VCs are pushing startups – will their investors turn the thumbs up too? • businessroundups.org

Over the past decade, many venture capitalists have built huge personal fortunes. Some of the money was earned through investments in companies that have performed better. But much of their wealth has been traced back to management fees that quickly mounted as the fund’s size grew to unprecedented levels – more rapidly than ever in history.

Given that the market has changed – and will likely continue to be a tougher environment for everyone for the next two years – the obvious question is what happens next. Will the industry’s limited partners — the “money behind the money” — demand better terms from their venture managers, just as VCs are now demanding better terms from their founders?

If there was ever a time for the institutions funding VCs to leverage and cut back on their leverage – on how quickly funds are raised, or the lack of diversity in the industry, or the hurdles that must be overcome before profits can be distributed —then apparently now would be the time. Yet in countless conversations with LPs this week, the message to this editor was the same. LPs are not interested in rocking the boat and jeopardizing their allocation in so-called top funds after years of solid returns.

Nor are they likely to make demands on underperforming and up-and-coming managers. Why not? Because there’s less money to go around, they suggest. “Markets like this widen the gap between the haves and have-nots,” noted one LP. “When we add someone to our relationship list,” another added, “we expect it to be for at least two funds, but that doesn’t mean we can meet those expectations when the markets are really tough.”

Some may find the feedback frustrating, especially after so much talk in recent years about leveling the playing field by putting more investment capital in the hands of women and others who are underrepresented in the venture industry. Underlining the precarious relationship of LPs with VCs, no one on record wanted to speak.

But what if they had more backbone? What if she could tell managers exactly what they think without fear of retaliation? Here are half a dozen complaints VCs could hear, based on our conversations with a handful of institutional investors, from an executive at a major financial institution to a smaller fund manager. Among the things they would like to change, if they had their say:

Weird terms. According to one limited partner, so-called “time and attention” standards have emerged in recent years – language in limited partner agreements intended to ensure that “key persons” will devote virtually all of their business time to the fund they raise. less and less often before almost disappearing completely. Part of the problem is that a growing number of managing partners were not focus all their attention on their funds; they had and still have other day jobs. “Basically,” says this LP, “GPs said, ‘Give us money and don’t ask questions.'”

Disappearing Advisory Boards. One limited partner says these have largely fallen by the wayside in recent years, particularly when it comes to smaller funds, and that it’s a worrying development. Such board members “continue to play a role in conflicts of interest,” the LP notes, “including [enforcing] provisions dealing with governance,” and which might have been better targeted at “people who took aggressive positions that were sloppy from an LP perspective.”

Super fast fundraising. Many LPs received routine distributions in recent years, but their portfolio managers asked them to raise new funds almost as quickly. When VCs compressed these fundraising cycles – instead of every four years, they returned to LPs every 18 months and sometimes more quickly for new fund commitments – it created a lack of time diversity for their investors. “You invest these little bits in momentum markets and it just stinks,” says one manager, “because there’s no diversification of the pricing environment. Some VCs invested their entire fund in the second half of 2020 and the first half of 2021 and it’s like, ‘Jeez, I wonder how that’s going to turn out?’”

Bad attitudes. According to several LPs, a lot of arrogance crept into the equation. (“Certainly [general partners] would be like, take it or leave it.’) The LPs argue that there’s a lot to be said for a measured pace of doing things, and that as pace went out the window, so did mutual respect in some cases.

Opportunity Funds. Boy, do LPs hate chance funds! First, they say they find this annoying because they view such vehicles – designed to support a fund manager’s “breakout” portfolio companies – as a sneaky way for a VC to circumvent his or her fund’s supposed size discipline.

A bigger problem is that there is an “inherent conflict” with opportunity funds, as one LP describes it. Remember, as an LP, she may have an interest in a company’s principal fund and a different type of security in the same company in the opportunity fund that may be in direct contradiction to that first interest. (Suppose she offered preferred stock in the opportunity fund, while her institution’s early-stage fund shares are converted to common stock or otherwise “pushed down.”)

The LPs we spoke to this week also said they hated being forced to invest in VCs’ opportunity funds to access their seed capital, which apparently happened a lot in the past two years in particular.

Being asked to support the other venture firm vehicles. Numerous companies have rolled out new strategies that are global in nature or see themselves investing more money in the public market. But, surprise, LPs don’t like the sprawl (it makes diversifying their own portfolios more complicated). They are also uncomfortable with the expectation of playing along with this mission creep. Says an LP who is thrilled with his assignment in one of the world’s most prominent venture outfits, but who has also become disillusioned with the company’s newer areas of focus: “They’ve earned the right to do many of the things that they’re doing it, but there’s a sense that you can’t just pick the venture capital; they’d like you to support multiple funds.”

The LP said he’s coming along to get along. The venture firm told him that if his additional strategies didn’t fit, it wouldn’t consider the decision a strike against his institution, but he doesn’t quite believe it, no pun intended.

So what happens in a world where LPs are afraid to put their figurative foot down? It largely depends on the market. If things pick up again, you can probably expect LPs to continue working together, even if they do grumble in private. However, in an ongoing recession, the silent partners who fund the venture industry may become less timid over time.

For example, in a separate conversation earlier this week with veteran VC Peter Wagner, Wagner noted that after the dot.com crash of 2000, a number of venture firms let their LPs go off the hook by shrinking the size of their funds. Accel, where Wagner spent many years as a general partner, was one of these outfits.

Wagner doubts that the same will happen now. While Accel at the time was narrowly focused on early stage investments, today Accel and many other powerful players oversee multiple funds and multiple strategies. They are going to find a way to use all the capital raised.

But if returns don’t hold up, LPs may run out of patience, Wagner suggested. Overall, he said that “it will take quite a few years before we are ready”, and that years from now “maybe we will be in a different [better] economic environment.”

Perhaps the moment of pushing back has passed, in short. However, if that’s not the case, if the current market continues as it is, he said, “I wouldn’t be surprised at all if [more favorable LP terms] to be negotiated over the next two years. I think that could happen.”