The marketplace for general partners raising institutional capital is opaque, particularly for first-time venture capital funds. To further exacerbate the issue, first-time managers are often at odds with a chicken-and-egg problem: how does one compel trust from institutional investors without a strong track record of having successfully worked with institutional investors?
We can re-think the LP dynamic from a different perspective– through the lens of design thinking. New funds have a challenging time launching for a few reasons: the institutional investment landscape is complex, if not arcane, and venture funds may lack the network, and tools and frameworks needed to raise capital from institutional investors.
The design thinking framework enables venture investors to step outside the narrow parameters of typical institutional fundraising. Design thinking is the foundation of design strategy. Design strategy enhances competitive advantage by aligning a firm’s value proposition to the needs of their end users. Similar to a SaaS product seeking product-market fit, this application of design strategy aims to better qualify the fund-LP fit by exploring the fund’s value proposition to specific LP types.
We will explore how fund managers can use design strategy to achieve clarity and precision in their fundraising process. Design strategy views fundraising as a set of hypotheses and tests, rather than a binary linear pass/fail process.
How to use design thinking for institutional fundraising
The crux of the problem is that the institutional landscape is opaque from most fund managers’ point of view. Successful fundraising becomes a matter of solving for the lack of visibility and inefficiencies.
Let’s consider the institutional limited partner landscape through the world of design thinking. This unlikely pairing of design and institutional allocation is a matter of using the needs-based approach of design thinking to refresh our understanding of the typical fundraising frameworks. Much of my inspiration comes from product development and how to apply its frameworks to the venture capital industry. As used in product development, we can use design thinking methodologies to refine fundraising as a set of hypotheses and tests.
So, why design thinking? The framework of design thinking ultimately helps formulate a strategy. Design thinking is the foundation of design strategy. Design strategy enhances competitive advantage by aligning your firm’s value proposition to the needs of your end users.
Strategy is how you achieve a competitive advantage.
Let’s think of design strategy in terms of microeconomics. The design surplus is the value created above and beyond the traditional consumer surplus. Consumer surplus, the delta between what someone is willing to pay minus the price they paid, makes the buyer feel like they got a deal.
The design surplus is an additional gain beyond the customer surplus. Much more has been written about the idea of the design surplus by my business school professor Andy Dong, now head of the Oregon State University School of Mechanical, Industrial, and Manufacturing Engineering and a professor of mechanical engineering.
So, let’s say you want to buy a new chair for your living room. You’re willing to pay a thousand dollars for that chair, but you got it for $400. So your consumer surplus is $600. You feel like you got a deal.
Let’s say you’re willing to pay $2,000 for a chair that was just absolutely perfect for you, but you paid $500. Now, your design surplus is $1500. The scenario is similar in the sense that you found a chair. The chair doesn’t beat your expectations because it’s good in the abstract. It is valuable because it’s so precisely tailored to you. Your goal is to produce a design surplus for your limited partners.
Design your hypotheses
So, how do fund managers create a design surplus for prospective limited partners?
When you fundraise, you’re selling a piece of your fund to a prospective limited partner. At a conceptual level, this isn’t far off from how potential entrepreneurs sell their companies to you, or how companies sell products to their customers. Limited partners have a high bar for their decisions, which means you must design your fund pitch accordingly and sell it to the right people for whom you are giving a precise and valuable benefit.
In order to figure out your key targets, we need a design hypothesis.
This is a basic design strategy type framework: desirability, viability, and feasibility to determine the key risks and opportunities for your fundraise. We’re going to focus on desirability, which is the work to identify which limited partners would gain the most from investing in your fund. Your set of hypotheses is a data-driven list of assumptions that you can test in the fundraising process.
Let’s define first the universe of limited partners.This two-by-two matrix divides the universe of limited partners by their check sizes and their approach to investing – those that are process-driven and discretion-driven.
The process-driven limited partners have an investment policy. They intend to allocate some percentage of their total assets to any given asset class and they have a very rules-based approach, which is mirrored in their diligence. These LPs tend to manage a broad portfolio of equities, fixed income, and alternative assets. When they invest in venture capital firms, they tend to write larger checks and prefer to invest in firms that are capable of raising multiple, successive funds.
