Starting a VC Fund, Episode 9: Identifying the Right Limited Partners

Hi there. I'm Patrick Evis. I'm the founder and CEO of MindMaven, an executive coaching firm that focuses on helping leaders free up 10 hours a week and then invest that time into relationships.

I'm Charles Hudson, managing partner of Precursor Ventures. We're an early stage venture capital fund that invests in founders at the earliest stage possible.

All right, and so today we want to talk about identifying the right LPs specifically for somebody who's starting a fund for the first time. So the first question that we would have there is like, what types of LPs are actually around?

There's so many different types of LPs, and when I started the fund, I had kind of a vague notion of the different types of LPs as well as their motivations, why they were in the business, what they cared about. So I think the big, broad classes that you'll encounter are family offices, which are the private investment vehicles of families that have generational wealth. You'll encounter endowments. Those can be endowments for universities, they can be endowments for charitable organizations, they can be endowments for museums, all types of things. There's the high net worth individual, which is just an independently wealthy person who has an appetite for investing in venture capital.

Okay.

You will also encounter what we call funded funds. And those are. It sounds kind of meta, but those are funds that are raised to invest in venture funds. So their whole job is to choose venture funds to invest it on behalf of their clients.

All right, and so tell me a little bit about each of these and then specifically what motivates each type of lp.

Yeah, yeah. My experience in your. You know, I have to say this is really based on my experience, but I think it's broadly true. Family offices, for the most part, I found their real focus is on building a strong relationship with the general partner or general partners at the firm. You know, most family offices have billions of dollars under management. They're investing in a wide variety of sectors. Could be real estate, property, forestry, natural gas, whatever it might be. And venture is a piece of that portfolio. And if you zoom out, most of these families are so wealthy that if they did nothing, they would remain wealthy for a very long time. So investing in venture funds is part of their risky asset strategy. It's a way for them to get some extra return. And I found most of the family offices I have worked with are very focused on building a strong relationship with you as the GP and understanding your strategy and what is that you're trying to do.

Okay.

So it's much more of a personal relationship, I find is a really important part of building strong connectivity. With family offices.

How are they different from high net worth individuals?

I think the difference is, generally speaking, a family office has been formed and has enough resources that it's. They're thinking oftentimes across generations. So is there enough money that like the current generation is fine and probably the generation after that is also fine. And part of what that family office is trying to do is manage that wealth with a generational eye. I find high net worth individuals might just be somebody who was an entrepreneur who sold their company, who has some money and is willing to invest. They may or may not be at the place where they're thinking about, wow, I'm setting up my grandchildren's grandchildren. They just happen to be at a place where they have the means to write a reasonable check to your fund.

All right, cool. And endowments, probably one of the biggest group there, right?

Yeah, endowments are definitely one of the biggest groups. My experience with endowments has been, you know, they have in many cases, an infinite time horizon. They plan to be around for. For as long as the institution that they represent will be around. If you're talking about universities, some of those have been around for hundreds of years. And I find, you know, their biggest objective is the entity that they're attached to has its own financial needs. So if you're a university, you've got every year you've got a bunch of bills that you have to pay. Tuition only covers so much. The endowment is responsible for generating a payout to help cover the bills at the university. So that endowment manager is thinking about two things. One, how do I make sure I generate enough return to cover all my bills, plus inflation for the foreseeable future? And two, how do I make sure I have some balance between really risky things like venture capital and safer things like bonds and liquid assets like stocks and illiquid assets like real estate. So in many ways, endowments think kind of like portfolio managers. And venture is a sleeve of that portfolio.

Okay, cool. All right. Then that weird one out the meta one, the funds of funds.

Yeah, the fund of funds are an interesting piece of the ecosystem. They're great because, you know, there's some people out there who want exposure to venture capital, but they don't want to go through the process of meeting with hundreds of VCs and trying to pick the ones that are the best fit. So they effectively will hire a firm like a fund of funds that has access to lots of venture capital funds that meets all these managers and is investing some combination of client capital and their own capital into what they think are the best funds on the planet. The interesting thing about fund to funds is they have to go to market and raise money periodically, just like we do as VCs. So my experience has been, you know, fund to funds care a lot about your financial performance. It is something that they really do care about. Because if you think about how you go out and raise money and convince people to give you money to choose venture funds on their behalf, you have to end up in funds that are very, very good and that they couldn't otherwise access without you because their business models, they're charging a management fee on top of the management fee that I'm charging. And the only way you'd pay that as a client is if the fund to fund is really bringing you access to stuff you wouldn't find on your own or couldn't get into without them.

So you know, that leads me to the question of case are fund funds type of LPs that would invest into a first time fund or. And also don't answer that for just a fund fund, but maybe for all of those categories like who should I focus on if I'm really going out there for the first time?

