Ben Choi has a unique perspective on investment intuition. He started out as a venture capitalist investing in early-stage startups and then became a Limited Partner, which gives him a comprehensive view of both sides of the VC/LP equation, and he believes that a deeper appreciation of the differences on both sides of this equation will help VCs build stronger relationships with LPs.
Choi is currently a Partner at Legacy Venture, a venture capital fund-of-funds, which aggregates nearly $2 billion from over 500 investors. Legacy’s mission is to amplify the impact of philanthropists through venture capital returns, so it requires all investors to utilize all returns (principal and gains) to further their individual philanthropic work. Legacy Venture has invested in premium VC firms with portfolio companies such as Facebook, Airbnb, YouTube, Skype, Twitter, LinkedIn, Fitbit, and LendingClub.
The shift from VC to LP doesn’t only require a slightly different skill set—it demands a psychological paradigm shift in one’s approach to risk.
Choi notes several “un-learnings” from his experience as both a VC and an LP: the differing point of view on acceptable risk, the importance of a productive relationship between VCs and LPs, and the difference in follow-on thinking. In Part 1 of this post, we explore acceptable risk and investment intuition while in Part 2, we discuss the difference between how LPs see follow-ons vs. VCs.
Differences in General Partner and Limited Partner Investment Intuition
There is a fundamental difference in how VCs and LPs think about risk and reward. Not only do VCs have to deal with more risk on a daily basis, they also have to fully lean into and embrace it. VCs target a large number of companies with the hope of finding the next project that will return 100x or 1000x on their investment. This risk-seeking behavior requires developing the stomach to handle the reality that the majority of projects you invest in might fail. “Early-stage investors have to be contrarian because that’s where the reward is the greatest,” comments Choi. “Great VCs fish in different ponds, look for unique insights, sometimes take a ‘flyer’ on a deal, and manage their risk by making small bets across a bigger portfolio.” As long as one of those “small bets” brings in power-law returns (note: Benchmark’s stake in Uber), you’re still winning big as a VC.
Benchmark’s stake in Uber, including prior sale to SoftBank, valued at $7.65 billion.
Investment made out $425 million fund raised in 2011.
All VC fundraising for 2011 was $24.7 billion.
Benchmark returns 1/3 of entire VC vintage year with a single deal.
— Dan Primack (@danprimack) May 9, 2019
In contrast, LPs generally seek returns in the high single digits. For an LP, doing slightly better than the market is a win, and even a 100x return is largely unheard of. That results in a much lower risk tolerance. Choi explains, “LPs need to focus a lot more on managing against loss. You really can’t afford to have zeros, whereas VCs can have many zeros as long as they hit one 1000x.”
It is important to recognize this inherent structural friction between the investing styles of VCs and LPs. In particular, VCs should focus on convincing LPs of the probability of outperformance AND low risk of failure. “The key, at a basic level of empathy, is that VCs need to understand why LPs take a long time to get to a commitment,” comments Choi. “LPs invest because they think a manager will generate an outside return of 5-10x, which isn’t asymmetric enough to make up for even a remote chance of a goose egg.”
When it comes to tactics to help LPs manage risk, Choi recommends focusing on the relationships with fund managers. “One of the most common reasons for a fund to go to zero and lose money is the management team risk,” says Choi. “LPs are in the business of picking managers. And if the managers don’t get along, for example, then there is a lot of lost energy that would otherwise be spent investing. An important part of the pitch is how and why you will stay together.” New partnerships mean risk, and in an already risky investment landscape, the less risk the better.
For VCs, Choi advises against trying to persuade LPs to just “try out” a partnership and put a few million dollars in their fund. “LPs are usually averse to the idea of investing small amounts of their capital in a large number of funds,” says Choi. “Some LPs may do this to learn about a market or gain insight into deal flow. But on a purely financial return basis, investing in a large number of funds offers little upside and only increases the exposure to partnerships that might fail. Rather than hoping for a single asymmetric return on a single fund with a VC, LP’s are more focused on investing in a manager’s thesis that their fund and many other follow-on funds will perform well.”
At the end of the day, success for an LP is achieving consistent outperformance through a portfolio of managers that consistently outperform and rarely fail. And that requires a different business approach than that of a VC who accepts a high chance of failure for an shot at wildly asymmetric returns. With such contrasting investment intuitions required for success, it’s on both VCs and LPs to appreciate these differences and nurture ongoing, productive relationships.