Comparatively, discretion-driven LPs take a more flexible approach and may not have an investment policy governing their asset allocation to alternatives. Some will write large checks over many funds; others are just dipping their toes in and exploring investing in the asset class. Many high net worth individuals are entering the venture capital asset class as limited partners for the first time. In tandem, first-time funds are investors who are starting their own funds as solo GPs. The rise of the solo GP is occurring alongside the rise of the solo LP. New limited partners allocating to venture for the first time are experiencing similar challenges as first-time funds. This framework can help connect the two sides of the private capital marketplace.
With this list of limited partners, you can begin to establish your set of hypotheses about the types of limited partners who might be interested in your fund. You will build on this set of hypotheses as you gain more experience and information from the limited partners you meet.
Define your limited partner archetype
Your LP archetype is a detailed characterization of the limited partners who will experience the most significant design surplus from your fund. They are the right buyer for your product. For them, investing in your fund helps them accomplish their goals.
To identify your LP archetype, start by building your dataset. This data set will include your existing LPs and prospective LPs. It should also include research into the LPs of funds that are of similar size and stage to you.
When you have a list of a few dozen names, you need to interrogate your data. You want to know things that will help you develop your hypotheses. You want to be intimately aware of their needs, pains, and what they hope to accomplish.
Consider a handful of initial questions:
- Where is the LP located?
- What is their familiarity with venture capital?
- What is their career?
- What boards are they involved in?
- What are their pain points in their work or investments?
- What kind of upside are they looking for, strategic returns and/or financial returns?
These answers can be gained from asking yet another set of questions that can be answered through personal research, interviews, and leveraging industry data.
You want to understand your potential LP’s motivations, career path, and whatever else can help you better understand them as people. As you begin meeting with LPs, track who seems interested and who doesn’t.
Testing your hypotheses
After your initial research, you can derive a set of LP archetypes and hypotheses that represent the trends you found in your data. Your LP archetypes might include regional family offices, leaders at companies related to your investment thesis, or individual executives within companies.
Proximity can play a significant role in achieving a design surplus for your limited partners. Limited partners who are most geographically proximate to you tend to be the most likely to invest because trust is the main factor that helps create an investment relationship. Your LPs can be geographically near you, or psychologically proximate if they deeply care about the mission of your firm.
By honing on the community element of venture in your messaging and in practice, you can target a familiarity with LPs that would otherwise have been neglected.
As you take your fund to the market, test your hypothesis and evaluate the level of engagement at each stage in the process. Fund managers use design thinking to consider your fund-LP fit at every phase of your fund construction.
How design strategy can drive change in institutional investing
Institutional capital allocated to first time funds has been declining since its ten-year high in 2018 at $10.9 billion, according to data from the Pitchbook/NVCA Venture Monitor. More venture funds are coming into the market, but fewer are closing. The number of venture funds in the market globally has increased each year of the past decade, with over 2,000 funds actively raising as of one-year ago according to Preqin. LP capital is being concentrated into existing relationships rather than new ones.
While we have focused on how venture investors can use design thinking to identify their LP archetypes and test their hypotheses, LPs can also use design thinking to innovate internally and identify promising funds that may be overlooked. With so many new venture funds in the market, 75 percent of global LPs have seen a five-year increase in time spent on sourcing, compliance, co-investments, due diligence and relationships in private equity and venture capital, according to a report from Coller Capital.
Institutional investors have underwritten technological transformation, but have failed to apply innovation internally, creating risk and homogeneity in the venture asset class. With more work and no new efficiencies, now is the time for institutional investors to apply the value creation capabilities of technology and design internally.
In 2019, institutional investors allocated $88 billion venture capital funds globally, according to the 2020 Preqin Global Private Equity and Venture Capital report. With the rise of global innovation ecosystems, institutional investors plan to increase their commitments to venture capital funds. How might the next $88 billion be invested to create a more diverse, equitable, and competitive venture capital industry?
About Jessica Straus:
Jessica uses her multi-disciplinary background to explore ways to create value for investors through technology as the Brand & Content Marketing Director at Carta. Jessica has previously served as a Venture Partner at Dundee Venture Capital, an Entrepreneur-in-Residence at GE Ventures, VP at the National Venture Capital Association and began her career in the U.S. Congress. She holds an MBA in Design Strategy from the California College of the Arts and an English degree from Davidson College. She is in Kauffman Class 22.