Rolling Funds - Welcome to the Uncommitted LP

Rolling funds are depersonalizing capital in a market that clearly rewards capital that comes with relationships and specialized expertise/networks/value-add

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Tl;dr

  • Rolling funds could bring new investors and sources of capital into the ecosystem, while giving LPs some control over the timing of their commitments to VC

  • The way rolling funds are structured, they may challenge the long-term nature of VC as an asset class, which could create misalignment for VCs, LPs, and founders

  • Rolling funds downplay investment concepts that could lead to VC outperformance, such as longer-term meaningful ownership, power-law investing, portfolio construction, and encourages stock picking versus relationship building

  • From a mechanics and cost perspective, rolling funds are not radically different from traditional funds, given VCs can already hold multiple closes with traditional structure, and rolling funds are not much cheaper to start

  • Rolling funds can empower a more diverse group of future GPs who otherwise might now have had the opportunity to invest, but are still restricted to accredited investors investing in other accredited investors

Our goal at Oper8r is to empower emerging VCs and bring more credibility and transparency to early-stage VC where we think there is a consistently large opportunity for founders to get great GP partners and LPs to invest in hungry and unique GPs. We are pro-VC and pro-innovation. We strive to make VC better overall, for founders, GPs, and LPs. In particular, we believe in developing products and platforms that enable alignment across founders, GPs, and LPs by improving process, information flow, and transparency.  

Some context: I want to make it clear that I applaud the AngelList team for continuing to expand the boundaries of the VC industry, creating opportunities for new innovators and investors to enter the market. Building on an opportunity presented by the Jumpstart Our Business Startups (JOBS) Act of 2012, AngelList introduced its rolling funds product, which rolled out in Beta earlier this year, and more recently was announced through a larger public effort. I see these efforts as largely positive, leveraging technology to drive innovation in the VC market. But I also want to share my view on how this product fits in the current VC ecosystem of founders, GPs, and LPs. 

Why I like the rolling funds concept:

  • Brings more capital to innovation. Few investment platforms are capitalizing on Rule 506(c) of Regulation D, which had an intention to help finance more startups. In 2019 alone, AngelList enabled the financing of over 1,600 startups, and AngelList pushing the boundaries through rolling funds should enable more financing of early-stage start-ups. 

  • Empowers new VCs. Currently, the expectation is that rolling funds will attract more operator-angels and those with large media followings to enter the business of VC. 

  • Enables more diversity in VC. Women and people of color can leverage the structure to raise VC funds, which may have a great economic benefit of bringing capital to opportunities traditionally underserved by VC. (More discussed here to this point by Minal Hasan.)

  • Gives more discretion to the LP over liquidity profile and commitment. The traditional VC fund structure locks up the LP’s capital for a minimum of 10 years; with rolling funds, LPs would now have the option to invest into VC with a shorter duration, which may give some LPs who are concerned about illiquidity more comfort. (As an aside, an active secondary market providing liquidity to early-stage VCs could also fill this role.)

  • Facilitates fundraising for long-tail LP’s by being a good channel for LP discovery, especially since rolling funds can be broadly solicited and generally advertised. (Although there may still be a limit on how many LPs you can take in as LPs into your fund by law. See here for an indication of where these VC funds may hit a regulatory wall.)  

  • Promotes accountability of VCs by measuring performance on a quarterly basis. If VCs have to answer their investors every quarter, it will be much more clear who is and who isn’t performing, which may help the “market” figure out earlier who has the Midas touch

Why I find the rolling funds concept problematic and wanting:

  • Makes VCs and LPs measure performance on a quarterly basis, which is at odds with the reality of how long it takes to build a great company.  Throwing away the traditional VC lock-up period may affect how VC is viewed as a long-term oriented business that should have a longer lock-up period to allow companies time to grow. It is to be determined how this structure could further drive short-termism in VC. 

  • Because VCs can already hold multiple closes with a traditional VC fund structure, rolling funds are not radically different than what already exists. From what I have experienced, most emerging VCs raising traditional funds already have multiple closes during a fundraising process. 

