded to, sometimes that can be on the low side. Top tier firms may charge a higher management fee. Additionally, they also typically front load the management fee. So you pay maybe it's 2% on average over time, but they front load it because there's just a little bit more heavy lifting on the front end life of a fund. So those are the typical management fees, should be a little bit lower if it's a fund to fund structure, just because you're talking about fees on top of fees.
Justin Dyer (16:49): And then on the 20%, that's the carry. So 20% carry is the second half of that piece. Also can vary depending on the fund, like you mentioned, but essentially what that means, not to get into the legal side of it is, the amount of profit or appreciation from investing. You used a million dollars. Let's say we invest a million dollars in a venture capital fund and it turns into $10 million. So there's a $9 million appreciation in this example, the venture capitalist or the venture capitalist firm gets 20% of that appreciation. So I didn't use perfect numbers. I mean, approximately that's around $2 million or think about it, $1.8 million is their carry. That amount goes directly to venture capital firm. All the rest goes to the LP base, based on their pro-rata share.
Brandon Averill (17:47): Yeah, I think that's a great quick overview. And we've talked a lot about persistence. We've talked about how hard it is to get into the really successful funds. I think quickly before we wrap up, it'd be good to touch on like, okay, I'm a limit of partner. How do I become attractive to these funds? How do I make it so that these funds actually want to work with me? And I think that for especially a lot of people listening to this is a really interesting proposition because, yes, money is one thing, but a venture capitalist, right, they want to win. They're competitive. Especially if they can get capital from anywhere, they're going to start to look at how can this limit a partner actually start to benefit me, right. Whether it's I'm a celebrity, and I'm a really famous rapper, and I've got a huge following and I'm going to influence buyers of this product. And maybe that's a way, right.
Brandon Averill (18:42): Or I'm a professional athlete. As much as we all love to think professional athletes have this enormous following, unless you're Tom Brady, you probably don't in reality. So you have to find other ways, right, to be a benefit too. If you're an entrepreneur, maybe it's your experience that you can lend advice to future portfolio companies. If you're an athlete, it could be product driven. Maybe it's a fitness company that's raising, creating a new product and you could provide unique insight there. But, if you want to touch on other ways, but I think really finding your unique ways and really understanding yourself and your passions and what you're willing to... The work you're willing to put in. I think there's a lot that anybody can add in value to a venture firm when they're putting together a portfolio.
Justin Dyer (19:32): Yeah. I wouldn't add much tangibly there, but value add creation is incredibly important, especially in the venture space. It's important even within private equity at large, for all the reasons you alluded to, but within the venture space, I mean, just think about it. These are small companies at the outset that hope to be very, very large, and any little angle that can help them in that endeavor is beneficial. Now, I do think you hit on too, be realistic with expectations, and commitment, and where value can truly be provided. And is that a commitment you're interested in? Or is this just something where it is interesting to get to know the ecosystem and a founder and hear how they think. These are really competitive individuals and it's really fun to be around them, especially given our clientele, how we think about things. There's a lot of overlap and synergies there, but being able to add tangible value is something we think about all the time and are able to come to the table with, but doing it in a meaningful way and really thoughtful way is, I think, where the rubber meets a road or where it becomes really, really powerful.
Brandon Averill (20:50): Yep. So, thanks for sticking with us. I know we went a little long today. You can tell we're passionate about the area. It's an exciting place. It's a place where there's a lot of innovation. These companies are the future. They're changing things. And so it's fun to be around these entrepreneurs. It's fun to be around these venture capitalists to see the world through their lens. So we get carried away from time to time. But next week, we're going to dive into a little version of this. We're going to get into private equity, because I think there's some confusion there. There are stark differences. There's a lot of similarities, especially in structures, et cetera, but we're going to dig in, unpack that a little bit.
Brandon Averill (21:31): So if there's questions that you have even on the venture space and we can answer those. But if there's questions about private equity, we would love to hear from you. As you know, you can text me. Text me at 602-704-5574 would love to hear those questions. Just shoot those questions in there. If you just want to get added to the list so we can shoot you our insights in the future, just put the little light bulb, emojis, or insights into the text message to me. Reminder its 602-704-5574. And until next time own your wealth, make an impact and always be a pro.