How to scale a venture capital (or private equity) fund


David Teten, HOF Capital, private equity, venture capital

By David Teten, HOF Capital

VC fund managers typically want to grow their businesses aggressively, just like the founders we back. But we normally have a clear ceiling on how high we can grow AUM before hitting practical limits to deploying capital within the traditional VC model.

My partners at HOF Capital are younger than I am, which means we have a half-century horizon for the franchise we are building. So we think about scaling a lot.

A VC fund can be scaled in a number of ways. I’ve listed them below in roughly descending order of efficiency, measured by increased dollars one can put to work, divided by the operational dollars required to implement each strategy.

– Template the entrepreneurial process: Provide checklists, standardized agreements and other reusable code. Among the sites we have found most helpful with practical guides for founders: BiztreeFirst SearchFoundersuiteGoodwin Founders WorkbenchGuides.coInc.comand StartupRocket.

– Encourage founders to turn to other founders and their broader communities, not just the VC’s own staff, as resources. This evolves the VC from a server to a router.  First Round Capital’s forum for portfolio executives is a powerful example of a scalable resource.

– Build out low-cost force multipliers such as scouts, advisers, entrepreneurs in residence, venture partners and so on. Sophisticated VC and private equity funds have a wide array of options for leveraging outside operating executives. Typically these outside resources are paid only on a success basis, so the marginal cost is low.

– Create a franchise and license access, e.g., the Draper Venture Network. This is a clever way for Tim Draper to leverage his brand and experience.

– Coinvest nearly exclusively, without leading rounds or taking board seats. This is a model used in at least one case by China’s third-largest private equity firm, China Science & Merchants Investment Management Group ($12 billion+ AUM), which in 2015 funded CSC Upshot, a $400 million seed fund, through AngelList.

Another example is Correlation Ventures ($300 million+ AUM), a VC firm that co-invests in financings with at least one other new outside VC. The firm attracts deal flow by promising a decision (positive or negative) in under two weeks, with minimal paperwork and without repeating due diligence. Other companies with variations of this model include Alpha Venture Partners,Connectivity Ventures FundCrowdfunderand Proof.VC. Co-investors need to figure out ways to prioritize themselves in a VC’s preference stack for syndicating opportunities.

– Syndicate Special Purpose Vehicles for specific opportunities. VCs can do this entirely themselves and/or use companies such as AngelListCircleUpFundersClubOurCrowd and SeedInvest to create a SPV. Some of the VC fund’s own LPs will typically invest in a SPV, plus the platform’s members can contribute additional capital.

– Raise an opportunity fund (aka sidecar, overlay or bolt-on) that selectively invests in later rounds of earlier portfolio companies, typically at lower management fees than the primary fund. This enables a VC to put more capital to work in its past portfolio companies with relatively little extra effort. (These are distinct from annex funds, which typically are used to support existing portfolio companies after the VC has run out of capital in its core fund to do so.)

Accel PartnersAndreessen HorowitzBatteryFoundry GroupGreycroftand Union Square Ventures all have created opportunity funds.

All the strategies above have very modest fixed cost. A few more listed below require meaningful startup and ongoing costs. This requires a real financial sacrifice. VC is a “get rich slow” business because most VC partners will not see a carry check for five to 10 years, after both liquidity events and payments to LPs. A VC’s job is to invest in unprofitable businesses, expecting to create long-term value. We all do that with our portfolio companies, but many VCs are not comfortable taking the short-term compensation hit by doing it internally within their management company.

– Hire more non-partner staff.  USC Marshall Professor Noam Wasserman observes in Upside-Down Venture Capitalists and the Transition Toward Pyramidal Firms: Inevitable Progression, or Failed Experiment?: “The early-stage VC industry was [historically] dominated by small firms composed primarily of senior staff members and only a few junior members. In this, they resembled many other professional services firms. In the late 1990s, a number of VC firms (following other professional services firms) adopted pyramidal structures and new internal procedures, relying on a larger number of junior staff, and becoming more institutional and professional.” Wasserman observes that the accounting, investment banking, and law firm industries all started off with non-pyramidal structures but now are hard to envision without their current pyramidal model. Thirteen years after Wasserman’s paper, the VC industry is still notably lacking the traditional pyramidal structure of professional services firms.

