Emerging Manager Q&A mailbag

Follow me @samirkaji for my thoughts on the venture market, with a focus on the continued growth with the emerging manager landscape

I’ve spent a considerable amount of my shelter in place time having discussions with some very smart people in the market about what this economic dislocation might mean for the emerging venture fund landscape. See my latest posts here & here for some of my observations and thoughts from this month.

Over the weekend, I asked the emerging manager community questions that were most topical:

[While I tried to keep the questions verbatim for the sake of accuracy, I combined some questions together for efficiency and paraphrased others for clarity. I realize I haven’t gotten to all questions, which I will try to do over the course of the week when I have free time.]

Here’s the Q&A mailbag:

Broadly speaking, what do you see happening to the seed fund market in the next couple of years? Do hundreds of seed funds die? Do you see sole GP funds that weren’t successful scaling fund (or raising 2nd or 3rd funds) team up?

Since I believe things will be turbulent well into 2021, I do expect a very sharp decline in number of active institutional seed investors over the next 2–3 years. Active in this context means firms that have capital to deploy into new companies (for those that remember, firms that cannot are often coined “Zombie Funds”). Since 2009, over 1200 new firms have formed in the US (nearly 1000 of them being seed funds, a likely understated number given the difficulty of tracking $1MM-$5MM Nano/Super Angel funds). With the sharp macro turn serving as the hammer, the mains micro reasons I think we will see a decline are:

· Fewer first time funds coming to market in current/projected fundraising conditions.

· “Tourist” managers that raised a small first fund (or two) determining that building a firm is either non-viable and/or not something they really want to do.

· The decrease of LPs willing to allocate to new names (even Fund II/III offerings) until their own seed fund managers portfolios have had time to season through the downturn. Over the past few years, healthy MOIC’s and IRR’s have buoyed fundraising efforts. It’s not unreasonable to project many of these paper gains will be walked back as downstream financing becomes tougher, leading to reduced valuations and more portfolio company casualties.

· The HNW/Single FO market will become more likely invest in follow on fund offerings with managers that have provided meaningful recent distribution activity. This point and the prior one will strand many managers on the sideline after current fund capital extinguishes.

· Dozens of firms will be forced to close funds in 2020 much smaller than target, resulting in running out of capital sooner and not being able to close another fund until markets even.

Do I think sole GPs that face fundraising difficulty will all band together to raise larger funds together? I see that for some, but it will be the exception not the rule. Partnerships are tricky constructs and introduce whole new risk variables for LPs, even when successful GPs come together (the question here posits a potentially different arrangement).

That said, I expect a second wave of emerging managers to form after the downturn (assuming this is the case) as investing talent starts shaking loose from venture firms. We believe that the Post-COVID world will give rise to new innovation streams that many managers will construct investing strategies around.

I’m a manager that’s in the early stages of raising my first fund ($25MM). I’ve already put together materials, and have gotten encouraging feedback from some family offices and institutional investors I’ve spoken too over the last few months. I believe I can get to a really strong first close. What should I do?

Assume anything you heard prior to March 13th is irrelevant now. Next, it’s important to remember a large chasm exists between first time funds and first time managers — The former category refers to those with prior attributable institutional track records, while the latter group represents those that may have relevant industry experience, but have little or no institutional track record. It’s still reasonable for those in the former camp to launch new raises in this environment, but only with a significant downshifting of expectations with respect to fund targets & time to close — I estimate that the faucet will begin to drip dry on this group soon due to the improbability of principals and GPs leaving the safety of larger firms in midst of a global pandemic (“COVID-19 handcuffs”) and the logistical difficulty of meeting the necessary people/partners to launch.

For those that fall into the camp of limited investing experience — historically about two thirds of new offerings since 2015 — the degree of difficulty will be enormous. Whether to launch or not today is a personal decision, but for this group, I’d start a new fundraise only if:

- Your personal financial situation affords you the luxury to get by with 3–4 years of marginal income, as it is unlikely your firm will have an AUM of >$30–40MM during this time.

-You can justify opportunity cost of doing this now versus waiting 1–2 years when the time and opportunity might be more favorable.

-You are comfortable that it may take up to 9–12 months for a viable first close (more on this later), and that the entire process may take 2+ years with no guarantee of hitting your target.

- You have spoken to dozens of existing emerging managers to understand all the non-investing elements that go into running a venture firm.

- You have clear and defined visibility into closing at least 30% of your target.

Question: We had a small first close [~$8MM) in January that was at 33% of our minimum viable fund size of $25M (our target size is $40M). We’ve started investing from the fund and had planned the next close in April which will now be delayed. Our obvious concern is hitting our Minimum Viable Fund (MVF) target on any kind of reasonable timeframe, and thinking about a plan B on our strategy to consider the possibility of not hitting the MVP now. What should LP strategy and communication be?

As you can imagine, you’re not alone in this predicament. Given the current state of fundraising affairs, you’ll need to re-assess initial check sizing, reserves, and size of portfolio. If you modify check sizing (common at early stages of a fundraise), I’d suggest conservatism and build a portfolio model either around your MVF number or an even more conservative model of just 2X of your current closed commitments.

Related: For those managers raising but who haven’t had a first close yet, I’d encourage that in the current climate you not execute a first close until you are at least 30–40% of target or 60–75% of what is the lower bound of a viable fund size.

With regard to LP communication, by now you should have sent all your LPs (and prospective soft-commit LPs) a letter outlining key fund considerations in the current climate. This should include your macro/micro view, how fund operations and performance may be impacted, and the definitive steps on how you will execute through it. Complete transparency here goes a long way.

