A Better LP Model for Micro-VC and Emerging Managers

Question: are limited partners meeting the needs of micro-vc and emerging managers? We don't think so.Raising capital from limited partners is hard. It’s harder if you are pitching a micro-VC strategy. But it becomes the hardest to raise during a global crisis like we are in today. But outside of these challenging circumstances, we asked the question - are limited partners meeting the needs of, and perhaps even capitalizing on, the opportunity to back ambitious micro-VC and emerging managers? We think so, but there are many unaddressed challenges for micro-VC, which are opportunities for enterprising LP. Some history:History: The explosive demand for early-stage capital has driven investor specialization across sub-stages, sectors, and geographies. As a result, a new asset class called micro-VC emerged, which are specialty venture capital firms with $25-$100M in assets under management (AUM). According to PitchBook only 100 micro-VC firms were active in 2012, and as of October 2019 over 900 micro-VC had been launched resulting in ~9x growth in just 7 years. The underpinning insight was that the “generalist” approach by legacy VC created an opportunity for bespoke firms that could better support founders at the early-stage in their respective markets and that this would lead to improved outcomes. One other argument for why micro-VC has flourished could be due to the changing cost structures of early startup-ups. Lindel Eakman, of Foundry Group says, “ I actually think the changing cost structure of early start-ups (cloud hosting, code repositories, and unlocking of talent during the financial crisis) is what enabled seed firms to make sense. You get a lot more data from a given dollar of risk capital than you ever did before. The competition of these firms made them more bespoke over this time period”. As such, founders, startup executives, professional angels, and career VC decided to venture as independent investment professionals leveraging their network and expertise to launch their own firms.There are several success cases in micro-VC, and many have graduated into name-brand firms in their own categories:

• First Round Capital: first institutional check, providing a robust support network.
• Floodgate: helping founders refine and scale product-market-fit.
• Homebrew: focused on the “bottoms-up” economy.
• Zetta Ventures: investing in ML-driven companies with proprietary data sets.
• Primary VC: betting on NYC as a viable tech ecosystem.
• Bowery Capital: vertical B2B software for legacy industries.
• DCVC: deep tech focused firm.
• Founder Collective: leveraging the network of amazing founders to source deals.
• Uncork Capital (fka Softech): "super angel" turned institutional micro fund
• And many more...

Many of the firms above benefited from early-mover advantage, and the support of downstream VC firms who have a vested interest in getting access to quality deal-flow. Only a limited number of limited partners (LP) have capitalized on micro-VC, despite seeing early success. Below are some examples:

• Cendana Capital
• Foundry Group
• Industry Ventures
• Greenspring Associates

The core challenges of micro-VC and emerging managers: 

Raising capital: given the long liquidity cycle of venture capital few of the early-phase micro-VC have returned capital (let alone realized carry), yet many have gone out to raise larger subsequent funds. This puts pressure on their LP to re-up their commitments, which limits their ability to make investments in other emerging micro-VC.Despite the growth and early success of the micro-VC asset class most institutional LPs are risk-averse and won't invest in emerging managers until they see them produce cash-on-cash returns, and at that point, they’re no longer an emerging manager. Their investment criteria is fixed, often driven by rigid parameters defined by their own investors. Many have access to proven VC managers with extensive track records, so they have little incentive to take risk with emerging managers. That said, many advertise they invest in “emerging managers”, when they really don’t. This leads to frustration and potentially wasted time by emerging managers that attempt to raise money from these LP. Jaclyn Hester at Foundry Group believes that “This isn't totally wasted time. Emerging managers who want to raise multiple funds and create a real franchise should take a long-term view of LP relationship-building. That said, there is certainly a balance to strike with how you spend time and prioritization of realistic targets.” However, emerging managers can benefit from understanding the approach of their prospective LP, make sure that there’s room for a new manager in their portfolio, and prioritize accordingly. It’s also crucial for emerging managers to understand that LP relationships in general just take time to forge.Therefore, most emerging managers are left to raise their first two to three funds primarily from family offices and high-net-worth individuals. In fact, according to a survey by Samir Kaji at First Republic Bank, on average 67% of capital raised by first time funds comes from family offices. The challenges when trying to raise money from these groups are:

• They tend to operate under the radar and are hard to find;
• Invest in venture capital opportunistically without a process, or don’t invest in it at all because they don’t understand it;
• Cannot add value in VC - have limited experience, and/or resources to support an emerging manager;

