LP Confidential Secrets from the Folks that Give VCs Money

Hey everybody, my name's David Apple. I'm head of the software and SaaS vertical at Intact. We are sponsors of the tactical stage. Thank you for coming to this session instead of any of the other ones. We usually, we've got ganghouse packed in, but I think the center stage is pulling people. But I think that's a mistake 'cause we got a fantastic session right now. A good friend of mine, Tom Barnes at Excel KKR, once said this phrase to me, everybody is labor, labor for somebody else's capital. And that's the session that we've got right now, which is for all of us who are investors or portfolio company leaders, we're trying to make our investors a return. But then the investors are labor for somebody else's capital. And that's what today's session is fantastically about. I'm going to introduce our panel in just a moment. They're going to give you perspective of what are the LPs asking the venture capitalists, so you have some context to know what your customers— customer is looking for. Harry Stebbins is going to be our moderator. For those of you who don't know Harry, Harry is leader of the podcast, the 20 Minute VC, 130,000 subscribers. If you haven't subscribed to it, I suggest it. He's also in charge of the official SaaStr podcast. And then we've got 3 great investors. Beezer is from Sapphire Ventures. Great firm. Alex is from Trusted Insight. And Chris is from Venture Investment Associates. So with that, allow me to introduce the four of them. Thank you.

Thanks, man. There you go.

You can scoot on over.

So before we start today, I do want to just kick off with a little promotion here for Chris. Now, Chris is slightly behind Beezer in Twitter followers. So if you get out your phones now and follow @cduvos, D-O-U-V-O-S, he will get closer to Beezer. He's 2,000 behind. So just please, look at that face. You can't say no.

Seriously, all I want to do is— it was my Christmas wish to catch up to Beezer. And then she went to Europe. And the next thing I know, it's like, brrr.

I told you, you've got to start investing in Europe. Right? Do we have people from Europe here? Anyone in the crowd?

Si?

Si?

All right. All right, I'm on it.

But let's start today, LP panel, with— for anyone that doesn't know, What are LPs and why do they matter in our ecosystem? So, so let's start with that. I'll start with you, Chris. What are LPs and why do they matter?

Well, as LPs, we're the money behind the money. So we're the people that, that employ the venture capitalists that fund your company. So when your venture capitalist is pounding on you and telling you that you need to make this thing work, it's because we're pounding on them saying we want 3x. LPs can only count to 3. It's like, that's our multiple, that's our hurdle rate. Anything else beyond that is like a once in a lifetime kind of thing, but we're pushing all our GPs to get capital, moolah in the cooler. We give money, we give our GPs a dollar and we want it to come back with two of its friends for a total of three.

Absolutely. I do want to then go to you, Beazer, in terms of you said about 3x. In terms of different fund sizes, obviously returns are very different according to the fund sizes, and you've invested in the likes of Local Globe and Blueyard, different fund sizes, and Local Globe smaller. Is the return expectations different then according to the fund size?

Uh, not necessarily. I think whenever we invest, and we only invest in early-stage venture, we're looking for a significantly large outcome. As Chris said, it's extraordinarily hard to have a 3x, but you invest in early stage because both seed and A, it's a high-risk, high-reward scenario. So that's what should dictate the return profile. As your fund gets a lot larger and starts doing multi-stage, that can bring down the return expectation just because returning a $2 billion fund is just— involves a lot more companies exiting at much higher valuations than it does at a $60 million fund. So I think about it more as stage and size of vehicle than just vehicle.

Can I double-click on that?

Yeah, double-click.

Sometimes we lose sight of basic arithmetic, and one of the things that's a real challenge is if a VC is running a $500 million fund for them to return 3 times that money, which is the number that would make the people on this stage happy, they've got to generate $1.5 billion in returns to their ownership. In a lot of cases, these folks are only owning 10% of companies, right? So they have to actually generate $15 billion under that scenario in enterprise value. And that's, last time I checked, a pretty darn big company.

You said obviously about returning the money and the liquidity. Intrigued about liquidity event itself. We've seen kind of the prolonged periods of privatization Alex, is that a concern for you in terms of the elongated exit horizon that we're seeing now with public markets potentially wanting more?

I don't think so, because for the first time in kind of recorded history, the best companies in almost every sector is a technology company, and those that don't have a technology company will get a technology company. So The best logistics company is arguably Uber. The best and the most prominent hospitality company is Airbnb. The best media companies are Google and Facebook. So we think in financial services, in healthcare, in oil and gas, the best companies will be technology companies. And realizing that for the first time ever, non-tech buyers like Unilever buying Dollar Shave Club and GM buying Cruise Automation— for the first time ever, non-technology companies are buying technology companies at the high multiples where a Google, a Facebook, or a Yahoo used to buy.

I do, I do want to stay on that in terms of kind of transitioning times and ask you again, Alex, how do we— do you think in particular the integration of of maybe artificial intelligence and machine learning is going to affect the LP landscape in coordination with the VC landscape and potentially the selection process for fund managers?

