Venture capitalists have made massive personal fortunes over the last decade, largely due to management fees generated by rapidly-raised funds of unprecedented size. Some wealth has also come from investments in successful companies.
Given the market’s shift and likely extended period of difficulty, many are asking: What now? Will those providing venture capital to managers expect improved terms for their investments, mirroring VCs’ demands for better terms from founders?
If ever there was a moment for LPs to use their leverage and push back on the VC industry’s speed, diversity, and payout hurdles – now would be it. But according to numerous conversations this week, LPs remain hesitant to rock the boat with top-tier funds due to years of solid returns.
LPs are pulling back from poorer performers and emerging managers due to their own market-induced cash constraints. As one LP put it, “Markets like these exacerbate the divide between the haves and have-nots.” Another noted, “When we add someone to our list of relationships, we expect it’s going to be for at least two funds; however, that doesn’t mean we can live up to those expectations if markets are tough.”
Many have advocated for increased access to venture capital for women and others who are underrepresented in the field, yet some may find LP feedback frustrating. As a testament to the delicate nature of LPs’ relationships with VCs, none were willing to speak on record.
What if VCs had more backbone to speak their minds without fear of retribution? From a major financial institution MD to a smaller fund of funds manager, here are six common gripes. If they could, these investors would change:
Limited partner agreements that included “time and attention” standards, meant to ensure GPs would focus on the fund they were raising, have become increasingly rare. This is due in part to a growing number of GPs having other day jobs and essentially asking for money without questions. One limited partner opines: “GPs were saying, ‘Give us money and ask no questions.’”
Advisory boards are disappearing, especially for smaller funds. This is concerning, as they serve an important role in resolving conflicts of interest and ensuring good governance – preventing people from taking advantage of LPs with aggressive positions that lack proper due diligence.
LPs were recently receiving routine distributions, but nearly as fast as they cashed those checks they were being asked to commit to new funds. VCs have shortened the fundraising cycle significantly; instead of every four years, LPs now receive requests for new fund commitments every 18 months or faster. This leaves little time diversity for investors and creates a lack of price environment diversification when investing their whole fund into momentum markets over short periods – like the second half 2020 and first half 2021. As one manager put it “It just stinks”.
LPs noted a rise in arrogance among GPs, with some acting as if their terms were non-negotiable. This led to a lack of mutual respect and an unsustainable pace that was ultimately detrimental to all parties involved.
LPs loathe Opportunity Funds, viewing them as a way for VCs to skirt fund size restrictions. These vehicles are intended to invest in “breakout” companies but LPs find this approach annoying.
LP’s face an “inherent conflict” when investing in opportunity funds. An example of this is if they have a stake in a firm’s main fund and are offered preferred shares in the opportunity fund, their institution’s original shares could be converted into common stock or otherwise “pushed down the preference stack.”
LPs have expressed dissatisfaction with having to invest in VCs’ opportunity funds just to access their early-stage funds, when the latter was all they were looking for.
LPs are uneasy with venture firms’ mission creep, including global strategies and more public market investments. One LP said of a prominent firm they’re invested in: “They’ve earned the right to do a lot of things, but you can’t just cherry pick the venture fund; they’d like you to support multiple funds.” This makes portfolio diversification more difficult for LPs.
The LP said he goes along to get along, but doesn’t believe the venture firm’s assurance that a mismatch in ancillary strategies won’t count against him.
As time passes, limited partners may become more confident. Peter Wagner, a seasoned venture capitalist who recently spoke with us, noted that during the dot-com crash several VC firms reduced fund sizes to help their LPs weather the storm; Accel – where Wagner was a GP for many years – was one of them.
Wagner questions if the same result is possible now, given Accel was then only investing in early-stage startups, while today they and other firms have multiple funds and strategies for their capital.
LPs could take action if returns don’t hold up, Wagner suggested. He noted that it may take a few years to see the outcome, but in an extended market downturn they “wouldn’t be surprised” to see more favorable terms discussed within the next year or two.
