Denis Tse, Class 10
Having moved to the limited partner (LP) side of the ecosystem in 2008 after eight years as a venture capitalist (VC), I have heard a lot of complaints about the “disconnect” between LPs and VC general partners (GPs), including an article from Volume 4 of the Kauffman Fellows Report.1 Speaking as someone with experience working in both sides of the relationship, I find that the difficulty often lies with GPs not sharing a “common language” to communicate expectations and results with their LPs.
Accessing great entrepreneurs and technologists, establishing the right interest alignment, negotiating a good valuation, making sound board decisions, and being proactive in business development and exit with great salesmanship—these are all fundamental aspects to the success of a VC business. However, given the constraints of time and size of a closed-end fund and the fund terms of the limited partnership agreement (LPA), further “operational craftsmanship” must go into making a good VC fund. I say “operational” because net internal rate of return (Net IRR), total value to paid-in capital ratio (TVPI), and distribution to paid-in capital ratio (DPI)—the three numbers that matter to every investor—can be better optimized with a rigorous, numbers-driven, operator mindset. “Craftsmanship” is also appropriate because that optimization exercise is as much an art as a science.
In this article, I draw on my experience as a VC-fund LP and discuss six interlinked, fund-management levers that, if managed systematically and thoughtfully throughout the fund life, can deliver significant additional value to both the fund manager and its investors. A GP can use reporting on the application of these tools as a means to provide more granularity on the performance of the fund, such that LPs may more objectively assess the institutional asset-management quality of the fund manager.
Carefully Scaling into Investments
Disciplined early-stage investors often rigorously scale their investments according to very well thought-through milestones, and have the wherewithal to cut the life-chords decisively. On the other hand, some expansion-stage investors operate on the logic that making concentrated bets will force them to dedicate sufficient attention to each investment, with a view of minimizing the loss ratio and generating large enough return from each deal to make their focused effort worthwhile. Both strategies may work—the problem is confusing the two and allocating early-stage bets as if they were late-stage investments. This fund-management lever sounds obvious, but some GPs lose their tempo when pressured by competition, or worse, by their own sheer fund size.
Rigorously Calibrating the Reserve Allocation
At the fund level, reserve allocation is an important guidepost in determining (a) whether to take on additional new investments and (b) when to raise the next fund. At what level should the allocation be invested for the fund manager to decide it is time to launch a successor fund? Honestly, there is no rule of thumb. This decision is not only a function of the progress of underlying assets, but also of the level of competition and deal flow of the vintage year, and of the sentiments of the LPs, which are often pro-cyclical (i.e., appetite is higher when exits are in the up cycle).
The GP’s rigor and frequency in systematically revising the reserve allocation matters a lot, given the changing dynamics the portfolio constantly faces (e.g., variances in performance, follow-on valuation and funding needs versus underwriting, availability of secondary opportunities, recycling buffer from distributions, etc.). Note that a GP’s team cohesion will be put to the test when it is time to make adult decisions on cutting the funding reserve to underperforming investments, as some partners’ individual attribution record will take a hit as a result.
In theory, putting all the fund’s committed capital to investment with the aid of recycling is nice, as the drawn amount for fund expenses is offset by the redeployment of distribution proceeds into investment. Recycling pares down gross-to-net leakage and may reduce the need for (and hassle of) additional capital calls. The key challenge for the GP often lies with deciding to what extent recycling will be relied on to fulfill the funding plan of the portfolio companies. It is important to be sensitive to LPs’ desire for distribution. The situation will become contentious if the GP insists on recycling to fulfill the portfolio company funding plan (usually due to ill-conceived reserve allocation) when the LPs demand to see distribution soon.
Concurrently Managing an Annex Fund
The idea of a concurrent annex fund is gaining popularity among both LPs and GPs who are primarily early-stage focused. These funds provide an additional war-chest for private follow-on financing to defend a fund manager’s positions, and charge fees on invested capital (and therefore distribute carry deal-by-deal). This approach stratifies investor risk-return appetites and expense sensitivities, and therefore can potentially capture a broader LP base. To a GP, an annex fund not only facilitates allocation budgeting, but by keeping the core fund size small, the GP is also more likely to achieve a higher realized return multiple—and therefore be paid a higher carry bracket (i.e., if the fund has a tiered carry fund structure). The deal-by-deal carry waterfall of the annex fund also compensates for the lower fee, making the GP more incentivized to work for carry when making later-stage investment decisions. Note, however, that the annex fund management fee structure may also create an agency problem, encouraging the GP to deploy (and manage for a fee) as much capital as quickly as possible.
Prudently Applying the Management Fee Waiver
Funds with this feature allow the GP, usually at the beginning of the year, to elect to waive a specified amount of management fees as a means to pay for the GP commitment within a specified period (usually for the year). A management fee waiver is particularly useful for emerging GPs whose partners do not have much initial cash capital to demonstrate interest alignment. The challenge comes down to the fact that, unlike the waiver amount, the frequency and amount of the actual drawdown is not pre-determined at the beginning of the same period. The waiver does eat into the GP’s operating budget and therefore should be carefully calibrated in light of the GP’s spending plan and assessment of the carry distribution schedule (since the GP may alternatively fund commitment through distribution proceeds).
Enhancing Management-Fee Income Predictability
In the post-investment period, management-fee income may become uncertain if it is charged on net invested capital (i.e., the invested cost of holdings not yet disposed of or written off). To address the need for fee income predictability, an alternative would be for the GP and the LPs to agree in the LPA on a post-investment period step-down fee schedule based on the fund’s total commitment.
For a VC general partner, simultaneously managing these six levers is a conscious, continuous acrobatic exercise. However, being mindful of the need to master that skill early on will save an emerging GP from learning it the hard way. Remember: there is more to fund performance (“the net”) than the underlying investment performance (“the gross”). These tools should not just sit in the quiet domain of the fund’s CFO—they require the strategic, collective effort of the general partnership. Moreover, their metrics will convey how much thoughtfulness the GP has put into operating the fund. From the standpoint of relationship management, such information will certainly be valued by sophisticated LPs. I encourage you all to become masters of fund-management craftsmanship.
Denis is currently Head of Asia—Private Investments with Lockheed Martin Investment Management Company and is considered one of “Asia’s 25 most influential people in private equity” by AsianInvestor.2
1 José Romano, “The Rise of the Innovation Strategist,” Kauffman Fellows Report, 4 (2012): 1–7, .
AsianInvestor editors, “The 25 Most Influential People in Private Equity,” 2 September 2013.