This article was originally published by Industry Ventures here on August 24, 2017.
We were taught as children about the golden rule: treat others as one would expect to be treated. Sometimes we forget this rule in business—particularly in the venture business. While we could take a sentence like that in several different directions, today the focus is on limited partner transfers.
In many cases, nobody is at fault when a venture fund investor decides to move on. General partners should bear this in mind when dealing with LPs, whether the latter are in it for the long haul or headed for the exits. Indeed, they should treat LPs the same way they expect to be treated by portfolio company CEOs. That is, with the understanding that while the relationship they have is undoubtedly important, it is only one of a broad mix that must be managed in its entirety.
GPs set a high bar for founders and CEOs—they insist on accuracy in reporting, efficiency in communication, excellence in execution, and patience in sponsorship. While portfolio company managers are scrambling to scale and achieve their missions, fund managers are intensely focused on their own marketing, financing, operations, and product development efforts. Under the circumstances, VCs expect empathy from portfolio management teams, yet they may forget that the shoe is on the other foot in their interactions with LPs.
This is particularly pertinent in the current environment. Venture-backed companies are staying private or independent longer than in the past, heightening demand for alternative sources of liquidity. The result: a robust secondary market in leading private company shares, as well as increased trading in private equity and venture capital fund LP interests, which, as noted previously, amounted to more than $40 billion in 2016. Specifically, Campbell Lutyens advisory firm expects this trend to accelerate in 2017, with a mix-shift of more transactions being initiated from endowments and foundations—as well as from less traditional LPs like corporate pensions and insurance companies (see Figure 1.)
Figure 1. LP-led Transaction Activity by Type of Seller 
The trend is not solely limited to LP-initiated transactions, as GPs are becoming increasingly accommodating of transfers. Indeed, Campbell Lutyens also reports 22% of 2016 transactions were GP-led secondary transactions (non-directs). Despite this, some GPs haven’t quite gotten the message. Although many willingly accommodate LPs looking to sell their interests, others make matters difficult, to the point of dismissively shutting down any such request. While a lack of empathy can be related to the position a fund is in—an oversubscribed GP with a waiting list for new offerings can afford to be more aggressive than one managing a first-time fund that has yet to prove itself—it does not seem to be the primary reason.
In fact, an unhelpful response likely stems from the perception—or, perhaps, misperception—that such a move reflects nothing but a lack of confidence in the manager. In our experience, this is misguided. There are numerous circumstances where the desire to move on has nothing to do with a soured relationship or, for that matter, an investor default. In fact, there are a variety of situations where LPs have little choice but to exit—and where it makes sense for GPs to allow and encourage others to take on the commitment. We’ve detailed eleven of these below.
- Macroeconomic Change. Macroeconomic downturns and disruptions can impact GPs and LPs alike. While the real deal may lead to LP defaults (and another outcome we discussed here), deteriorating perceptions alone can spur investors to preemptively batten down the hatches and shift funds into less risky assets. We briefly witnessed such a development in early-2016, when markets anticipated a reversal of fortunes (that never came). Otherwise, some LPs, such as pension funds, will readily sacrifice long-term gains to avoid near-term losses.
- Portfolio Rebalancing. LPs may decide to free up capital for other purposes, regardless of how well (or poorly) a fund is doing. In fact, some may have little choice but to liquidate their interest because of other developments, including margin calls and the kind of idiosyncratic volatility that has been seen in the energy patch in recent years. While private equity and VC markets may appear to be holding their own, unrelated factors could force the hands of any number of LPs. Ironically, resiliency in PE funds could flag them as attractive sources of liquidity.
- Return Management. There doesn’t necessarily need to be problems elsewhere; too much of a good thing can also encourage LPs to take money off the table. Significant gains in a venture investment or a PE allocation can stimulate efforts, perhaps automatically, to pare down the exposure in question. Many pension funds and asset managers, as well as other types of LPs, have portfolio limits they must adhere to by charter or mandate. Under the circumstances, it is not unusual to see them selling winners and buying laggards based on strategic allocation targets.
