“It was the best of times, it was the worst of times.” The opening sentence to A Tale of Two Cities by Charles Dickens sums up the current fund-raising environment for emerging managers. It is the best of times given the substantial and increasing demand from limited partners to invest in venture capital, but it is the worst of times because most of these LPs are focusing on investing in established, proven managers.
With so many emerging managers in the market right now, it can be very difficult for a new fund to attract the attention of LPs. Here are 10 tips offered by one LP to help emerging managers in their fund-raising efforts.
Tip 1. Offer a Convincing Strategy
Emerging managers must be able to convincingly demonstrate why their investment strategy will be successful, and how it is differentiated from other funds in the market. Core among these considerations are the target sector(s), the target stage(s) of investment and the geographical focus of the fund. LPs must be convinced that the investment strategy is focused and will be successful and repeatable over the life of this fund as well as future funds. Be prepared to discuss the potential risks of the investment strategy in some detail.
In addition, LPs will want to dig deep and understand specific elements of the strategy such as deal sourcing; due diligence; target total dollars invested per deal; target ownership positions; lead vs. co-investing; passive vs. active investments; reserve strategy; number of board seats per partner; board value add; investment pace; syndication strategy; exit strategies; and rationale of fund size to opportunity. It’s surprising how many emerging managers don’t have ready answers to questions on these topics.
It’s not enough for an emerging manager to be able to articulate the strategy. The manager must also differentiate the investment strategy from other funds in the market. A deep knowledge of the competitive landscape is essential. An emerging manager must be able to discuss in detail other funds in the same space, how the investment strategies differ and why the emerging manager’s strategy is better. There are so many new funds in the market today that only those emerging managers with an investment strategy that has the hallmarks of being successful, repeatable and differentiated will get the attention of LPs.
Tip 2: Demonstrate Relevant Experience
A key area of diligence by LPs lies in the experience of the partners and its relevance to the investment strategy. LPs must be convinced that the background of each partner supports the investment strategy, and that the collective background of the team demonstrates a capability to generate top-tier returns. Core to this is prior experience as a venture capitalist. At least one (and preferably most) of the partners should have prior venture experience with a respected top-tier firm, working through the entire apprenticeship cycle. Operating experience is also important. An emerging manager comprised of two successful, experienced venture capitalists and a proven, respected entrepreneur could be a very attractive team.
While an impressive, proven and relevant background is important, the reputations and networks of the partners are considered critical to the success of a fund. A partner’s reputation among (and relationships with) entrepreneurs, corporate executives, other venture firms and technologists enable partners to generate high-quality deal flow, conduct due diligence, help portfolio companies access customers, build management teams, attract quality co-investors and facilitate exits. The venture business is a relationship business, and each partner’s network and reputation will be highly scrutinized.
Tip 3: Prove You Are a “Dream Team”
In real estate, the mantra is “location, location, location.” When LPs consider investing in emerging managers, the mantra is “team, team, team.” This is one of the most difficult areas for LPs to assess. LPs need to feel comfortable that this partnership will be successful and sustainable for several funds to come. For example, compare the team risk of two partners forming a new fund who never worked closely together to two partners forming a new fund who have worked and invested together for the past several years. LPs typically invest in emerging managers that they think will have a number of successful funds and will grow to be dominant franchises.
Core to this assessment is the motivation of the partners. Are the partners motivated to succeed-for this fund and for the long run? One element of this involves the ownership and economics of the fund and firm. The partners of an emerging manager should have equal equity and economics. If not, there must be a compelling reason for the inequity. Note that many LPs are wary of “one partner” funds, where the success of the fund will primarily depend on the performance of one partner.
Another element of the team equation is growth and succession. LPs will want to know when and how the manager plans to add new partners. Will they cultivate talent in-house or will they hire partners from outside the firm? What is the manager’s plan for growth? The ages, drive, outside interests and personal wealth of the current partners will be scrutinized. LPs would prefer to invest in a multi-generational firm in which the partners are motivated and the issue of succession has already been addressed.
Tip 4: Show a Track Record
It is often said that the best future venture capitalists are existing venture capitalists-meaning that those individuals trained in this “apprenticeship” business will be the best venture capitalists in the future. What makes the “best” venture capitalist is open to debate, but when it comes to emerging managers, experience counts. Two experienced partners with verifiable track records of successful investing will have a distinct advantage over two entrepreneurs who now want to be venture capitalists.
When presenting a track record, the key word is “transparency.” Nothing frustrates an LP more than a feeling that a manager is hiding or manipulating returns. When presenting a prior fund’s returns, present the multiple and IRR on both a gross and net basis. LPs are keenly interested in fund returns on a true “net” basis-net of all fees, expenses and carry. Also, LPs will analyze whether a return is due to one hugely successful investment vs. a good number of solid, successful investments. A “one-hit wonder” may suggest the manager was lucky rather than skilled.
Evaluating a partner’s investing track record isn’t just about the financial returns a partner has achieved, although the returns are critical. The most successful venture capitalists are those that can identify new and developing markets, business models and technologies; assemble management teams to exploit these opportunities; manage a successful investment to exit; and repeat the process again and again. LPs want to know that the partner has been involved in all aspects of their deals. A partner should be able to discuss, for each of their deals, how they sourced the deal, evaluated the opportunity, conducted due diligence, negotiated the terms, added value and generated a return, including the management and timing of the exit.