Most of the analysis performed by these groups focus on the qualitative aspects of the investment team and their work to date. Fundamentally, most emerging managers don’t have a reliable investor track record, and while the qualitative aspects of a new investment team are super important they’re not directly correlated with investment performance.Emerging managers report early performance-based on markups, which is the result of a subsequent financing round increasing the value of their portfolio companies. So, these are unrealized, paper returns based on the value ascribed by a later-stage investor. The problem with markups is that they don’t always reflect the intrinsic value of a company - for example: a) company has made progress, but hasn’t raised a follow on round, so it’s carried at the prior round’s value; b) company hasn’t made enough progress relative to its valuation; c) company is fundamentally mispriced. Most LP know this, but few know how to use data to objectively assess the intrinsic value of underlying early-stage investments, and thus are unable to objectively assess the current and expected performance of an emerging manager based on their early track record. The reason is because calculating “intrinsic value” at the early-stage requires non-traditional methods, which are based on a deep understanding of how startups are built (i.e. assessing product-market-fit, market positioning and advantages, unit economics, growth vectors, and more).Building a durable asset management business: many emerging managers complain that few of their LPs add value beyond their capital commitment. Being a great asset manager goes beyond having access to great deals, making good investment decisions, and working with founders. Some of the asset management “jobs” that emerging managers have to do well, but often fail at are:

• Investor relations and reporting
• Fund accounting, tax, and audit
• Cash-flow management
• Portfolio construction and risk management
• Liquidity management
• Investor community development
• And more…

Obviously, returns are king, but these aspects are critical for an emerging manager to master in order to build a long-term, enduring franchise and evolve into having permanent, institutional capital. Some emerging managers may have experience in some of these areas, but rarely across all.Personal liquidity: a manager can only charge so much in management fees (up to 2.5% of commitments) and remain competitive. Micro-VC managers struggle with tight operating budgets, and in most cases have to cut corners, and/or not pay themselves for years. In addition, they’re expected to commit hundreds of thousands to millions of dollars of personal capital in each fund. This puts tremendous financial pressure on emerging managers, and typically they have very limited sources of financing other than their personal balance sheet. And even if an emerging manager experiences early success they’re likely to be paper rich and cash poor for many years with limited alternatives for liquidity.In summary, these are the jobs-to-be-done that emerging managers struggle with and their root-cause:

Is there opportunity(?): currently there are ~900 micro-VC in the market representing demand for ~$20 billion in capital commitments every 2-3 years, which may double to triple in the next 10 years. Does this create an arbitrage opportunity for an “Emerging”, data-driven LP who can correctly assess the expected value of a portfolio by identifying and evaluating the leading growth indicators of underlying investments, and who provides a world-class support platform for the emerging managers it backs?This of course isn’t easy. Jaclyn Hester of Foundry Group notes, “Even with data, these companies are so early and there is so much volatility. This also doesn't solve the problem of emerging managers without existing track records (i.e. there's nothing really to value). The other thing to consider is check size jump for angels-turned-VCs that isn't considered here. A strong angel track record of $25k checks doesn't necessarily transfer to a micro seed fund strategy where you're leading/co-leading rounds with $500K + checks and need to win allocation.”In the meantime, below are some ways an Emerging LP could support emerging managers:

Raising capital: 

• Solely invests in emerging micro-VC, with a strong focus on second and third funds.
• Its unique data-driven ability to price the underlying portfolio’s intrinsic value allows it to identify underserved emerging managers with top performance potential. 
• Plays a “lead investor” role investing with high conviction, and connecting managers with a robust and curated network of co-LP (i.e. institutions, family offices, and HNWIs)
• Its data-driven analysis can help family offices and HNWIs gain confidence in their decision process, becoming a critical component of the fundraising materials.

Building a durable asset management platform:

• Provides unparalleled access to a network of top-tier peers and advisors who can help answer the non-obvious questions and plan ahead.
• Develops relationships with curated providers obtaining discounts and preferred terms, which then passess through to it’s portfolio managers.
• Develops proprietary fund management software tools and products that help managers eliminate friction and save time.

Liquidity:

• Provides emerging managers and their LP with creative liquidity alternatives - for example, leveraging the GP stake’s accrued value in earlier funds (i.e. loan collateralized by fund one’s carry and GP capital; secondary purchases) to reduce the financial burden.

Next questions: 

1. How can money be made as an Emerging LP?
2. Are there opportunities in micro VC secondary transactions as an Emerging LP?
3. How does a data-driven, intrinsic value assessment model for early-stage companies work?