The More Things Change... (The Mostly Inert State of the Limited Partner) - 1

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The More Things Change... (The Mostly Inert State of the Limited Partner) - 1
The other day I was watching part of 500 Startups' PreMoney conference live video stream and I happened to catch the Limited Partner ("LP") panel.

It was a group of five or six CIOs and Alternative Investment Managers from large institutional investment funds and fund-of-funds, and it was incredibly boring.

It immediately brought me back to my time attending conferences and listening to LP panels while fundraising for Square 1 Ventures in 2008. Everyone was saying the exact same things as they were back then and speaking in generalities about the characteristics they look for in a manager: "good track record", "honest about performance", "patient approach", "can manage in all macro environments" and more empty and banal platitudes.

Right after the LP panel, Naval Ravikant, founder of AngelList (a company that is completely changing angel investing and which I believe will continue to eat its way downstream) had a fireside chat in which he discussed the impact of AngelList. Contrasting these two sessions left me shaking my head: how can there be so much change and excitement going on in the world of direct investing, while one level up the food chain everything is so stagnant and dull?

There are a lot of reasons, but one of the biggest factors is not complicated. Almost all institutional LPs set mandates where they divide their assets into allocation pools in pursuit of a target diversification. They then make investments in order to maintain these acceptable ranges of exposure to each asset class. For example, an endowment may have a 50% allocation for public equities and a 10% allocation to private equity. Within that 10% allocation, 5% may be PE and 5% may be venture capital. If the endowment is $2 billion, this means that at any moment in time the endowment is seeking to have $100 million invested in VC funds.

Furthermore, the endowment will have an investment minimum, likely in the range of $10-20 million. This means that the Alternative or Private Investment Manager will look to maintain a portfolio of 5-15 funds. If a fund is liquidated and exposure diminishes, the manager makes a new investment to get back to that target allocation. This model drives decision-making.

While at the macro level this may seem like a logical approach to investment management, it results in some dumb actions in real life scenarios. Take for example 2008, when we at Square 1 Ventures had the misfortune of raising capital while the public markets were taking a nosedive. All of the institutional investors we spoke to were in crisis mode: their public portfolios were down by around 50%, and as a result, they were heavily OVER-allocated in all the other positions. This is called the "denominator effect" because if you managed $2 billion and had a 5% allocation to venture ($100 million), but your portfolio suddenly shrunk to $1 billion, guess what? 10% of your money is now in venture capital! You're over-allocated! Sell!! SELLLLLL!!!!

The secondary markets were suddenly flooded with institutional LPs seeking to liquidate the PE investments they had just made at pennies on the dollar - all in order to get their allocation pie chart to look like the one their CIO or investment advisor developed for them. Fortunately for us, we had no pie chart - all of our capital was allocated for venture funds. I say fortunately because funds raised in 2008 actually ended up performing quite well and our fund is actually the top performing PE fund-of-funds of its vintage year.

Over the course of our fundraising efforts, we ran into a number of investment managers who told us outright, "Look, I agree with your strategy and I like your portfolio [we had a pool of ~5 fund investments in advance of our final close] but there's no way I can take this to my investment committee right now".

In other words, there was no incentive for investment managers to do what they thought would actually produce the best return for their fund. Why, you may
The More Things Change... (The Mostly Inert State of the Limited Partner) - 2
ask? Because most managers don't get compensated for performance, and if they make an unpopular investment that doesn't work out, they get fired. This 2 by 2 grid should explain their thought process.

The point of the chart is that most investment managers would prefer to follow the crowd and look for brand name investments they won't get blamed for if things go wrong, rather than try to pursue opportunities that they think will produce the best returns. Put another way, they're incentivized to avoid personal downside, not pursue performance upside.

Also relevant to the discussion is the fact that PE (and venture in particular) is a long term investment. It may be 10+ years before venture investments made today are realized, and at least five years before the investment manager has a solid idea of an investment's expected performance. Now, consider that many asset managers are looking to advance their careers by either moving to a larger endowment offering a better salary or to the direct investment side of the business (PE or VC), which offers better compensation through carried interest and salary.

High turnover means that the person responsible for an LP's asset class allocation today may not be the person who actually built the existing portfolio. It can also mean that the original manager doesn't care about how the investments made ultimately perform, since he or she will probably be on to the next role before it's even known if a decision was good or bad. This provides further disincentive for investment managers to pursue funds and strategies outside what is trendy or popular.

These factors combine to generate irrational decision-making. No wealthy person would ever (intentionally) manage money this way, yet because institutional capital is usually a pool of public money owned by no single person and managed by a group of individuals with no skin in the game (i.e. personal capital risk), incoherent decisions are regularly made and explained away as the status quo. The people paid to be experts and make hard decisions (investment managers) only stand to lose if they go against the crowd but end up being wrong. It's a broken system, but those who know the system is broken have nothing to gain from speaking up.

That brings us back to the present. Despite all the macro changes going on with venture capital - the lowering cost to build a company, innovation by companies like AngelList, increased transparency through sites like Mattermark, even regulatory changes like equity crowdfunding - the institutional LP world is still telling the same story from years ago.

These institutions like experienced managers with skin in the game and high integrity. They look for teams with an unassailable strategic advantage. They seek diversification across stage, sector, vintage year and geography. They seek to outperform the market while limiting risk.

And if you happen to know about a job with a better salary and maybe a little bit of decision-making freedom, give them a call.