Over the past decade, many venture capitalists have accumulated huge personal fortunes. Some of the money was made by investing in companies that have outperformed. But much of their wealth stems from management fees, which quickly added up as fund sizes — which have been increasing at a faster rate than at any time in history — soared to unprecedented heights.
Given that the market has changed — and will likely remain a tougher environment for everyone for at least the next year or two — what’s happening now is an obvious question. Will the industry’s limited partners – the “money behind the money” – demand better terms from their venture managers, just as VCs are now demanding better terms from their founders?
If there was ever a moment for the institutions that fund VCs to leverage and push back — how quickly funds are raised, or the industry’s lack of diversity, or the hurdles that must be met before profits can be shared — it is apparently now is the time. Yet in numerous conversations with LPs this week, the message to this publisher was the same. LPs aren’t interested in rocking the boat and jeopardizing their allocation to so-called top-tier funds after years of solid returns.
Nor are they likely to make demands on underperforming and up-and-coming managers. Why not? Because there is less money, they suggest. “Markets like this exacerbate the divide between the haves and have-nots,” noted one LP. “When we add someone to our list of relationships,” added another, “we expect it will be for at least two funds, but that doesn’t mean we can meet those expectations when markets are really tough.”
Some may find the feedback frustrating, especially after so much talk in recent years about leveling the playing field by putting more investment capital in the hands of women and others who are underrepresented in the risk industry. The precarious relationship between LPs and VCs was underlined, nobody wanted to comment on the record.
But what if they had more backbone? What if they could tell managers exactly what they think without fear of retaliation? Here are half a dozen criticisms VCs might hear, based on our conversations with a handful of institutional investors, from a CEO at a large financial institution to a smaller fund of funds manager. On the things they would like to change if they had their brothers:
Strange terms. According to one limited partner, in recent years so-called “time and attention standards” — wording in limited partnership agreements designed to ensure “key” individuals devote essentially all of their business time to the fund they raise — began to appear less and less before almost disappearing altogether . Part of the problem is that a growing number of general partners are not paying full attention to their funds; They had and still have other day jobs. “Basically,” says this LP, “family doctors said, ‘Give us money and don’t ask questions.'”
Disappearing Advisory Boards. According to one limited partner, these have largely fallen by the wayside in recent years, especially in the case of smaller funds, and that is a worrying development. Such board members “still play a role in conflicts of interest,” notes the LP, “including [enforcing] Provisions that have to do with governance” and which might better target “people who took aggressive positions that were sloppy from an LP perspective”.
Hyper-Fast Fundraising. Many LPs have received routine payouts in recent years, but they’ve been asked to get into new funds almost as quickly by their portfolio managers. As VCs compressed these fundraising cycles — returning to LPs to invest new funds every 18 months, and sometimes faster, instead of every four years — it created a lack of time diversity for their investors. “You invest these small pieces in momentum markets and it just stinks,” says one manager, “because there’s no diversification in the pricing environment. Some VCs put their entire fund into the second half of 2020 and the first half of 2021 and it’s like, ‘Gosh, I wonder how this is going to turn out?’”
Bad attitudes. According to several LPs, a lot of arrogance crept into the equation. (“Definitely [general partners] would be like: take it or leave it.”) The LPs argue that there is much to be said for measured pace in getting things done, and that in some cases, with pace, mutual respect went out the window.
Opportunity Fund. Boy do LPs hate opportunity funds! First, they say they find them annoying because they view such vehicles – designed to back a fund manager’s “breakout” portfolio companies – as a sneaky way for a VC to circumvent the supposed size discipline of his or her fund .
A bigger problem is that there’s an “inherent conflict” with opportunity funds, as one LP describes it. Consider that as an LP, she may have an interest in a company’s main fund and a different type of security in the same company in the opportunity fund that may be in direct contrast to that first interest. (Suppose she offered preferred stock in the opportunity fund while her institution’s shares in the early-stage fund were converted to common stock or otherwise “pushed down the preferred stack.”)
The LPs we spoke to this week also said they dislike having to invest in VCs’ opportunity funds to gain access to their early-stage funds, which seems to be happening a lot, especially in the last two years is.
It is asked to support the other vehicles of venture companies. Numerous companies have adopted new strategies that are global in nature, or see themselves investing more money in the public market. But surprisingly, LPs don’t love sprawl (it makes diversifying their own portfolios more complicated). They’re also uncomfortable with the expectation that they’ll play along with this mission crawler. Says an LP, very happy with his assignment at one of the world’s best-known venture firms but also disillusioned with the firm’s newer focuses, “They’ve earned the right to do many of the things they do . do, but you feel like you can’t just pick and choose the venture fund; They want you to support multiple funds.”
The LP said he goes along to get along. The venture firm told him it wouldn’t count the decision as a strike against his institution if their side strategies didn’t fit, but he doesn’t entirely believe it, no pun intended.
So what happens in a world where LPs are afraid to put their figurative foot on the accelerator? It highly depends on the market. When things pick up, you can probably count on LPs continuing to cooperate, even if they bitch privately. However, in a prolonged downturn, the limited partners who fund the venture industry could become less timid over time.
For example, in a separate conversation earlier this week with veteran VC Peter Wagner, Wagner noted that after the dot.com crash of 2000, a number of venture firms let their LPs off the hook by downsizing the size of their funds. One of these companies was Accel, where Wagner worked as a general partner for many years.
Wagner doubts that this will happen now. While Accel was narrowly focused on early-stage investing at the time, today Accel and many other power players oversee multiple funds and multiple strategies. They will find a way to use all the capital they have raised.
However, if returns don’t hold up, LPs could run out of patience, suggested Wagner. In general, he said that “it will take a few years to work,” and that in a few years, “we might be in a different situation [better] economic environment.”
Perhaps the pushback moment is over, in short. However, if that’s not the case with the current market dragging on like this, he said, “I wouldn’t be at all surprised if [more favorable LP terms] were discussed over the next year or two. I think that could happen.”