How LPs should really think about GP commits in Emerging Managers

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

Limited Partners (LPs) use various filters and metrics to assess how investable a venture fund is. One of the more heuristic measures is assessing the GP’s alignment with them through the percentage of a fund’s commitments that the general partner(s) themselves contribute — In VC this is typically 1–3% of total fund commitments.

As you’d expect, LPs typically prefer fund managers with higher GP commitments as % of the fund (“skin the game” concept).

While I believe there is general merit to linking fiduciary incentives to an investment manager’s stake in a vehicle, it is far too simplistic of a metric to rely on as a visceral filter. Like many things in capital markets, changing programming (in this case, LPs) is hard to do.

For LPs focused on GP skin in the game, I’d encourage thinking through the following considerations when assessing incentives (Note that some of the below do gear toward the seed and emerging manager industry):

• What percentage of the GPs Net Worth is committed to the fund (or in the case of a multi-fund firm, how much has been committed to the franchise)? Most family offices put 5–10% in venture capital across many funds — — For example, if a VC is putting north of 5–10% in a single fund, regardless of what % of capital it represents of the total fund commitments, it certainly would speak to alignment. While this isn’t easy to calculate precisely, a quick back of the envelope is probably possible using public information about the GP’s background (and some GPs have been forthright about this as well).
• What other elements speak to “true” GP commitment? Let’s take an example of a $25MM fund with two partners with a 1% GP commitment (which may be considered low).
• Assuming total Management fees in the first two years are 2.5%, this equates to $625K/year.
• After non-GP salary-related expenses, this may leave $450K-$500K for the GPs, or $225K-$250K each. In cases where the GP team has built a team and has an operating model that requires larger cash outlays, the GP may be going with a much lower salary (or, in extreme cases, none).
• Assuming this is a seed fund, 70% of capital will likely be drawn in the first 24 months. For each partner, this represents about $90K. Unless fee waivers* are utilized, this is $45K post-tax per partner. At $225K per year per partner (or about $145K after tax if in CA), this leaves $100K per partner in after tax cash flow per year! Hardly living in the lap of luxury in high-rent districts.

*A fee waiver is when management fees are foregone for amounts equivalent to some % of GP commitment. Most commonly, this is 50–80% of the GP commitment. Fee waivers were ubiquitous in the past, but many firms have gone away from this due to potential shifts in tax law.

• Given the pedigree and talent of most GPs, they are likely forgoing higher paying jobs elsewhere. Let’s say, in this case, the GPs are former senior product managers that have an earning ability of $350K per year. This represents a $125K loss of gross pay per year by taking the fund manager route (even more when factoring in the GP commitment) . This opportunity cost needs to be considered when assessing the GP’s financial alignment with their LPs’.
• Assessing the mission orientation and long term view of the investor. For emerging managers, significant financial outcomes come when 1) Fee stacking across funds occurs at scale or 2) Future carried interest. For nearly all GPs just getting started, raising a single (often small) fund isn’t the goal but rather the building of a longstanding firm. As such, there exists a natural alignment that goes well beyond the size of the GP commitment. Of course, sometimes this just comes through in conversation.

Am I suggesting that GP commitments are meaningless in driving or assessing financial alignment? No, but I don’t think the necessary considerations to measure the metric accurately occur regularly enough.

Penalizing new fund managers with small GP commits could result in talented managers (particularly those who don’t come from affluent backgrounds) not getting a shot on goal to start as a standalone venture investor, which doesn’t bode well for founders searching for quality and diverse capital.