I think if you're starting your first fund, most people are going to push you toward two groups of people, family offices and high net worth individuals. You're going to get steered toward those two audiences. If you don't have connectivity into those communities, getting steered toward them is not super helpful because family offices can be very hard to find. Most of them don't have websites that you can go to and submit your materials. Most of them are not actively scouring the planet looking for managers. Most of them are kind of hard to find. And so telling a first time fund manager who has no relationships with family offices, you should go find family offices is not terribly helpful. But it's advice I see given quite often.

And for individual investors it's sort of the same thing. People will sometimes say go find some high net worth individuals. But if you don't know those people, that's not a terribly actionable piece of advice to be given. What I see a lot of people end up doing is they gravitate towards the LPs that are the easiest to find. So the fund to funds people are relatively easy to find. Their firms do have websites. The people behind the firm are visible on the website. You can figure out how to get to them because they're really in the business of meeting managers. The endowment folks are also relatively easy to find because these endowments exist. If you pick a university or a college or an arts organization, they probably have an endowment in some team that's responsible for managing those assets. But I would just say the people that are easiest to find for you are probably the people that are also easiest to find for everyone else as well. So those are the people that tend to get inundated with inquiries.

So the problem is that those that are easy to find also might not be the type of LP that is in need or interested as much into taking the risk on a first time fund manager.

That's right.

All right, but what you didn't answer is why are the high net worth individuals and the family office so good in this regard? And I don't want you to answer how to get to them. We'll take that up in another part. But like, why do people get pointed to those?

My experience has been family offices and high net worth individuals will bet on the person.

The underwriting and decision making really tends to focus on the person. And also it's their capital. They're not really investing it on behalf of some theoretical client. So in an endowment you're really investing on behalf of the university. That brings a certain weightiness to the discussion. It brings a certain weightiness to the analytical and review process. And I found family offices tend to be a little bit more if they like you and trust you and can get comfortable with you. That's the secret to the underwriting process. It's not as much about having this huge due diligence folder. It's about getting to know them well enough such that they trust you. And I'd say the same is true of high net worth individuals.

Yeah.

And if you're a first time fund without a long operating and investing track record, those are the kind of people you need to help you get in the business.

So in those particular groups.

You can find the desire to create conviction into you while the other ones might not need to have that as much. And sometimes that conviction is the one thing that might bring them across the finish line.

That's right.

All right, that's cool.

So.

Maybe we'll do this in a separate video, but can you drop a few words around? What advice do you have? If you don't have a nice Rolodex full of high net worth individuals or family offices, how do you go find them?

I think the question is what resources are available to you? There are some paid resources you can use to get access to large numbers of limited partners, including some data about who they've invested in their services like PitchBook that you can pay for and get access to. Actually quite a bit of data about who these people are. Now that won't help you necessarily build relationships with them or get connected to them, but it does tell you where to look and it does give you something kind of like a treasure map or a hunting license in terms of looking for LPs.

There are services like Allocate, which have just launched, which are really in the business of trying to connect first time founders, fund managers to limited partners who are interested in backing funds. And there are a number of programs like that, so recommend those highly. And then last, I'd say the best resource, if you can find it, is other VCs who've raised their first or second fund in the last five years.

Ask them for for help because the data on LPs gets stale really quickly. I have limited partners in my network who two or three years ago were chomping at the bit to find new fund managers to back and now they feel like they're full, they've made their commitments. I have other people who were full five years ago, but some of the funds they backed, they've moved away and now they have some capacity. And what you really need is you need this sort of real time map of who's open for business, who's open to adding new relationships and who isn't. And that's not something that's widely advertised. That's something that people usually share with each other one on one.

Which is one of the reasons why, you know, there's a lot of work into getting that first fund up and running. You just have to have that long breath and really rebuild that map of who's who for yourself.

And the best thing you can do is seed it with the relationships you have already that might have access to those types of people.

You also once mentioned that there's this interesting group of people that are consultants that do work. I think companies like Cambridge or.

Other folks.

What's their role?

Yeah, you know, you'll probably encounter, I mean Cambridge is everywhere. There are other colonial, there are other great advisors out there, you know, their role is to help their clients, many of whom want access to venture, to have a trusted partner to help them vet those firms and do the due diligence on them and make sure that they're getting put into great firms. In some cases that consultant has the independent discretion to choose the manager and they can make a choice on behalf of the client. In other cases, they can make a recommendation to the client that, hey, you should invest in this fund or you should not invest in this fund. And here's why.

The challenge can be depending on the consultant. Some of them work under a model where if the client is really excited about you as the manager, they will have their research team do work. In other cases, the client will tell you, hey, we only meet with managers that the research team has blessed. So sometimes you can get stuck in this loop where the client is telling you, go talk to the manager or go talk to the consultant. The consultant is the person we look to for guidance. So go get them comfortable with what you're doing and then we can take a look. And sometimes that consultant will say, it really helps me out a lot if you have a client of mine who's already enthusiastic about the fund. And so each of them, sometimes it feels like it's telling you to go talk to the other person.

And so I think you have to learn how to navigate that process. And I don't think they're doing it to be opaque or to sort of send you on a wild goose chase. It's just, I think what they're saying is true though. Their job is easiest when they're excited about your fund and the client's excited about the fund. Fair enough. In the absence of that, it's hard.

