More institutional investors than you might think are hungry for venture exposure—as long as co-investing rights are on the table.
I recently asked the CIO of a large public pension plan what terms they’re asking for from new prospective venture managers, and getting into GPs’ deal flow was what they cared about more than anything else.
What would bring this CIO to the table? “Fee-free, carry-free co-investing,” the CIO said.
Co-investing rights give LPs the ability to acquire an equity stake alongside the GP, often through a sidecar vehicle. This direct access to deal flow allows allocators to concentrate their portfolio in specific companies or an emerging technology—generative AI, for instance.
Within the venture world, co-investing has taken off full steam. As many emerging managers are scraping to get to their funds off the ground, allocators can demand more favorable terms—and ramp up the upside potential of venture by joining the cap table of their favorite startups. But for GPs, whether to offer co-investing rights isn’t a no-brainer.
Lower fees can attract LPs by saving them money, but the benefits are marginal. Co-investing rights can move the needle for performance in a more meaningful way. “If you’re in a fund that has a 4x return, a 10% discount on fees is like, ‘Why did I bother?’. You want the GP economics, the optionality of the upside,” the CIO told me.
Blue chip mega-funds and emerging managers with stellar networks can still raise capital on attractive terms. But many who aren’t as established, especially first-time fund managers, are weaving in co-invest rights without fees or carried interest.
After all, LPs have the upper hand in today’s market. Allocators have cooled on venture in favor of more liquid holdings, and if they are still making commitments to the asset class, they’re mostly doubling down on existing relationships—not taking big bets on untested funds.
Take Eyal Bino, a first-time fund manager who recently closed his $20 million fund, 97212 Ventures. Bino offered co-investing rights on a no-fee, no-carry basis to his LPs. “This is a first-time fund and I wanted to be as friendly as possible to my LPs,” he said.
Co-investing allows LPs to access pro rata rights on the cap tables of high-growth startups, a tempting opportunity to find the next Uber or Facebook before anyone else. The best founders typically want to work with VCs, and co-investing allows LPs access that they’d struggle to get on their own.
‘Blood in the water’
“There are some funds that are scraping for every dollar just to get off the ground and up and running,” said Javad Mostofizadeh, a partner at Latham & Watkins who advises venture capital funds. “LPs smell a bit of blood in the water and are asking for a lot of things.”
But if LPs are more interested in co-investments than fund commitments, it can create a weird dynamic. If an LP is only making the minimum possible check size required for a fund, but reserving larger pools of capital for direct deals, it misaligns the LP and GPs’ incentives and means GPs have much less flexibility. “We advise clients to be careful,” Mostofizadeh said.
If LPs are devoting more capital to co-investing than to funds , it may be a sign that an LP is only investing in an emerging manager to get access to their deal flow—rather than as a vote of confidence in the manager’s strategy. “It’s far more about, are you building a relationship with the managers you’re investing in?” said Josh Porter, managing partner at FirstLook Partners, a fund-of-funds that also invests directly in high-growth software companies.
Instead, Porter’s strategy is to invest foremost in seed and early-stage fund managers, then step in for follow-on rounds once the manager is tapped out to provide an additional source of cash.
The dream that a family office might stumble upon the next generation’s AirBnB or PayPal is an enticing one. But if they’re not familiar with the asset class and its pitfalls, it can quickly turn into a trap.
GPs’ pro rata rights “can always be rewritten by the next investor coming into the round,” Porter warned, where an LP still risks being written out of the lion’s share of the upside in subsequent rounds.
Featured image by Megan Woodard/Pitchbook News
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