Selecting the right Limited Partners (LPs) for your fund is a critical component for a successful, long-lasting venture capital firm. This is the second of a two-part series that explores how to partner with the best long-term LPs, and what pitfalls to avoid. The first article focused on the Limited Partner landscape by stage of fund.
Jeff Weinstein joins us to shed light on how to find the best LPs for your organization. Weinstein runs LP fundraising for FJ Labs, a New York-based early-stage venture firm focused on online marketplaces and consumer Internet companies that has backed over 500 companies including Alibaba, Betterment, Delivery Hero, Fanduel, and Flexport.
Keep in Mind What Your LPs are Looking for
Limited Partners have very different goals and requirements based on their composition and underlying stakeholders. For example, fund of funds managers may prioritize financial returns, whereas corporate LPs might invest for the purposes of knowledge transfer (understanding potential companies or business models that can disrupt their core holdings) or strategic positioning (looking for future startups to acquire).
As such, your relationship with these groups can vary significantly. “Be aware of what your LP wants out of an investment and try to tailor your relationship accordingly,” comments Weinstein. “Each LP will prefer a particular cadence and style of communication. With some investors, we have recurring dealflow-sharing calls, while others only want to receive quarterly reports that outline financial performance”.
Understand potential tradeoffs. “We pride ourselves on our speed and flexibility”, explains Weinstein, “but selecting for that can come at a cost. Typically the largest LPs in the venture landscape are institutional investors like endowment and pension funds, who may have onerous due diligence processes, take years to make a commitment and can be fairly rigid to work with. That’s why we prefer to work with family offices, who are often faster-moving and more flexible”.
“Another major consideration is alignment of investment philosophies,” comments Weinstein. “Some LPs have strict mandates on what they can and cannot invest in, and may prohibit investments in some categories alcohol and cannabis. One of our institutional investors has a restriction on investments they deem ‘reputationally risky’. Of course, what a multi-billion dollar conglomerate deems ‘reputationally risky’ does not always align with the philosophies of forward-thinking venture investors, so this can create some tension.”
“Other institutional LPs may have geographic or sector mandates to be mindful of, so VCs run the risk of being prevented from pursuing amazing opportunities that fall outside their predetermined core focus. On the other hand, this tradeoff may be worthwhile as there aren’t many family offices out there who can write $50-100M checks as endowments regularly do.”
“Another consideration is that if you take certain money from certain governments or pension funds, you may have to publicly disclose your returns. CALPERS, for example, has published all the returns of the underlying funds in its portfolio. Most funds don’t want this transparency forced on them”.
Understanding what you value at each stage of your funds will help you sift through the various categories of LPs and find the perfect partners.
Know What You’re Getting Into
When you go down the institutional investor route, you need to be building the necessary infrastructure that caters to their reporting desires. Jeff explains, “With a fund consisting of institutional investors, you should consider assembling an advisory board of your largest/most important investors, also known as a Limited Partner Advisory Committee (LPAC). You should also expect to hold a yearly LP meeting where you walk investors through your portfolio progress and updates with your team, strategy and mindset. Institutional investors expect some kind of service. Some institutional clients may only want a quarterly update, others may be more active and want to talk through the portfolio to cover they should expect.”
But not all VCs have to go with the institutional approach. “We try to work with LPs that don’t make our lives difficult and we try to set expectations going in”, says Weinstein. ”If you’re a large fund with a large back office and investor relations team, you can handle significant reporting requirements. But if you’re an emerging manager, the extra managerial responsibilities tend to fall on your head,” says Weinstein.
Make your LPs feel important – they are!
LPs often don’t want to feel like a small and insignificant part of your fund. “Our LP base is under 20 LPs, so we try to give them individual attention,” says Weinstein. “This alone can be seen as a point of differentiation. When you have so many LPs, they may not feel like they’re getting enough attention from the manager. Solving this problem could be as simple as making custom content and hosting check-in meetings.”
Stay Away From These LPs:
All that glitters is not necessarily gold. According to Weinstein, there are some LPs that can be detrimental to your fund’s overall progress.
“LPs with a lack of experience with the venture asset class tend to also want a certain level of control. You typically don’t want to be the first venture investment for a new group because you run the risk of them wanting an inordinate amount of influence over your decisions.”
“Comparatively, if they’ve invested in venture capital before, they tend to be more trusting and comfortable with you doing your job and acting in their best interest.”
Try to avoid outrageous requests. Having to fill out 50-page plus diligence documents can stifle a relationship before it begins.
“Of course, every LP should do their due diligence, but it’s usually a bad omen for the future relationship if they send a billion questions for every minor action,” says Weinstein. “They’ll likely continue to do that, and you need to spend the bulk of your time running a fund, not answering overkill diligence questions.”
Notable Trends in the LP Landscape:
The LP landscape has expanded to new classes of LPs over the past few years. Corporates are getting more involved and family offices are becoming far more interested.
Jeff notes: “Due to negative interest rates in Europe and Japan, there is a large number of investors looking to move up the yield curve and try to earn a larger return. Family offices, banks and insurance companies have a higher risk appetite and are warming to venture as an asset class. But as I noted before, be wary of working with first-time LPs as they may not be fully committed to the asset class.”
Further Considerations When Selecting an LP:
There are a few more considerations to keep in mind to maintain the longevity of your funds.
Know your LP. At minimum, an LP relationship lasts 10 years, as long as the average marriage in the U.S. Make sure you know, trust, and ideally enjoy working with your counterpart.
Diversify your LP base. “Stakeholders can move. Personal/family issues can pop up. There are many reasons unrelated to performance that LPs may not re-up in your next fund, and it’s important to protect yourself by not over-relying on a concentrated number of LPs for too extended a period. Branch out as needed, try to attract different types of LPs along the way, and make sure that other LPs can size up as necessary should any other investors decide to drop out of your next fund.”
Look for patient capital. “An important advantage of working with institutional investors is the long-term outlook and stability of their capital. Pension funds and endowments have very little counterparty risk. If the macro climate changes, there’s a small chance of smaller investors not being able to fulfill their commitments, which could be devastating. This risk is much lower if you’re dealing with large institutions.”
Consider value-add LPs. “When you’re building your LP base, think about how your LPs can bring you and portfolio companies value. Some might only be financial support, but other LPs, particularly corporates and family offices, can be used to win deals or help with recruiting, BD and M&A efforts for your investments.”
“Don’t shy away from pitching your LP base to prospective and existing founders. If you’re doing well, you can really try to maximize the non-financial value added through your LP base. Recruiting LPs is more than simply just raising money. It’s about building long-term partnerships that help you create the most value possible for your portfolio companies and all partners involved”