Top of the funnel conversations with new LPs are fine, but I’d encourage a short “cooling off” period of 2–3 weeks for a few reasons; A) unlike recent past recessionary periods, our daily personal lives have been completely disrupted overnight. We are still early in the coping phase of the new normal and LPs are understandably emotionally distracted B) while many institutional LPs will take initial calls, there is risk that many are simply gathering data for their own planning and thought models. Use this time to instead to stress-test your own thesis, speak with existing LPs, and work with portfolio companies. To be clear, there will be institutional LPs that opportunistically make new manager investments in 2020 (and I know many that are going to be aggressive at some point this year), but it’s going to take time for the lid to truly come off.

Question: Common pushback amongst potential new LP’s at this point is “We’re super interested in your thesis, but the focus right now is getting through the current situation”. Besides the obvious kicking the can down the road, is this what you are seeing across the LP/GP universe? Are institutional LPs closed for business for new managers?

What I’m hearing is that only a small percentage of institutional LPs are seriously considering new manager allocations for 2020 (absent those that are in their current pipeline or who they have followed for a material amount of time). This is still based on a limited sample set of those I’ve spoken to, but I’d expect the same logic to hold with others.

Most are hunkered down and planning around three potential outcomes: 1) COVID-19 is just 1–2 quarter recession with a sharp V-shaped recovery (unlikely) 2) COVID-19 is a 12–18 month shock to the system during which most major asset categories severely deflate even more before recovery (very likely) and 3) COVID-19 bumps us into a multi-year global depression akin to the great depression (possible, but less likely).

Most are modeling around scenario 2, which would result in many institutional LPs being confronted with the denominator effect (the over allocation to private equities due to a plunge in other assets holdings such as public equities, commodities, and real estate — which typically represent ~40–60% of endowment holdings.

During these times, institutional investors often put a hold on adding new managers to their portfolios and instead look to opportunistically cull positions by not investing in the new funds of non-performing managers, or sometimes pursuing secondary sales. When markets settle and private holding valuations reset, we should see a renewed period of active private investing. While the venture fund of funds industry doesn’t directly face the denominator effect, many top fund of funds are reliant on traditional institutional capital for their own funds.

Question: I am currently investing from Fund I and about to close Fund II. In this market, would you suggest trying to raise a small opportunity Fund to support existing investments / SPVs or try and raise a smaller Fund II to take advantage of companies looking for bridge financing at lower valuations?

I’m going to make some assumptions here. For a separate opportunity fund to support Fund I companies, it probably only makes sense if you have existing LP relationships that can move VERY quickly (~3–4 months) to a close. I’d get a temperature check through discussions with your largest Fund I LPs to determine the likelihood of it.

If not, I’d probably pass on this idea as trying to raise two funds concurrently in this environment is not advisable. Better to use SPVs or let your LPs directly invest in follow-ons where possible.

On the latter part of your question, if you are asking whether Fund II should in part have the ability to support Fund I companies, I would generally avoid that outside of a couple of opportunistic investments that are made with consent of your major LPs or LPAC. If not, you run the risk of strategy drift with your core fund offering, which isn’t going to help in the long run.

Question: Looking at the performance of Vintages 2007–2010 wouldn’t it be a no brainer to invest in VC funds in the next 2–3 years?

I do think the next few years will represent good vintages due to falling entry prices, less competition, and healthier capital behavior at companies and VC firms. But we don’t live in a vacuum, and LP willingness (human investing naturally tilts toward fear during tough times) and capacity (denominator effect/personal liquidity) are often strained during these periods. Also you are correct in that 2007–2010 were very good vintages, but the 2013–2018 vintages also have been strong (albeit I would bet that the ultimate DPI’s for 2007–2012 will be superior).

Question: Have the recent events shifted interest (for those LPs still interested in emerging managers) within the emerging manager class (sector v generalist, concentrated v diversified, single GP v multiple, etc.)? What does a “safe haven” (aware of the irony) emerging manager look like?

Unfortunately, I don’t believe a safe haven with respect to any of those areas exists today. However, I think certain areas such as healthcare, social impact, diversity, investment strategies aligning with the Post-COVID world (expect to see this a lot in decks), and secondary funds will enjoy micro-tailwinds. However, this is not to say that any of these areas will single-handedly be enough to override prevailing market headwinds.

In truth, the established emerging managers who have built brands and durable LP bases stand to benefit the most in the years ahead, particularly as competitors wane and valuations start to dramatically reset once current dry powder deployment slows and depletes.

The main question today isn’t about differentiation across managers, but rather about the capability and willingness to invest in privates. With the 35% drop in public equities over the last month, family offices and HNW individuals (who collectively comprise 70% of capital on average to first time managers) are feeling appreciably poorer today than they have in a long time. To provide historical context, it took 12 months for the Dow to drop 35% from its peak in October 2007.

Additionally, this is the first time the institutional seed ecosystem has truly been tested, and it’s too soon to determine what investor preferences will look like until we revert to a more stable economic outlook.

Question: What are LPs expecting of existing managers, and do you see any change in LP behavior (i.e. defaults, transfers, etc.)?

This depends on LP type, but outside of the obvious general fundraising pullback, we could see stressed LPs convey a need for relief on capital calls through asks of slower deployment and more visibility to capital drawdowns. As most know, the cost of making a capital call is much higher today for LPs, chiefly for those that must liquidate stressed assets to satisfy capital calls. I don’t expect to see many (if any) US institutional LPs default, but think that smaller family offices and individuals could, particularly early in a fund’s life when there is limited NAV to protect. At the very least, they may ask for a short capital holiday to buy time.

We saw this in 2008–2009, and many of those stakes were ultimately picked up by stronger LPs or secondary players. However, it’s a good time to have open conversations with LPs you think may be distressed to ensure that neither side has an unpleasant surprise when capital is called.