The ability to verify the track record is critical. Some emerging managers have obtained “attribution letters” from each partner’s prior firm confirming the track record and participation in each deal. These attribution letters help give comfort on a prior track record. Make sure not to overstate, or “puff” elements of the track record or involvement in deals. LPs will find out if a partner is inflating their returns or involvement, and that will end the discussion.
Tip 5: Ante Up
It often isn’t enough for emerging managers to have a solid investment strategy, experience, track records and good team synergies. LPs want more. Many emerging managers are able to add an element of differentiation that will appeal to LPs. This may be that the partners contribute a meaningful portion of their net worth to the fund-having “skin in the game.” They may underwrite investments prior to the closing of the fund to demonstrate their investment strategy and process, or the firm may be affiliated with a corporate partner that adds tremendous value to the fund. A highly regarded “cornerstone” investor that invests a significant amount in a fund with no special terms is also a plus; however, a cornerstone investor that has very favorable terms may not be looked upon so favorably. The bottom line is that a new fund that has “something extra” may be more appealing to an LP.
Tip 6: Offer Reasonable Terms
While having “market” fund terms should be a given for emerging managers, it bears repeating. First time funds should be “plain vanilla,” which begins with the standard fee/carry structure, which for funds of less than $200 million is gravitating to a management fee of 2.5% and 20% carried interest. The management fee typically will begin to decline annually after the investment period, and the carried interest is typically received by the general partner after committed capital is returned to the LPs. Higher levels of management fee or carried interest would be a red flag to most LPs. Also, the fund size must be rational and directly tied to the investment strategy of the firm.
Tip 7: Make it Easy on LPs
While LPs are increasingly interested in looking at new funds, investing in an emerging manager requires an incredible amount of time and effort. Make it as easy on the LPs as possible. For example, prepare in advance a thorough due diligence binder. Provide raw data in spreadsheets that can be easily manipulated, and include all backup for how the track records and returns have been calculated. A detailed reference list is very important. Deliver the information to the LP in both a hard and soft (electronic) copy. Bend over backwards to comply with an LP’s due diligence requests. Many LPs are understaffed and the decision to invest or not may boil down to whether the emerging manager provided all of the requested information in a thorough and timely manner. Remember to follow up. It’s amazing how many managers simply don’t follow up.
Tip 8: Don’t Neglect Marketing
The marketing process is often an afterthought for emerging managers, and this is a mistake. The presentation material should be clear, concise, convincing and visually appealing. Plan on a one-hour meeting with an LP, with the presentation being no more than 20 to 30 minutes long. Be flexible: Some LPs may be passive in some meetings, saving questions for the end, while other will be highly interactive and want to jump around the presentation or not use it at all. One good practice that should be used by emerging managers is to take notes at the meetings and to update the presentation to address questions that LPs are asking.
As LPs want to evaluate the team, make sure that all team members participate in the presentation and in the Q&A session. It may send a negative signal if one partner dominates the meeting. Make sure that each partner can deliver the presentation and answer all questions by themselves, and that the partners’ answers are consistent. Practice, practice, practice. Practice among friends in the industry and outside the industry, and get them to ask as many questions as possible. The more input you have before meeting with LPs will only help the process.
Tip 9: Be Honest and Up Front
The truth is that nobody’s perfect, and emerging managers aren’t exempt from this rule. One partner may not have a great track record; another partner may have founded a company that went bankrupt. The key is not to hide these “warts,” but be prepared to discuss them openly. LPs appreciate honesty and directness. One effective approach is to turn weaknesses into strengths. For example, a partner can turn an investment disappointment into a “lesson learned.” Remember, a fund may last up to 10 to 12 years, and there will certainly be some bumps along the way. Establishing a basis of trust and honesty is critical to the long-term health of relations with LPs.
Tip 10: Be Persistent
Fund-raising is a difficult, lengthy, arduous process. For emerging managers it can take a year to a year-and-a-half to raise a fund, sometimes even longer. Plan for that. It is a massive commitment of time, money and travel, as well as a considerable burden on family. The managers that have spent time thinking about these issues up front will find it less of a shock as the process drags on and on, as it will.
Emerging managers should also be prepared for the “herd” mentality of LPs. It is very common for LPs to want to wait until other LPs commit. Many LPs are “second closing” LPs, waiting to see how the first closing goes before committing to the fund. Other LPs are just so busy that they won’t react until the final closing is almost upon them. The key here is persistence and to keep to process moving forward. Yet again, follow-up is critical.
Also remember that a “no” for this fund may be a “yes” for your next fund. Venture capital is a relationship business, and developing a relationship over time with an LP can only help you in the future. And don’t take a “no” personally. Confronting an LP is never a good way to handle rejection, but asking for friendly, constructive advice may help you develop a relationship with the LP for the future.
Fund-raising is a long and difficult journey for emerging managers. The tips offered here will hopefully provide a helpful road map for the fund-raising process.
Good luck and good fund-raising!
Allen Latta is responsible for VenCap’s business development activities and heads the San Francisco office for the fund-of-funds manager. Prior to joining VenCap, Latta was an executive director in the Telecommunications Investment Banking Group at Bear, Stearns & Co. and before that was a director in the Media and Telecommunications Group at CIBC World Markets. Before pursuing a career in investment banking, Latta was a corporate finance attorney specializing in private equity and VC transactions, public offerings and M&A.