If you are in favor of innovation, free markets, and competition, all of the above should be unsettling. You could argue that venture capital is following the same “professionalization” that other sectors of financial services have experienced, but that doesn’t make it any less concerning. After all, venture capital’s purpose is to generate outsized returns by identifying outliers, and in its current form, it is fundamentally about discretion. Having fewer decision-makers means that founders working on under-appreciated or unfamiliar ideas have lower odds of getting funded, resulting in an immeasurable loss of both financial returns and innovation.
Everyone’s fingers are in everyone’s pies
This concentration of decision-makers is troubling enough, but something even more concerning is happening: an enmeshment of venture capital.
Enmeshment is “a description of a relationship between two or more people in which personal boundaries are permeable and unclear”. This term is used predominantly in psychology and interpersonal relationships, but it is also an apt descriptor for the financial entanglement occurring in venture capital.
We are increasingly seeing venture capital firms, particularly established franchises with tens of billions of dollars of AUM, investing in smaller, newer firms as LPs. In many cases, the VC firms acting as LPs are executing on the same or similar investment strategies as the VC firms they invest in. Established funds anchoring new ones isn’t a new phenomenon, but as this practice has accelerated, the conflicts have become clearer.
A few recent examples:
- Seven Seven Six, a pre-seed and seed stage-focused venture capital firm, announces they will be seeding micro funds
- Founders Fund, a stage-agnostic venture capital firm that also sometimes incubates startups, led a $20M Series A in On Deck, a company that runs numerous fellowships as well as a startup accelerator that structurally seems similar to YC. On Deck’s founder & co-CEO is also a co-founder and partner at Village Global, a different $100 million venture capital fund
- Tiger Global’s partners committed $1 billion to fund early stage tech funds while Tiger, as a fund, focuses on private investments as early as seed (this is not the same as Tiger’s fund investing as an LP in other funds, which it may also be doing, but it’s worth mentioning given the sheer magnitude of the commitment)
- Sequoia and Andreessen Horowitz, stage-agnostic venture capital firms with dedicated seed funds, invested $23M in a holding company that holds Product Hunt, a leading startup product discovery platform, and another early stage venture fund 🤔 (I can’t be the only one scratching my head at this one)
Look at the LP list of any emerging fund over $25M from the past year, and you will almost certainly see a big fund named. Many, many more such deals are happening under the radar, including anchor checks of hundreds of millions of dollars.
There’s a bit of an “everything old is new again” feeling here. In 2014, Y Combinator announced that in order to “reduc[e] conflicts”, they had ended all “LP and LP-like … relationships with several VC firms”. I don’t know if YC’s LP base still excludes VCs, but this decision is one of few public acknowledgments I’ve seen of the fraught nature of these relationships.
While hybrid investment strategies are not new in and of themselves, institutions typically do not directly compete against the funds they back. They also generally have clear policies on conflicts of interest, separate teams for fund investments vs direct investments into companies, and limited-to-no influence in the funding dynamics between venture funds and the startups they back. As the lines between stakeholders increasingly blur, the enmeshment of venture capital becomes harder to deny.
Given the structural constraints that new managers face when raising from institutional LPs, it comes as no surprise that emerging fund managers are seeking alternative capital sources, including from other funds. Plus, the benefits of this kind of arrangement are tempting:
But for new fund managers looking to build a long-lasting firm, this type of relationship is akin to winning the battle but losing the war. Especially if decision-makers are not clearly delineated and conflicts of interest are not transparently addressed, emerging fund managers who accept LP capital from larger funds are:
- Strengthening incumbents’ positions as arbiters of innovation capital. These large funds have a vested interest in controlling distribution, and favoring them distorts capital flows into the startup layer and risks emerging funds’ future market leadership potential.
- Boosting the returns and accelerating the financial prominence of established VCs. Sure, the paltry check they write into any individual fund is a rounding error for their overall AUM, but given they’re backing many managers, the returns can be meaningful in the aggregate. We still believe emerging funds have the potential to deliver 5–10x+ net to LPs, don’t we?
