Recently, I stumbled across a firm that approaches Limited Partners (“LPs”) in a very refreshing way. Once you enter Lead Edge Capital’s (“Lead Edge”) website, the first thing you will notice is that their LP network and LPs are mentioned in several areas. In fact, Lead Edge has a profile for every single LP (over 200) listed on their website. On first glance, this seems a bit strange as it should be the partners at the firm that matter for PortCo introductions. Over 200 LPs also looks excessive for a fund of Lead Edge’s size. Typically, one looks to raise larger amounts from select institutional investors to limit the number of LPs needed. Both of these points, however, are crucial points of differentiation to ensure Lead Edge maintains a competitive advantage when competing for a deal. Below are a few of my thoughts on the advantages of setting up your investor network in a similar manner.
The Optimal Network
In an ideal world, your social network is constructed in a fashion where your closest connections do not know each other. This makes you integral to the flow of information. If the two connections are linked, you can easily be bypassed as information moves from A to B. See below:
Another key issue is that if your connections know each other (if A knows B), they might be in the same social circle. This means that your secondary connections, or friends of friends, may have redundant links (both A & B know person C - see below), which limits the potential size of your network. If A and B do not know each other, there is a significantly lower likelihood that they both know C. Thus, this situation gives rise to a greater number of secondary connections. See below:
In the first network, two primary connections results in nine secondary connections. When the network has redundancy, two primary connections only result in six secondary connections. Keep in mind, in both situations A has four connections and B has five connections.
Enough with the theory - how does this translate to an LP network? If a firm advertises only its investment or operational partners as a strength, its network looks more like a “Redundancy” network. Each partner knows each other and likely shares a set of mutual connections. The network they have is likely excellent, but its reach is almost certainly restricted.
If a fund uses its LP network as a point of differentiation, its network looks a bit closer to the “Central” network. If designed correctly, each LP (think of the A’s and B’s in the diagram) operates in different social circles. This massively expands the network the fund has access to. Further, the fund already has the “Redundant” network at the fund level (aka everyone who works there), the LP network is icing on the cake. In fact, it's more similar to a whole buffet on top of the cake.
Unlike social networks which develop more organically, an LP network can be methodically designed. Certain industries, social networks, and connections to important institutions (i.e. a professor at MIT for access to upcoming talent) can be targeted. This is where theory turns into application.
Why Your LPs Matter
While maintaining a good relationship with your LPs is important to ensuring recurring capital commitment to future funds, they can also be vital in supercharging the growth of PortCos.
The Lead Edge strategy works something like this:
Raise capital from a variety of well-connected high-net-worth individuals (“HNWIs”), collectively the “LPs”:
- As the LPs are personally invested in the success of the fund, they are more incentivized to do what they can to help Lead Edge’s investments.
Market the LPs on the fund’s website, highlighting the potential introductions that they can make for potential PortCos:
- Most funds focus on advertising either their investment team or operations team. However, since every fund does this, no single fund stands out. Further, while VCs and growth equity investors are typically well-connected, it is not immediately clear how the fund can help accelerate the development of a growth-stage company.
- Directly advertising the LP network shows a startup how Lead Edge will accelerate its growth and significantly expands Lead Edge’s reach (200 LPs plus Lead Edge’s team vs. 30 investment and operations professionals at another fund).
When competing for a deal, reference specific LPs and how they can help the business expand:
- This makes the fund’s capital more than just a commodity. Each $1.00 invested is worth $1.20 as it allows the business to focus on high-probability sales leads through effective introductions by the LPs or introductions to the right talent to grow areas of the business. A host of intangible benefits is tied to each dollar of capital invested by the fund.
- Essentially, the conversation goes like this: “We have over 200 LPs to connect you to any potential client or partner you want. If you know who you want to chat with, we can get you a direct line.”
- Another key point here is that GPs have direct access to a variety of sector expertise through the LP network if an opinion is needed on a certain space or business. For example, in the medical device industry, often Key Opinion Leaders (“KOLs”) are referenced to understand how well a product will be adopted, which can give a firm greater conviction on a potential investment. Further, KOLs are typically used to give products credibility and gain traction. An in-house LP network can essentially serve the same function, giving credibility to PortCos.
For PortCos, actively engage the LP network in areas such as making introductions to the right people and thinking through key business decisions:
- With a large enough LP network, you are bound to have at least one professional who has gone through a similar situation as your PortCo - leveraging the LP’s experience can be vital for navigating tough issues
- Benefits of using your LPs to help the PortCos can include: spending capital with greater focus, minimizing poor decisions when it comes to new products or entering new markets, introducing the right talent to lead a team, potential partnerships with established businesses, more effective sales leads, guiding thoughts on product design and market fit, giving credibility to a team or product, etc.
- These direct efforts can lead to better PortCo performance and thus better returns for the fund and LPs, creating a very strong monetary incentive for LPs to help.
- Overall, this leads to better alignment between GPs and LPs, giving LPs a greater feeling of responsibility for fund performance.
Outsized returns allow Lead Edge to raise future funds, in which they can strategically pick future LPs to enhance the network they can provide their PortCos - and the cycle continues.
This Sounds Perfect. What’s the Catch?
As an investor, it is incredibly important to understand the commitment one must take, in terms of both effort and time, when committing to a fund like Lead Edge. As the typical life of a fund is over 5 years, an LP lacks liquidity if needed. While the PE secondaries market is growing larger each year, typically it is large institutional stakes that are bought and sold instead of $2mm stakes from HNWIs. While its not impossible to get liquidity, an investor with a mentality that aligns with Lead Edge’s strategy needs to be found to acquire the stake. This can result in a significant discount to the stake’s net asset value if liquidity is needed.
As the fund, a greater number of LPs means a significantly greater effort to maintain clear communications and keep the network engaged. Understanding which LP may be helpful in different scenarios can also become more difficult as the network grows larger. Well-organized internal processes should be implemented to ensure that the network is fully cataloged and understood. LP profiles would also help to map out the potential connections that each investor can contribute.
Another key issue is scaling capital commitments from HNWIs becomes increasingly harder the bigger your fund becomes. It is a lot easier to take a sizable capital commitment from one institutional investor than it is to gather commitments from 100+ HWNIs for the same amount of capital.
While there is no perfect way to structure an LP network, the benefits of selectively choosing the individuals that participate in a fund cannot be understated. Finding the right balance between small connected HNWIs and large institutional investors is likely needed to maximize the performance of a fund and profits for the GPs (through carry and management fees).