Thoughts on the outdated VC fund model
Pros and cons of permanent fund structures
Before launching FullCircle, I did several months of research to evaluate the best fund model for the type of firm I wanted to build and the investing strategy I wanted to execute.
I determined that a permanent fund structure was appropriate given my objective of maintaining a right-sized fund and a collaborative pre-seed investing strategy in order to deliver persistent outperformance year after year, while better aligning interests between funders and founders.
Since yesterday, I have received a lot of inquiries regarding FullCircle’s unique fund model in light of Sequoia’s announcement of their new permanent fund structure. Unlike Sequoia, my goal is not to be able to hold assets longer, necessarily, which is clearly one of Sequoia's primary objectives.
My overarching thesis in raising a permanent vehicle is that the VC asset class is going to continue evolving more and more towards the public markets, specifically when it comes to increased transparency and greater liquidity.
Here are the primary reasons driving my decision to form an open-ended vehicle:
Maturity mismatch. Clearly companies are remaining private longer. The average life of a fund is 15 years, not 10 years. For an industry that invests in the best and brightest and the most innovative companies, it is shocking that the VC asset class suffers from such a lack of fund structure innovation, merely continuing to increase the number of 1-year extensions that can be obtained on the fund's maturity date.
Biased capital deployment. If a manager invests at pre-seed and their fund must be dissolved in 10 years, the manager is almost certainly going to compress the capital deployment period down to a minimum (first year or two of the fund) so that the companies have as much time to mature as possible.
Incentive misalignment. On a side note, this is compounded by the fact that the current compensation structure of a manager (2/20) has contributed to a race for assets under management (and increasingly short time periods between fund cycles). Permanent fund structures often have a different management fee structure which better aligns the manager to investors.
Time diversification. A closed-end vehicle unnecessarily constrains a manager's deployment pace and limits her/his ability to provide time diversification to investors.
Rushed exits. In a traditional fund context, the manager will in many cases not be able to unlock maximum value in each position in the portfolio. Why should the fact that the manager is coming to the end of their fund's life dictate the timing of a company's exit or their growth strategy?
Capital recycling. A key fund performance driver is the ability to recycle capital and eliminate the expense/fee drag. A 10-year term makes that exponentially more difficult: a lot has to go right for the manager to be able to do that well, if at all.
Alignment of incentives. A single vehicle provides much stronger alignment of incentives across the board (GP/LPs/founders).
LP/GP. Given the lack of transparency around fund performance metrics, LPs often renew their commitment over several fund cycles without the ability to truly evaluate the manager's performance. This information asymmetry can lead the manager to quickly move on to the next fund if they know the prior one is highly unlikely to get into carry.
Generally, cross-fund investing and/or opportunity vehicles create significant conflicts of interest (unless the LP base is virtually the same across all vehicles which is extremely rare).
GP/Founder. From a founder’s perspective, it makes a big difference whether a manager is writing the last check of their prior fund or the first check of their most recent fund. If the former, the manager might have to push the founder towards a faster exit (in an even more extreme scenario, the manager could be deploying out of a non-performing fund and looking to simply move on to their next fund, in which case they will be unlikely to spend any time at all with the company). If the manager is deploying out of a permanent fund, this artificial timing consideration and misalignment are largely eliminated.
Fund size. Unlike in a traditional fund context, the size of a permanent fund is much less relevant. The power law dynamics of venture are largely driven by fund size. Depending on exact structuring, the concept of a "whole fund" returning company is not applicable in the context of a permanent vehicle. The manager's incentives are more in line with each company in the portfolio.
Fund formation costs. Finally, this is a small point but a non-trivial one: the cost associated with forming a fund is significant. A perpetual vehicle should result in enhanced administrative ease over time and therefore lower fees for investors.
There are certainly some drawbacks to a permanent structure:
It can be seen as more complex. I would argue it is only so because investors are less familiar with it. Evergreen funds are more common in Europe, for example.
This leads me to my second point. The fundraising process is almost certainly going to take more time for a manager who is not raising in a "plain-vanilla" traditional fund structure (unless, of course, you are Sequoia). I am certain that is not a good reason not to try.
One can argue the forcing constraints of a closed-end vehicle are a good thing. For a disciplined manager who maintains a fairly consistent fund size and LP base over time and has the experience necessary to properly recycle capital into each fund, I would agree that is the case.
The biggest unknown with a perpetual fund model, again depending on the exact structure, pertains to the value of the fund and how it is determined. If investors have redemption rights or additional capital is raised in the vehicle in the future, the value of the fund needs to be determined. This can be difficult (and costly) in the context of a fund whose assets are partially or entirely private. Given the growing transparency and liquidity of private markets, I believe this will become less and less of an issue over time.
This is a super thought-provoking post, Virginie!! Thank you for sharing. The insight at the end - on understanding the value of the fund (and that becoming more straightforward with the evolution of private markets) is super interesting.