 Hire more partners. For a VC fund to actively engage in a large number of investments, it needs to hire more partners to sit on more boards. Beyond a certain number of partners, however, VCs historically have not been manageable; it’s too hard to herd the cats, who are often each former CEOs. Even the largest VC funds rarely have more than a dozen partners. Andreessen Horowitz’s compromise: The firm has a half-dozen board partners who are not full-time employees of A16Z but represent the firm on the boards of its portfolio companies. If you’re thinking of hiring a partner, see How to Negotiate a Partner Role at a Venture Capital or Private Equity Firm.

– Provide hands-on operational support for portfolio companies. HOF Capital provides hands-on support through our in-house team, plus a network of outside mentors who work with portfolio companies on an as-needed basis. We particularly help companies in winning revenue from our LP network and raising capital for subsequent rounds from top-tier late-stage investors. I see a small number of other VCs at our stage pursuing a similar, equally expensive strategy.

– Launch a venture studio or foundry. (I’m distinguishing these from incubators and accelerators.)  Venture studios work as co-founders with a founding team, with the larger ones assigning dedicated internal teams for each startup idea (e.g., engineers, designers, business developers). Typically, they get co-founder common equity in addition to the preferred stock that a conventional VC gets. Examples include BetaworksExpa,Efounders, FJLabs, Idealab, Juxtapose, Science Inc, Prehype, Rocket Internet, and numerous others. For more, see the Startup Studio Playbook.

– Launch a venture capital fund-of-funds. Foundry Group recently launched Foundry Group Next, which will further strengthen its impressive connectivity in the ecosystem.

– Semi-automate the investing decision by using analytics on large datasets to generate idea flow and inform investing decisions. Among the VCs pursuing variations of this model are Correlation VenturesHOF CapitalGoogle VenturesIronstone GroupSignalfire and Venture Science. For details on this, see The 9 Steps of Using Technology to Improve Investing in Private Companies.

– Go public. Examples of publicly traded investors in tech companies in the U.S. include Alphabet (GOOG); Actua (formerly Internet Capital Group) (ACTA); GSV Capital (GSVC); Harris & Harris Group (TINY) and Safeguard Scientifics (SFE).

Many more public U.S. entities invest in almost any category of private company (typically taking a majority or 100% stake), including my former client Icahn Enterprises (IEP); Fortress Investment Group (FIG); MCG Capital (MCGC); Apollo Investment (AINV); Blackstone Group (BX); Ares Capital (ARCC); Berkshire Hathaway (BRK-A) and Prospect Capital (PSEC). Prominent investor Chamath Palihapitiya recently said he was launching a blank-check public VC fund, hoping to raise $500 million in an IPO.

Unlike the modal VC, U.S. public companies typically find it difficult to take small minority stakes in companies as their core business because of their regulatory regime. There are significant challenges to being a U.S. publicly traded VC, including compliance with the ’40 Act, negative tax implications, and unpredictability of revenue.

That said, Europe is different: Draper Esprit (LON: GROW) is a British VC that recently IPO’d, joining a number of public VC firms in Europe, including Imperial Innovations, IP GroupBGF Ventures, Eight Roads, Octopus Ventures and Partners Group.

Disclosure: I have a financial interest in Foundersuite, an ff Venture Capital portfolio company.

David Teten is managing partner at HOF Capital (HOF.capital@HOFCapital), an international venture-capital fund. He has particular interest in fintech, technology-enabled services, analytics, artificial intelligence, sales/recruiting technology, SaaS and international startups. You can follow him at teten.com and @dteten. You can reach him via http://teten.com/contact.

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