  • Because LPs already make relatively short-term decisions on whether to re-up (about every 2 years), rolling funds are not radically different than what already exists. In the current market, VCs raise traditional funds about every 2 years, so LPs are already making decisions to invest on a short-term basis (even if their capital gets committed for a long-term duration). 

  • If VCs have to ask for commitment/re-commitments on a quarterly basis, this could make the relationship between the VC and LP more transactional, and less focused on first finding alignment on long-term investment objectives. If the VC and LP are not engaging, building trust, and finding alignment, does this actually help the VC scale over time? 

  • Causes the LP to potentially miss the power law dynamics of VC that usually create returns at the fund level, which could negatively impact LP performance. If LPs are new to the asset class, and don’t understand VC assets, then rolling funds may drive LPs to buy high or sell low. This is not aligned with LPs’ objective to access VC to achieve outperformance in their portfolios. 

  • Never creates a forcing function for LPs to commit to VCs in the fundraising process. On the one hand, rolling funds let an LP invest (or withdraw funds) on a quarterly basis. On the other hand, this could mean the LP is never forced to make a decision because another decision point is only a quarter away. In traditional VC funds, LPs are forced into making a decision when the fund is open. If the LP does not commit during that fundraising period, then the LP can’t invest at the original cost-basis. If larger investors, mainly institutional LPs, are not being forced into a commitment decision and initial funds are already being financed by friends and family with the traditional structure, then it’s not clear why this structure truly changes the current market dynamics. 

  • May create conflicts between LPs who commit in different time periods. As the VC, which LPs are you serving if you are closing a new fund creating different LP bases every quarter? VCs should be aware about potential conflicts of interest with respect to access, terms, and timing of deals. 

  • Is another fund product that strays away from optimizing performance for the LP.  If returns are calculated on a quarterly basis, this could create misalignment, similar to how an AngelList syndicate may misalign incentives, because absolute performance is generated on a short-term oriented vehicle, versus a long-term oriented vehicle where the VC has to manage the long-term success of the fund. 

  • May downplay decision-making frameworks for making new investments. My view is that pattern recognition and experience developed over time based on a long-term understanding of successes and failures can contribute to good investment decisions. If rolling funds do not attract this type of investor, then while it should enable deployment of more capital, it does not necessarily provide the long-term partners VC-backed entrepreneurs are looking for as they scale their businesses. 

  • May make being a VC a part-time business. If you are investing part-time, for example, because you are running another business full-time, this may mean that the companies being financed do not get the attention they require. Full-time VCs, on the other hand, provide capital, as well as platforms to help their portfolio companies (the performance of these platforms can be debated in another post). While it’s cool to be a VC (so they say in Europe), being part-time may erode some investment lessons that could prevent costly errors in the long-run (presuming VC is an apprenticeship business)

  • Rolling funds focus on making raising capital easy for VCs, and not about managing risk or enhancing LP returns. While rolling funds have an intention to “democratize access to VC”, enabling less well-versed LPs to invest in the highest risk assets in VC may not be the best long-term for the VC industry if too many LP’s are negatively impacted through this structure. 

  • Rolling funds ignore the important concept of portfolio construction, which is a valuable exercise for fund managers, especially as it relates to reserves and liquidity management. Is this necessarily a bad thing for a first-time fund? Well, that depends if you think follow-on dollars and protecting equity dilution is a good thing. Or if you’ll need capital for that pay-to-play provision down the line. 

  • According to the fine print that I’ve seen, as an LP, you can still cancel your “subscription” to the fund at any time, which may not be favorable for a VC trying to build a long-term business. Again, this seems to potentially disadvantage VCs who will have to dedicate time to fundraising, but the slightest mis-step or psychological change of the LP may lead to cancelled subscriptions. 

  • From what I can tell, the cost structure of running the fund does not change for the VC starting a rolling fund. For rolling funds, AngelList charges VCs three times: fund administration fees, entity structure fees, and carry if they help you secure LPs.

  • There’s still a glass ceiling when it comes to rolling funds enabling more diversity in VC, given the exemption that rolling funds fall under requires that they are led by accredited investors marketing to other accredited investors, which is less than 10% of U.S. households. Effectively if you don’t have a high salary or $1 million (excluding your house) in the bank, this may prevent certain groups from still accessing LP dollars.