I think it'd be way beyond, uh, way beyond the selection process. I think, you know, and this is the way I rationalize it, if we can have autonomous cars, if we can have Alexa, then why shouldn't we have manager selection and security selection with algorithms. So I think in 10 years we will have autonomous portfolios across all asset classes, but perhaps not in 3 years. So I think the landscape that you see will radically be different in the next few years.

So how would a computer pick a first-time manager?

I can't tell you my trade secret.

Next stage, we'll get a cocktail and then we'll chat.

Absolutely. On the picking element, though, I'm always very much a fan of venture and venture returns that are predominantly based around access in 95% of situations and not picking. I'm intrigued. Chris, obviously an LP in first round when— back in the early days when I'm Sure, it was a picking ecosystem. Talk to me, what's your thesis on the access versus picking thesis?

You know, it's interesting because I spend a lot of time trying to figure out how I can be non-consensus right, right? So we're, you know, a lot of people, as you guys know, a lot of people in the investing world spend their lives trying to avoid being wrong and alone, right? And if you try to be, you know, if you avoid being alone to take the chance of being wrong and alone out of play, you take the right and alone box out of the mix, and that's where fortune and glory reside, right? And so I spent a lot of my day looking for folks who were kind of off the beaten path, or it seems kind of almost quaint to think of first round before it was first round with a capital F and a capital R, but Josh and I used to sit there in the Conshohocken Marriott in 2004, 2005, and he'd be like, I have this idea, like how can we like make the venture firm a platform? How can we create the Napster of venture capital? And I said, you know, Josh, you're talking about portfolio as community. And he goes, holy smokes, this is amazing. It was so much fun because it was kind of totally untrod ground. And Alex, I think, has talked about AI and kind of autonomous portfolios. And Beezer's amazing. I sit next to Beezer only so that I can like osmote the intelligence. But for me, I'm just kind of like out there trying pick things that are different in hopes that, uh, that I can— in being courageous, you know, fools rush in where, uh, where angels fear to tread. And that's kind of how I roll.

I'm intrigued, obviously, uh, staying relatively on the theme of first round there. And one particularly interesting element for me is the scaling of funds as they achieve success, the likes of SoftTech, lowercase first round scaling. What are the thoughts on this and the ability to scale successfully with fund movements upwards? And this is put out to the floor?

I think, I think in venture more than anything, and I think that's why traditional venture capital, which is most people's portfolio, is not venture capital anymore. As funds have scaled, they have increasingly become private equity. And if you look at the success of First Round Capital or Y Combinator, they are now the first call of entrepreneurs. No longer is Sequoia, Kleiner, Accel the first call. It is Y Combinator and the myriad of accelerators. Why? Because it literally takes $10,000 to start a company. And so some of these newer models that are coming, they have not only displaced venture capital, traditional venture capital, they have also created structural advantage. So Picking is less relevant. So picking is less relevant in a new structure which will attract the best founders. And so I think that has been a sea change. And with online platforms like AngelList, and I think AngelList is just the beginning. So we will see many, many platforms which like Amazon, like Uber will have global network effects. So the very things that VCs invest in, their businesses will be disrupted the same way Amazon and Uber disrupted traditional businesses. In fact, if you look at Jim Goetz's letter of resignation at Sequoia, he mentions how their business finally is getting disrupted, and Sequoia so far has evolved and changed, but perhaps not in the future.

I think I agree with a lot of the points Alex is saying. I was also contemplating part of your question, which is, can you scale from a— if you leave out the beginning stages, right, where the YCs in the world play a lot, and you get into the, like, can you be the same fund if you're $150 million, if you're a billion, if you're $3 billion? Some people can, but my experience in venture is most funds are incredibly idiosyncratic, and appropriately so, as expressions of the individuals that are there. And so some people, it's much better to stay $150 million and stay in their lane because scaling isn't going to work for the kind of firm that they want to be part of. And staying true to that is hyper important because if you are someone who believes in selecting, you can't select well if you're shifting what you're doing.

Actually, can I double-click on that? Because, you know, it's really interesting. And this is, you know, if I were an entrepreneur, the thing I'd be thinking about is, is kind of the relationship between, uh, between time and capital, the cost of time and the cost of capital. And a wise man once told me— and I, I actually have no native wisdom, I just repeat things people have told me in the past— and a wise man once told me, he said, when venture capital works really well, capital is really expensive and time is cheap. And when things get crazy, capital gets really cheap and time gets really expensive. And so as people have more money to deploy, you know, you as an entrepreneur want people to devote their time in addition to their capital, but you want, you know, that energy. Maybe you don't, maybe you don't want these meddlesome VCs. I feel like Scooby-Doo, you know, one of the Scooby-Doo villains, meddling kids, you know, meddling VCs. Um, but, but maybe there are VCs like Jason M. Lemkin, like, has a lot to offer, right? You know, uh, like this conference, right? And so you want that time and engagement, and you want that to be cheap and the capital to be expensive, and that's how the business doesn't scale.

I want to double-click on something here with you now, Chris, uh, in terms of the displacing of the VC ecosystem. Uh, we've talked before about the hybridization of GPs and LPs with direct co-investments. I want to hear your thoughts on this and whether this is a very but possible outcome in the next few years in terms of displacing VCs with direct co-investments and your thoughts surrounding that.

