Framework: Not All LPs Invest In Emerging VCs For The Same Reasons

Use cases for investing in emerging VCs

Oper8r is focused on enabling the next generation of great founders in VC by empowering the next generation of great emerging micro-VCs that fund them.

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  • Emerging VCs go here

  • Friends of VCs (LPs, mentors, experts, partners) go here


TLDR

  • As a VC, your fund is your product, and your LPs are your customers

  • As an emerging VC, you have the opportunity to shape your fund to solve specific problems for your LPs

  • We outline some use cases we observe LPs solving by investing in emerging VCs, and provide a framework for understanding LP’s preferences

  • Both VCs and LPs can use this framework to improve how they go to market


VCs: Your LP Is Your Customer - Spend Time Understanding What They Want!

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We wrote previously about who invests in emerging VCs. Now we want to talk about why, drawing from insights VCs and LPs shared in our summer cohort.

First, it’s clear that the distinctions between emerging and established VCs are as important as those between Pre-Seed and Series-C startups. 

Sure, from far away, all startups are “startups.” But you don’t need to look very closely at each to know that they have very different needs and present very different opportunities to their customers. 

Second, a VC’s customer is an LP in the same way a startup’s customer is a consumer or a business. A VC’s product is their fund - including features such as structure, portfolio construction, fees, etc. - which the LP is buying, so it’s important to consider what problems your fund solves for your LP (“start with the customer and work backwards”), and how those needs may change over time.

For example, Stripe meant something very different for its first set of users in 2010 than it does to its major enterprise clients today. The fundamental use case is largely the same, but the product underwent numerous iterations in response to what the market needed.

The same is true for an emerging VC for its first set of LPs... So let’s talk about it!

Different LPs Want Different Things From Emerging VCs

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Here’s a test: Ask a handful of LPs why specifically they invest in emerging VCs. Try to get past “great returns” to understand what’s truly motivating them. 

I would bet that you will get different responses from each one, and that many will fit into the following categories:

Generational fund returns

What: The classic institutional allocator strategy is about putting large amounts of capital to work into established platforms with decent, reliable returns - the types of VCs that nobody can access today. This strategy is about building a portfolio of the next generation of coveted VCs.

Who: In 2011, Princeton, Hall Capital, and Wellcome Trust backed Thrive Capital’s $40M fund. Thrive is now a $1B+ AUM platform.

Seed fund returns 

What: The “Generational fund returns” strategy may require LPs to re-up ever-larger commitments to ever-larger funds over decades, so it works well for “permanent capital” LPs. LPs with less capital and shorter time-horizons may instead build a revolving portfolio of small and early VCs with the objective of maximizing exposure to the next generation of unicorns.

Who: Cendana pioneered this strategy in 2009 with its first fund of funds.

Deal flow

What: Returns from the fund are secondary. The primary goal is to get visibility into which startups are outperforming before they raise what will likely be a competitive round at Seed or Series A.

Who: Established VCs like Andreessen Horowitz (among many others).

Access

What: Similar to the “Deal flow” strategy, but coupled with access, i.e. pro rata or actual exposure into specific companies in the form of co-investment allocation rights or secondaries.

Who: Industry Ventures institutionalized this strategy in 2009.

Insights

What: Also similar to the “Deal flow” strategy, but more about market insights and data about emerging trends and specific startups that could enhance or disrupt a legacy business.

Who: SAP started a dedicated fund of funds in 2012 (Winter’s alma mater!). More recently, Facebook was reported to be implementing this strategy.

In summary…

There are a variety of use cases that will drive an LP’s decision to invest in emerging VCs. Needless to say, LPs will rarely fit neatly into any single box - many of the above LPs combine strategies - so consider these examples as indicative rather than prescriptive:

LPs Also Need To Balance Desires And Constraints

One way to think about these strategies is in terms of the degree to which an LP is actively involved in the direct investment process, and to which the LP has buying power (e.g. to get allocation into competitive rounds, make significant acquisitions, re-up into multiple mega-funds, etc.):

This doesn’t mean LPs are confined to one strategy. Instead, as the LP’s circumstances or ambitions change, they can choose to transition or expand from one strategy to another. What seems clear is that emerging VCs have a role in all of these.

Approaches To Product/Market Fit Are Different… But The Ingredients Are The Same

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At the crux of all these strategies: Most great emerging VCs tend to exist because they have unique market insights (especially around frontier markets and technologies), have a track record of identifying potential very early, and lack a brand / are highly motivated to prove their value to their LPs and portfolio companies.

Also, micro-VCs tend to be allocation-rich, but capital-poor. In other words, it’s hard for emerging VCs with small funds to reserve enough capital to exercise pro rata in their best companies round after round. If you are an LP that is far outside the VC ecosystem, however, you likely have the opposite problem... which makes for a potentially perfect pairing!

Finally, emerging VCs also present a “front-runner” opportunity to LPs, whether it’s getting into great startups before brand-name VCs do, identifying technology trends before other incumbents do, or building a platform that other investors will struggle to access in the future.

Some thoughts on how to put into practice:

  • VCs: When defining your strategy, consider the use case(s) that you can address best for LPs, and the types of LPs that you would benefit most. Focus on identifying where you can find the strongest product/market fit

  • LPs: Consider the use cases that are most important to your strategy, and which features you need to fill critical gaps so you have a clear sense of what to look for

Growing the market for emerging VC is important, so tell us about other use cases you are seeing where emerging VCs and LPs are working well together.

Thanks to Ben Metcalfe, founding GP of Monochrome Capital, and member of Oper8r Cohort I, for his feedback on this article.