Evaluating the Opportunity Fund boom

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Historically, investing in venture funds consisted of picking a manager and then investing into their core funds every 2–4 years.

Over time, the number of offerings by fund managers has expanded to include products such as “Opportunity funds” (sometimes called Select or Growth funds, which may have unique nuances to them. According to Pitchbook, VCs have raised nearly 400 opportunity funds over the past decade. In the past few years, opportunity funds have been raised by both seed firms such as Homebrew, Costanoa, Susa Ventures, and Uncork, as well as larger firms such as Lightspeed, 8VC, and Emergence Capital.

Different funds had a great report on this recently.

An opportunity fund’s primary premise is to invest in the later rounds of breakout portfolio companies in which a manager has previously invested in through (typically) prior funds. These types of investment do not usually fit within a core fund either because of the core fund’s early-stage thesis or due to lack of capacity available in the core fund.

These reasons are common with seed and early-stage funds, where fund portfolio construction models generally support companies through only 2–3 rounds of financing. However, many VCs retain contractual or earned rights to invest in additional rounds.

Currently, managers have three ways to approach these later-stage portfolio opportunities: 1) Forgo the pro-rata (or earned) position and not participate in the round 2) Set up a Special Purpose Vehicle (SPV) and look to raise capital from investors to invest specifically in the company’s round or 3) Invest out of a previously raised opportunity fund.

#2 can work well but often poses some issues for both LPs and fund managers.

Very commonly, and particularly in hot later stage opportunities, the deals have rapid timelines (1–4 weeks to close). These timelines often don’t provide the manager the necessary time to corral enough capital from LPs, either because a subset of their LPs do not invest in direct deals or simply cannot evaluate deals in the quick timeframe allotted to execute the transaction.

In the cases where a fund manager has an active LP base that can act rapidly on SPV’s, it can be a tremendous win-win — — LPs have agency over what they invest in while the manager gets deal by deal economics (typically SPV pricing is 0–1% management fees, and 10–20% carried interest).

Because of the issues mentioned above facing SPVs, opportunity funds have become very popular in recent years despite conflicting views from LPs and GPs.

Some of the benefits of investing in opportunity funds are:

• Opportunity funds are pre-established blind pool vehicles that eliminate the timing issues that come with deal-by-deal SPVs.
• LPs that do not have direct investing programs can gain exposure to the manager’s breakout investments from past funds. And inherently, the benefit of backing an opportunity fund is that the manager should, in theory, have a highly asymmetric view of the company from prior round investing.
• Opportunity funds sometimes have reduced economics from traditional 2/20 structures, including management fees that are sometimes charged on deployed, not committed capital.
• Unlike individual SPVs, losses from one portfolio company in an opportunity fund offset gains from another when factoring in carried interest.
• Opportunity funds are lower on the risk/time to liquidity spectrum than early-stage funds (getting a 20% IRR with a 2–2.5X multiple is a great target return).

The case against opportunity funds are:

• The potential distraction away from the core fund product.
• The different skillset that is typically necessary for late-stage investing vs. early-stage investing.
• Possible conflicts if there aren’t clear parameters on what goes into an opportunity fund vs. core fund.
• Whether the presence of an available core fund affects the manager’s portfolio construction decisions in the core fund.
• Investing in an opportunity fund assumes that there are high-alpha winners the manager has invested in or will invest in the future and that those companies continue to grant the manager allocation. If this doesn’t happen, LPs could face the prospect of an adverse selection fund, as the opportunity fund will be deployed somehow.

Some considerations and questions when evaluating an opportunity fund:

• How clearly defined is the investment model of the opportunity fund? Notably, is there a clear delineation of when a portfolio company investment will fall out of the core fund thesis and into the opportunity fund?
• How will the manager evaluate later stage opportunities to determine suitability (i.e. what type of return and time to liquidity is the fund manager underwriting to)?
• Does the manager have the general skillset to evaluate these later investments?
• Suppose the manager is leading and pricing rounds out of the opportunity fund. How will they handle marks on the prior round investments (while it’s getting more common now, as with Clubhouse and a16z, most fund managers do not set the pricing on follow-on rounds of portfolio company investments)?
• If the opportunity fund is raised simultaneously as a core fund, is the manager requiring LPs to come into both? If this is the case, what is the proportional split between the two funds, and how does this affect the aggregate investment’s overall risk/return analysis?
• Does the manager have the latitude to make later-stage investments in companies that are not part of a previous portfolio? Is there a cap on the % of these types of investments, and how will the manager source/assess these opportunities?
• What is the economic model? Is it appropriately set up to align interests across the firm?
• Has the manager demonstrated the ability to secure allocations in the later rounds of the biggest winners? If the track record is not there, how can LPs ensure there will not be adverse selection? Reference calls with founders can help alleviate these concerns.
• At the time of close, does the manager have a general sense of what companies in the existing portfolio may be candidates for the opportunity fund in the 1–2 years ahead?

Opportunity funds can be an excellent way for LPs to gain exposure to top breakout companies, deploy more capital per manager (mainly for institutional LPs who must write more significant amounts per manager), and diversify risk per manager. However, many key considerations must be carefully analyzed when investing in opportunity funds.