So it's really interesting, and again, this is, I think, for the entrepreneurs in the room, a really interesting question, because you're probably getting a lot of calls from your VCs, LPs, about potential co-investments. And, you know, I started my career at Princeton University's endowment, so I went from a, you know, a.edu to a.org, and I'm at a.com, so the descent of man to the sullied commercial. But at Princeton, we had a pretty active co-invest program, and as it turns out, the co-investments produced about the same returns as the funds, but the incentives are all screwed up and people made a lot more money from the co-investments, right, as individuals. And, um, and so one thing I always think about is like, you know, the principal-agent problem is like rife through all of finance. And so as, you know, we see more and more LPs looking to do co-investments, you as an entrepreneur should ask like, why are they here? Why are they doing this? Are they trying to enhance returns? Are they trying to like cut their fees? Are they trying to like save their business because the fund-to-funds business is under kind of great pressure, the pricing umbrella is collapsing, etc. And is this like the way that they're trying to remain relevant for their LPs? And what does that mean for your interaction with this LP? Are you just going to be, you know, kind of— are they just gonna be dumb money? And are you okay with that? And so I think, you know, as we look forward, I think, you know, there are some who would say— I don't know if I'd go this far— but there's some that would say the average VC doesn't add a lot of value. And if LPs can disintermediate that person, um, that might be a net benefit for the ecosystem as there are less, you know, kind of golden crumbs being taken from the capital. But that said, you know, it's really important as you guys think about your own cap tables to get the right people around the table.

Beza, what do you think about the direct investments in terms of if you are seeing them? Is there any signaling thoughts that occur to you when you do see opportunities?

Well, anytime anyone brings you a deal, there's always the question, why am I so lucky? And that is writ large a truth if you're an investor, right? Everybody should always be like, why is this happening?

I think that question every moment. Why is this happening?

So yes, you worry about adverse selection because the world of the LP actively engaging in direct investment has existed for a long time. To Chris's point, Princeton was doing it a long time ago, many other endowments. But the pace of it and the amount of money that's now flowing out of LPs directly is increased over the last few years. And that feels like that might be a bit of a trend that could go down if dollars aren't returned. So like with every investment, I think you should— exactly what Chris said— approach with caution, ask why. And if you have an LP coming to you that has material value and it works for you and your cap table, sure. But there's also a lot of times where it might just be them trying to work, like any investor trying to work on their returns, and it might not necessarily be a— you could have somebody else playing in that money and it could work too, right?

That, that actually, the Asian problem is a problem. As you might have read, Harvard now is firing half of its 200— Harvard Endowment is firing half of its 230 or 60 people, 130, because they were direct investing, not in venture capital, but in private equity, in real estate, in hedge funds. And their compensation was out of whack, and they were optimizing only, only their piece, not the entire portfolio. Portfolio, which was losing to their competitors. So that is a real problem. However, however, having said that, the big problem with venture capital and why LPs are coming in is because venture capital is increasingly becoming like private equity. Most of the funds, the billion-dollar funds, they cannot return venture capital type returns unless they invest in a $50 to $100 billion outcome. Most of them are not intellectually honest in telling that to their LPs. And so what is happening is increasingly they are investing in $10 million, $50 million run rate businesses, as some of you have seen the traditional investors. So now there is more opportunity for family offices, for strategic investors, um, to come in and provide real value, whereas the VCs, um, in a lot of cases are not able to provide real value. So I think that is a trend which is continuing. And the flip side of that trend is that the real value is actually being created by some amazing entrepreneurs. I don't need a VC to tell me that Max Levchin's companies are going to do great. I don't need a VC to tell me that Elon Musk's companies are going to do great, right? So why are we paying 2.5% management fees and 30% carry to give money to amazing entrepreneurs who are creating multiple businesses. So I think that disruption is afoot.

Absolutely. I do want to do a really quick, quickfire though. So I'm going to say a question and we're going to go across the line and have a quickfire. I love my quickfires. So let's start then with what's the most challenging element of your role day to day today? 20 seconds each.

20 seconds. Oh my gosh. The most challenging role is keeping my spidey sense sharp, because I spend a lot of time talking to people who are trying to bullshit me, and making sure I've got my bullshit detector adequately calibrated.

Beza?

Yeah, some version of that, which is not getting snowblind amongst all of the new potential funds and existing funds that are out there, because there's been such a growth of new activity. So seeing signal from the noise.

Alex, my biggest challenge is, is just looking at this, the landscape of ordinary funds. It is mind-numbingly boring where so many GPs today don't have aspirations. They don't have— they don't want to push the envelope. When I first worked with folks like Founders Fund or First Round Capital or Chris Saka, they all had aspirations of doing amazing things. In the same thing where I was lucky to work with Jason M. Lemkin, um, uh, 15, 16 months ago when it was only Jason and Gretchen, uh, they have amazing aspirations. And I think that is, um, that is so hard to find.

Well, team, I think that's time up, but it's been so fantastic to have the chance to interview you all at once, uh, as opposed to one at a time. So thank Thank you so much.

Thank you.

Thank you.

Thanks, guys.