Potential LPs in a venture fund ask themselves and wonder about incentives. How can I align interests with the fund manager to reduce the principal-agent problem? How can I ensure that that GP will be focused on stewarding my capital and taking appropriate risks to generate returns?
A classic answer is to seek to invest alongside GPs who are investing their own money in the fund.
When GPs have “skin in the game” like this, the hope is that they will act more like investors when making decisions. If the GP were to have no money in the deal to lose, then carry can be equivalent to a call option which may cause more risk-seeking. (Early-stage venture is such a risky asset class, that maybe you could argue that it doesn’t matter? You do want GPs making good decisions that have a very high payoff if high-risk.)
Financial capital is not the only form of skin in the game for a GP. Reputations, time, and social capital are other forms of skin in the game for a GP. Yet, as ILPA’s policy says: “We continue to believe that a GP’s own capital at risk serves as the greatest incentive for alignment of interests.”
In theory, your fund is a great investment, so as a GP you will want to invest a lot of money. But there are trade-offs. If you have too much of your networth in one fund, you are not properly diversified and may become risk-averse. LPs don’t want a GP to be overly risk-averse anymore than they want them to be too risk-seeking.
So, there can be too much GP money in a fund and too little.
The middle ground appears to be 1 to 5% GP commit expected.
And further ILPA’s policy says “GP equity interests in funds primarily made through cash contributions result in the higher alignment of interest with LPs compared to those made through the waiver of management fees.”
But fund cycles have sped up from every 4 or 5 years to every 2 or 3 years. And with growing average fund sizes, the amounts can add up. It can become a challenge for a GP who has not already had significant financial success.
For a $250M fund, for example, a 2% commit among 4 partners is $1.25M per partner. And then again for the next fund or two without being able to count on cashflow back from carry. With a 20% allocation to venture capital (which would be high by traditional standards) that would require a personal liquid balance sheet of $12.5M+.
In reality, GPs often allocate more to venture capital than is prudent for net worth. And/or they choose one of the following options. You will want to think carefully about what happens if a partner leaves the fund after financing part of their GP commit.
- Uneven GP Split: If there are partners who have more capital and are willing to invest more in the fund, other partners can contribute less.
- Financed by Other GPs: The others partners individually or through the management company or other entity can loan money to the GP for their GP commit.
- Financed with Fee Waivers: Management fee waivers can be used to count towards GP commit.
- Financed from Carry: Applying future unearned carry to GP commit is possible although starts to get further from having money at risk in the deal.
- Outside Loan: There are specialized banks that will provide a loan to the management company or to individual GPs. If borrowing the money, then you have leverage in the system and that has the potential for putting more stress and risk into the system. You will want to manage a prudent level of borrowing.
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