As an investment professional your professional relationships are your most valuable currency. Your relationships with your limited partners are no different. The investment landscape continues to shift toward and favor teams that can create and continue to demonstrate value through long-lasting connections.
Your LPs are no longer just looking for a firm to invest in, they want a firm they can actively collaborate with. Here are three ways in which the traditional relationship between LPs and GPs has evolved and what has triggered these key changes.
LPs are strategically influencing business practices to “do what is right”
With growing respect for sustainable investing through environmental, social, and governance (ESG) as well as the sustainable development goals (SDG), LPs are voicing their desire to look at investments through a lens of global consciousness. More than ever before LPs want to strategically influence how and where your firms investments are made and, in some cases, affect the governance of your firm itself.
Establishing good business practices is, of course, not foreign to venture capital, but the approach to doing so is evolving with LP interest. Dave Richards, Co-Founder and Managing Partner, Capria Ventures, shares that many GPs are now hiring consultants to assist in building compliance-oriented policies and systems that can report against these requirements.
Richards suggests that this approach can be strengthened by proactively building internal capabilities, noting that this approach sits well with LPs while also contributing to strong financial results. Richards advises that this rich area is one where LPs and GPs can work together to make a real difference. Alternatively, teams that can confidently rely on the security capabilities of their tech stack can position themselves, and their LPs, for success.
LPs are aiming to increase return on investment through co-investing
There is nothing stopping sharp LPs from investing on their own. Indeed, many LPs want to directly invest at an early stage in promising companies. One way of doing this is to co-invest in one or more companies alongside the firms in their fund. McKinsey found that the value of co-investing deals like these more than doubled from 2012 to 2018 to $104B.
William Kilmer, Managing Partner with C5 Capital, shared his views on the motivation for co-investing, referencing a Preqin study that showed that 80% of investors found that their co-investments outperformed private equity fund investments, and 46% of those outperformed by a margin of more than 5%. And because investors typically pay lower fees for the additional investment, they see a higher profit on these “blended” investments if the company is successful.
This makes it even more important to effectively track potential deals in detail to make sure you can efficiently close any co-investment opportunities and continue to build a quality partnership with your LPs.
LPs are increasing their likelihood of success through active participation
In a recent article, aptly titled Collectivizing Finance: Why The Future of VC is Multiplayer, co-authors Annika Lewis, an investor at Vanedge Capital, and David Phelps, a two-time founder, describe the emergence of multiplayer finance. Lewis and Phelps speak of one of the root causes of this trend—the desire to increase the probability of success by working collectively, rather than individually.
Recognizing that LPs have a lot to contribute to the success of a business is key. Lewis and Phelps outline the change that is already occurring as venture capitalists look for new and unique ways to compete. With hungry, intellectually curious LPs coming to the table with a capability set that extends beyond just capital injection and objectives that extend beyond just financial returns, Lewis and Phelps envision a state where “Limited” Partners are no longer limited.
While the three areas outlined here indicate an evolving change in the relationship between LPs and GPs, the effort required to embrace the changes should not be underestimated. Colin West, an investor at Ensemble VC, and Nihar Neelakanti, during his tenure as an investment associate at Kauffman Fellows, summed up the greatest challenge LPs and GPs face as they work more closely together.
At the end of the day, success for an LP means achieving consistent outperformance through a portfolio of managers that exceed expectations and rarely fail. And that requires a different business approach from a venture capitalist who accepts a high chance of failure for a shot at wildly asymmetric returns.
With such contrasting investment intuitions required for success, it’s on both GPs and LPs to appreciate these differences and nurture ongoing, productive relationships. Having a toolset that allows both parties to transparently communicate about the performance of a deal pipeline and to set and manage expectations on big deals is more important than ever.