- Compromising their own independence and their portfolio companies’ optionality, potentially to the detriment of returns. In Mario Gabriele’s piece “ The Future of Solo Capitalists “, he quotes the former manager of a large fund: “Many [solo GPs] I’ve backed have taken large LP checks from a16z, Thrive, TPG and others. Those funds tend to get exclusive rights to pro-rata and follow on rounds…again this will knee cap returns. It is certainly appealing to get that money in the door but it limits future growth and ability to show institutional LPs a track record worthy of a bigger fund II.” Agreements favoring some later stage investors over others also create another layer of incentive misalignment between VCs and founders. Even if there are no binding terms regarding the emerging manager’s strategy and the relationship with the portfolio companies, it is impossible to completely disregard the interests of these LPs, especially given the strategic importance of their ongoing endorsements and references.
- Further choking out institutional appetite to allocate to emerging managers and reducing independent sources of capital for new funds in the future. The risks here are multiple. For one, the larger fund that put a new one in business may expand its own direct investment strategy in a way that cannibalizes them. Additionally, institutional LPs will be less motivated to invest in emerging managers directly if they receive sufficient exposure to them through their existing fund investments. Over time, this trends toward even greater consolidation and lower industry-wide returns, as established VC firms have neither the objectivity nor the incentive to fund the highest potential managers. After all, if you were an established market leader, would you elevate someone who you thought could beat you at your own game? At scale, this reduction in uncompromised, independent LP capital sources leaves emerging managers at the mercy of their larger, better funded competitors in perpetuity.
The notion that established venture capitalists could be reliable judges of future VC industry leaders under any circumstances is suspect, particularly given VCs’ shortcomings and deeply entrenched biases. Diversity in funding outcomes is the canary in the coal mine: it doesn’t guarantee optimal performance, but the homogeneity we’ve seen to date guarantees the lack thereof. Over-reliance on incumbents has resulted in not only broad financial inefficiency but also stunning lapses in judgment. We witnessed LPs committing $300M to a new venture firm based on the founding partners’ Tier 1 VC track records and glowing endorsements, only to later discover that there were reports of sexual harassment allegations against one of the partners at three of his prior firms that no one told them about. In another instance, we saw LPs increase their commitment to a $5B+ Tier 1 VC firm with $560M of fresh capital for a new fund with no women or Black/Latinx investors on their 7-person investment team (yes, in 2022).
Even initiatives explicitly aiming to fix venture capital’s diversity issues rely on existing managers for new manager selection. Screendoor is “a coalition of experienced venture capitalists, institutional investors, and seasoned operators”. Their first investment vehicle is an $87 million fund, raised mostly from more than a dozen large institutions with over $200 billion in collective AUM. According to Screendoor’s FAQ, investment decisions are made by an Investment Committee composed of both venture capitalists and institutional investors. None of the affiliated venture capital firms are LPs in Screendoor, though all of the Founding Advisors (i.e. the individual venture capitalists) have reportedly invested personally. The cynical view is that this feel-good initiative lets large LPs off the hook without moving the needle; a press release that institutions have committed 0.04% of their AUM to diverse emerging VC managers is only inspiring if you don’t do the math. The ambitious interpretation is fraught with conflict: if this is the first step in a meaningful shift toward institutional capital allocation into new VC entrants, why are other VCs whom they’d potentially displace involved?
Despite all these reservations, I’m willing to suspend my disbelief and entertain the idea that involving existing VCs in the selection process for new VCs could have any merit. In such a scenario, what would be the best practices for structuring these relationships at scale? What are the mechanisms for transparency, governance, and accountability that ensure that conflicts of interest are adequately mitigated, independence is maintained, and capital is deployed efficiently? Absent progress in these areas, the increased enmeshment is sure to result in continued suboptimal outcomes, including lower returns and a decline in innovation.
The more time I spend peeling back the onion, the more questions I have. Maybe you can help me unravel some of them.
If you are a founder:
If you are an LP:
And, finally, if you are an aspiring venture capital fund manager:
As a chunk of the existing market ends up stuck in this web, there’s a wide open field for anyone who sees the potential of bucking the trend. Building a new structure is the most exciting opportunity we have. If you have any thoughts, feedback, or ideas, I’m at geri [at] laconia [dot] vc and @geri_kirilova on Twitter.
Thank you to Doba Parushev, Halle Kaplan-Allen, Frank Brown, Rich Cooksen, and my Laconia teammates for their thoughtful feedback on this piece and Del Johnson for countless conversations on this topic.
Originally published at https://www.laconiacapitalgroup.com on March 21, 2022.