So what's your advice specifically? Would you say ignore them for your first time around because it's probably going to be a waste of time or invest a little.

But yeah, I would say get to know them. I think in general, many of their clients are not going to do a first time fund either whether they're advised to do it or the consultant has discretion. Unless it's just sort of an all star team spinning out of a really well known platform. The one thing I will say with the consultants is like they do care about the length of time that they've known you. They do keep pretty detailed records about your fund's performance, what you said you were going to raise, how much you ended up raising. And I find that like that's the kind of relationship you want to start in fund one. Even if they're unlikely to be an LP in your first fund because the time, the clock really starts when the relationship starts.

All right, then let me move on. Because one of the.

Challenges, I think very similar to entrepreneurs who are fundraising, right, for a person who's trying to convince LPs, this is the job of getting them across the finish line. Right. And the first finish line is the first close. Do all LPs jump on the chance of doing the first close or are they also considerations?

Not every LP will do a first close. If you think about it, until you've had a first close, you're not actually a venture capitalist, you're an aspiring venture capitalist. The first close is this milestone. And I think it's important to remember once you've had your first close, your fund exists and it's real. So here's one hypothetical. If you had a $20 million fund and you had a first close on a million dollars, you're locked into being a fund manager for the next 10 years, but you've only closed a million. So if you weren't, if you don't close another dollar, you're stuck running a million dollar fund for the next 10 years. And that's not going to be a very comfortable existence for most people.

So a lot of LPs are interested in seeing you get to a first close and also get to a number on that first close that allows you to execute your strategy. And so there's a set of LPs. We'll just say, look, we don't want to do the first close. Because if you get to a first close and there's no subsequent close, what happens if the fund ends up being sub scale? What if you can't execute the strategy and a lot of folks don't want to be in that first close? And also it's, in most cases you don't really get a premium on your investment for being in the first close. It's not in most cases common that you get better terms or superior economics. You're really just doing it for one or two reasons. One, you want to help the GP that you're backing get their first close done. Or two, maybe on some level you're worried that you won't be able to get your full allocation if you wait till the end.

The incentives are actually running against you as a first time fund manager in that sense. So who of those LPs.

Will be the ones you should focus your time on to get to that first close? That seems to be a very important component of being successful.

I think every fund manager ends up finding their own set of LPs for whom the model resonates? For me, it was community foundations. They ended up becoming like a really core constituency for us. I didn't know that would be the case when we started the fund. But they've become a really important and reliable limited partner category. For us. So I now know to spend a lot of time with those folks. I didn't. In the moment, in the moment, everyone told me, focus on high net worth individuals and family offices because they can be part of a first close if they choose to lots of other institutions, first close, first fund. They're probably only doing that if they're really worried about getting an allocation. And that the risk of like waiting for a second or subsequent close puts the chance of investing the amount of money they want at risk.

All right, fantastic. All right, the last question that I think we should cover is sort of like, you will have LPs that you run into that will not go for your first fund. What do you do with those?

I think this is sort of the art of fundraising. So I think there's a set of LPs and this is how I've always managed it. I always ask myself two questions. Do I think they liked me and our model and do I understand why they passed? If I feel like the LP I met liked me or liked our model and I understand why they passed, I'll probably go back to that person for a subsequent fund.

Now, here's the reality. My guess is for LPs who are not in my fund, the most times I'm going to talk to them in a given year is two to three times. That's about the number of touch points I'm going to get a year. So use them wisely.

And the way I think about it is if I understand why somebody passed on my fund and I feel like I'm chipping away or making progress against those things, like, for example, you might be a single GP and had a bunch of LPs who said, Gosh, we know you want a partner. We'd feel a lot better if we knew who that partner was. And the chance to kind of evaluate the two of you as a duo, well, if you happen to find a partner, that's a pretty good reason to go back to that person. And So I have LPs in our current fund who said no to multiple previous funds at Precursor. And I think this is the one thing that's different about raising a fund than raising money for a company. When you're raising money for a company, there's just a lot of stage specific investors. There's people who invest at the seed stage. Yeah, Once you're past the seed stage, you don't go back to those people to ever pitch your business again. Because, like, that's not what they do. Yes, limited partners are not generally speaking stage specific. So just because someone passed on your first, second and or third fund doesn't mean that your fourth fund won't be the one that breaks through for them.

Okay.

I think that's a bit of a mindset. A mindset shift for folks is like you will likely end up going back to the same people over and over again if you have a good relationship with them. And each time you come back, you're going to come back with more data, more insights, more progress. And simply the fact of still being alive as a fund manager and still being in business is, you know, survivorship bias in action. And so I would say don't over index time wise when you're trying to get your fund one done and the people you're trying to build long term relationships with, you'll have time to do that after your fund is closed.

That's fair. That's awesome. All right, I think this was a fantastic little rundown on how to identify LPs. Thanks so much and we'll see you guys soon.