How to Accelerate the Fundraising Process of Venture Capital Funds

Exploring Preferential Economics Offered to Limited Partners

Fundraising poses the most significant challenge for first-time or emerging venture capital fund managers. However, there is a strategy that aspiring fund managers can employ to accelerate the fundraising process: offering preferential economics to limited partners (LPs).

These "deal sweeteners" often involve fee and carry discounts or a long-term percentage of gross revenue in exchange for a substantial or early upfront commitment. They play a pivotal role in attracting LP interest to first-time funds.

Preferential economics in fundraising include seed deals, anchor commitments, deal warehousing, and co-investing rights. These options can significantly impact a fund manager's ability to raise capital and even create a domino effect, enabling successful fundraising from other investors.

However, the decision to engage in any of these deals should be carefully evaluated by each manager. Aspiring first-time fund managers need to weigh the potential benefits against the long-term economic implications over an extended time horizon.

Now, let's delve into each of these options:

⚓ Anchor Commitments ⚓

Anchor commitments refer to LPs' commitments that make up a significant percentage of the target fund size, typically around 20% to 25%. These commitments are often pursued during the first or second close of a fund and can help accelerate the fundraising process for aspiring General Partners (GPs).

As I mentioned in one of my previous Linkedin post, an anchor investor typically commits a maximum of around 20% of the target AUM (Assets Under Management) for a fund. This is in contrast to a company that can secure a venture capital fund investing more than 50% of the round. Achieving success for emerging managers in such a scenario requires the involvement of multiple "anchors," making the situation more complex.

When a reputable LP makes a substantial commitment to a fund, it establishes the fund manager's credibility, making it easier to attract additional commitments from other LPs. In exchange for taking on the risk of making a large commitment to a new manager, LPs usually receive a fee discount. For example, an LP making an anchor commitment could have a fee and carry ratio as low as 1 and 10, compared to the standard 2 and 20. However, this situation could potentially trigger a Most-Favored-Nation (MFN) clause and might pose challenges when explaining it to other LPs.

🌱 Seed Deals 🌱

Seed deals, initially developed in the hedge fund industry, have become a popular option for managers across various private market asset classes. The terms of seed deals vary significantly depending on the parties involved, their negotiating power, and their contributions.

Similar to anchor commitments, seed deals aim to support first-time or emerging managers beyond the initial fundraising phase while providing long-term economic benefits to the seeder. These deals typically involve a commitment to the fund, and in some cases, additional "operating" capital to help the manager establish and run their operations.

In scenarios where an LP makes only a fund commitment, temporary revenue or profit sharing may be involved. On the other hand, if the LP provides working capital alongside the fund commitment, it is usually accompanied by an equity stake in the firm. For instance, a GP might receive $500k in working capital, pay a 10% interest rate to the seeder, and provide a 20% stake in the management company. Meanwhile, the LP commits a certain amount to the fund. Investors in these arrangements usually pay full fees and carry for their fund commitments since they receive an equity stake or revenue share.

Zooming in on "Revenue or Profit Share"

Revenue or profit share allows LPs to benefit from preferred fund economics without the complexity of owning an equity stake in a GP or management company. Revenue shares, in particular, are preferred over profit shares, especially for early-stage funds that often face slim profit margins. These shares typically involve a percentage, typically around 20%, of the revenue generated from management fees and carry. The seeder receives this share until a specific triggering event occurs, such as the launch of a third fund, the repayment of a predetermined investment multiple, or the achievement of various milestones.

Zooming in on "Equity Stake"

Equity stakes align the interests of the seeder with the success of the fund. However, careful structuring of agreements is essential to avoid complications. Equity stakes can be permanent or have a sunset clause triggered by specific milestones, such as reaching a certain AUM or performance hurdle.

📦 Warehousing 📦

As a first-time fund manager, you may consider "warehousing" portfolio deals, which involves securing a set of investments before officially launching the fund. This can be done by personally investing as an angel investor, negotiating with portfolio companies to reserve allocations for your fund, or convincing LPs to warehouse investments in a special-purpose vehicle (SPV) that will be transferred to the fund at closing.

In a standard warehousing agreement, an LP typically provides funding for the initial deals executed by a GP, which are then placed into a dedicated SPV. Subsequently, when the GP closes the fund, the SPV (or the deals) is transferred to the newly established fund. Warehousing de-risks the fund, allows participation in marked-up deals at lower valuations, and showcases the GP's deal flow as well as value-add. However, if the fund doesn't materialize, the LP must take on the warehoused investments.

🤝 Co-investing Rights 🤝

Co-investing rights have gained popularity as LPs increasingly express interest in direct investing. Co-investing allows LPs to invest alongside the fund as co-investors. This approach often comes with reduced (or preferably no) management or carry fees, enhancing the overall profitability of the co-investment. LPs appreciate the additional control over their portfolio exposure compared to blind pool investing. While offering co-investing rights can attract LPs, it's crucial to efficiently manage the deal-making process and navigate potential conflicts of interest with other LPs seeking the same rights. Again, it's important to be mindful of any MFN clause that may be triggered in such cases.

⚖️ Pros & Cons ⚖️

When it comes to accelerating the venture capital fundraising process, preferential economics can be a game-changer. However, it's important to consider the key factors and weigh the advantages and disadvantages.

Advantages of Preferential Economics:

1️⃣ Accelerated Fundraising: Offering preferential terms, such as anchor commitments or seed deals, can attract LPs and provide significant upfront capital. This can shorten the fundraising timeline, making it ideal for first-time fund managers who need to establish credibility and build momentum swiftly.

2️⃣ Enhanced Credibility: Securing an anchor commitment from a reputable LP can bolster your fund's credibility. When other potential LPs see a respected investor on board, it instills confidence and encourages them to join in. It can act as a catalyst, paving the way for additional commitments.

3️⃣ Mentorship and Support: Seed deals often come with mentorship and support from the seeders. This guidance can be invaluable, especially for emerging managers who may benefit from expertise in areas like marketing, risk management, access to a new network, and overall business development.

Disadvantages and Risks to Consider:

1️⃣ Long-Term Economic Impact: Preferential economics may result in lower initial revenue for fund managers, as investors often receive fee and carry discounts or a share of the fund's revenue. It's crucial to evaluate the long-term implications and assess whether the potential benefits outweigh the reduced revenue over time.

2️⃣ Complexity and Deterrents: Some preferential structures, such as revenue or profit shares, can become intricate and deter other LPs from committing to the fund. Striking a balance between attractive terms and simplicity is vital to avoid complications and maintain broad investor appeal.

3️⃣ Loss of Autonomy: In certain cases, having an anchor or seed investor can lead to reduced freedom in managing and operating the fund. They may expect more involvement and influence, potentially affecting the fund's decision-making process. A diversified group of LPs can provide a healthier dynamic for long-term success.

By carefully considering these factors, you can make informed decisions about pursuing preferential economics in your fundraising journey. The right approach will depend on your unique circumstances, goals, and the trade-offs you're willing to make.

🎬 Conclusion 🎬

Fundraising can be a daunting challenge for first-time or emerging venture capital fund managers. However, preferential economics offer a promising avenue to accelerate the fundraising process.

These strategies come with their own set of advantages and disadvantages. On the positive side, preferential economics can lead to accelerated fundraising, enhanced credibility through reputable LP commitments, and valuable mentorship and support. However, fund managers must carefully evaluate the potential long-term economic impact, navigate complexities, and consider the potential loss of autonomy associated with these arrangements.

Ultimately, the choice to incorporate preferential economics rests with each fund manager, who must carefully weigh the potential benefits against the trade-offs they may encounter over an extended time horizon.