- Change in Strategy. Organizational missions and investment mandates can change, instigating a shift in portfolio preferences. A major pension fund, for example, could decide to reduce its commitment to private equity and allocate resources elsewhere—due to the political climate or other factors at play in a particular administration. In the wake of such a decision, there may be a flurry of transfers and buyouts relating to interests the pension giant no longer intends to manage. In those instances where capital is sourced externally, LPs may find themselves at the mercy of others, regardless of any intention to stick with a VC investment.
- Change in Investment Personnel. The appointment of a new CIO or PE chief can spur a rejigging of relationships and capital deployments, often to the detriment of existing managers. LPs with strict allocation targets, for example, may need to free up capacity through transfers. Even when such constraints are not an issue, other factors can intervene. For one thing, the efforts of now-outgoing personnel may have played a key role in why a commitment was made; without that support, an LP may decide to go in a different direction. That said, LPs aren’t always the catalysts for change. In some situations, discriminating GPs may, from an investor relations perspective, view a transfer as a plus.
- Overstretched Teams. LPs may be short-staffed or lack certain resources. This can be the case at large family offices or other organizations where staff must juggle a wide variety of duties, including researching investments, traveling to company meetings, responding to capital calls, and performing due diligence on prospective new managers. Constrained by time, lean LP teams may seek to reduce the number of commitments they have or allocate a larger share of available capital to a smaller number of funds.
- Tail-End Funds: A fund’s residual investment exposure may not be enough to warrant an LP’s continued commitment. Some funds may distribute the lion’s share of contributed capital but be left with unrealized investments well into their ninth, tenth or eleventh years—or longer. In essence, what began as a broad-based portfolio commitment becomes a smaller, less impactful collection of long-tail positions. From an administrative standpoint alone, it can make sense to move such interests off the books, perhaps by transferring them to wholesale-oriented buyers.
- Regulatory Requirements. Financial institution and foreign LPs may be constrained by issues that don’t affect other investors. For example, new rules or regulatory policies might require the former group to reorient portfolios or dispose of holdings after commitments had been made. This was the case in 2015 and early-2016, when the Volcker Rule forced banks to pare down balance sheet exposure to risky assets. Still, while such changes can happen unexpectedly whenever politics or regulation is involved, those affected are typically given ample time to make the necessary adjustments.
- Mergers and Acquisitions. Changes of control or other M&A activity can spur corporate LPs to reduce or eliminate fund commitments. As with the personnel and investment-strategy shifts referred to above, an evolving enterprise may no longer have the desire or justification for maintaining certain interests. Alternatively, prospective targets may preemptively shed such investments to facilitate a merger, or do so after the fact based on the acquirer’s requirements.
- Facilitating Recommitment. When GPs are seeking to raise for new funds, existing LP interest-holders may consider exiting from older vintages to free up capital that could theoretically be allocated to the new offering. It’s worth pointing out while LPs may initiate such transfer activity, it could actually be in the GP’s strong interest to proactively offer a liquidity program like this. Such actions may also be taken at the fund level. For example, capital may be returned to LPs on a pro rata basis to boost the ratio of distributions to paid-in capital, or DPI, for marketing or other purposes (which is a topic for another article).
- Expiration of Fund Life. Some of a fund’s most exciting investments can take more time than originally planned to reach fruition, which can lead to GP requests for an extension. While LPs may grant extensions once or twice, excessively long harvest periods can create tension between a manager and LPs that have strict time preferences on the lives of the funds they own. In such a scenario, it may be in both parties’ interest to permit a new investor to come on board—alongside those with more accommodating holding-period thresholds—allowing the full value of the investment to be harvested.
In sum, there are any number of reasons why LPs (or GPs) may want—or need—to suddenly change course. While the rationale may well be liquidity issues or a souring relationship, it is quite likely that neither is to blame. Under the circumstances, there is little to be gained by making matters difficult. Indeed, an infusion of fresh blood could turn out to be just what the doctor ordered.
 Source: 2017 Secondary Market Overview Report by Campbell Lutyens
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