GP Finance IS Personal Finance

The personal J-curve when starting a fund

Venture capital isn't just about innovative startups—it's also about the risk-taking capital entrepreneurs who build funds and those allocating the capital. If we want to innovate funding, we need to lower the barriers for new and diverse fund managers.

Today, I'm going to guide you through one of the most critical yet often overlooked barriers: the personal financial challenge faced by emerging fund managers.

The Emerging Manager's Dilemma

Imagine you're a talented individual with a keen eye for promising startups and a passion for fostering innovation. You've angel-invested, crowd-funded, ecosystem-mentored, and learned from masters in the field. Now you've decided to start your own venture capital fund. Exciting, right? But here's the catch: the next big thing can drain your personal resources.

Let's break down the basics:

1. Fundraising Timeline: Typically, it takes 12-18 months to raise a first-time fund. You're working full-time on the fund but not earning any income from it during this period.

2. Fund Costs: Starting a fund incurs significant upfront costs, including legal fees, fundraising expenses, and formation costs. These costs can easily reach six figures.

3. Cost Reimbursement: The fund can reimburse many initial formation and fundraising costs, but only after the first close, which may take over a year.

4. Management Fees: Once the fund is raised, managers typically earn a 2.0-2.5% annual management fee on committed capital.

5. Timing of Income: Management fees don't kick in until after the fund's first close and gradually increase as commitments rise over 12-18 months.

6. GP Commit: General Partners (GPs) are expected to commit their own capital to the fund, typically 1-2% but often more. This is not insignificant.

Now, let's examine the numbers to see how this plays out in reality.

The Financial Gap: A Case Study

Initial costs

Before the fund’s first close, an emerging manager might face costs like:

• Management company expenses $60,000

• Formation/Fundraise expenses $80,000

Total: $140,000

These costs are typically paid out of pocket and can only be reimbursed after the first close. The manager's living expenses are not included.

Management fees

Assuming a fund size of $8 million with a 2% management fee:

• Annual management fee: $160,000 (less during the first year ramp-up)

• After operational costs (estimated at $104,000): $96,000 available for GP compensation

However, this doesn’t start until after the first close and doesn’t reach that run rate until the entire fund is raised, most likely by year two.

GP commit

If the GP is expected to commit 2% of the fund investment:

• GP Commit: $160,000

Even spread across multiple years, this can be a significant personal investment.

Personal cash flow gap (Y0-Y4)

The above three variables create significant costs prior to income, similar to a startup. Let’s examine the personal impact on the early years of an $8M fund.

Year 0 (Pre-first close):

• Income: $0
  Expenses: - $140,000 (fund startup costs)- $100,000 (living expenses)

• Gap: -$240,000 (remains over $100k after reimbursement at first close)

Year 1 (Post-first close):

• Income: $60,000 (portion of management fees going to the manager)
  Expenses: - $100,000 (living expenses) - $40,000 (GP Commit / 4)

• Gap: -$80,000 (and the remaining unreimbursed $100K+ from Year 0)

Years 2-4 (Investment period)

When management fees are fully flowing, the GP might only take home $56k ($96k minus the $40k GP commitment)—leaving a $44k gap every year. Plus, committing to years of a “salary” that might be $50k-$250k less than market rates in the financial industry.

The personal j-curve— not counting living expenses

Totals for the life of the fund

Assuming the fund performs in the upper quartile and creates a 2.5X net return, this cash flow gap persists for 3-5 years until the fund (hopefully) starts generating returns:

---

Income: $2,604
+ $924k take-home portion of mgmt fees (60k year 1, then 96k/year)
+ $400k return on 2% of committed capital
+ $1,280k for 20% carry (assuming the manager receives all the GP carry)

Cumulative Expenses: $1,331k
- $160k for 2% GP commit and $1,170k living expenses for 11 years

Net Upside: $1,273k ($116k/year), or just shy of 2.0X personally over 11 years (while the LPs net a 2.5X return).

Interestingly, the fund manager has zero net upside if the fund performs at the historical median of 1.5X. Below that performance level, it’s philanthropy or personal bankruptcy.

This (very personal) case study illustrates why an emerging fund manager can endure a personal financial gap of hundreds of thousands of dollars in the first few years. That’s a deep hole to self-fund. But more than one LP told me it is simply the cost of entry and an incentive to perform— one suggesting wealth is correlated with talent.

Thinking like this is a significant barrier preventing talented individuals from entering the field, particularly those without substantial wealth.

What could we gain from removing the barrier?

I love this from Gridline:

Emerging managers not only have a smaller share of their income coming from management fees, but they’re also trying to build a personal brand to justify bigger, successive funds. You can only do that with a strong performance.

Emerging managers are grinders, hungry for success the way a young underdog is against a perennial winner in the sports world. This tightly aligns their goals with LPs – a strong return means both the manager and their partners win.

The Impact on Innovation

This financial barrier has far-reaching consequences:

1. Lack of Diversity: Only those with significant wealth or strong networks can afford to become fund managers, limiting diversity in the VC ecosystem.

2. Risk Aversion: GPs under financial strain might make overly cautious investment decisions to protect their personal finances.

3. Missed Opportunities: Talented managers who can't overcome this financial hurdle never get the chance to innovate how to fund startups.

4. GP Blind Spots: A homogeneous group of fund managers may overlook promising companies outside their homogenous networks.

5. LP Blind Spots: Limited partners focused on GP commitment (or existing wealth) may overlook promising fund managers outside their standard view.

6. Asset Class Performance: These small funds will likely include the top-performing funds solving the biggest problems. Funds that focus outside typical innovation hubs outperform. This is a power law play… the domain of emerging managers.

Potential Solutions

Addressing this challenge requires a multi-faceted approach: defining what GPs need, helping LPs understand the challenges and benefits of supporting them, and innovating in the gap:

1. Flexible GP Commit Structures: GP commits could be tied to a percentage of the manager’s net worth instead of a fixed percentage of the fund. “Skin in the game” is dependent on how much skin there is to begin with.

2. Grant Funding/Philanthropic: Specialized funds that can commit to a first close as an anchor to catalyze market-rate LP participation.

   • Offer lower return expectations or junior preference to another capital.

   • Larger checks in the initial close allow the management fee to start at a more sustainable rate and cover more costs earlier for the manager.

3. Early Management Fee Activation: Be flexible with front-loading management fees to align with the fund’s actual expenses.

   • Front-load more management fees into the investment period. Some LPs still oppose this, but most sourcing and selection costs are spent in the investment period.

   • Pull the final year of management fees into the first close to help cover for the time spent raising without pay (before the first close).

4. GP Funding Vehicles: Create specialized financial products to help emerging managers bridge the cash flow gap.

   • Investment in the GP entity or the overall Investment Firm entity.

   • A catalyst fund with forgivable loans to cover the initial cash gap.

   • Creative funding tied to the emerging manager (like GP Runway Fund, Chisos Fund, or SPACE agreement), where the return of capital is tied to the compensation and distributions to the emerging manager.

5. Institutional Support: Established firms and institutions could provide grants or low-interest loans to promising emerging managers for these cash gaps.

Conclusion

Lowering financial barriers for emerging managers can unlock a new wave of innovation in venture capital. This isn't just about making it easier for capital entrepreneurs to start funds—it's about ensuring the best ideas, regardless of origin, can secure funding and change the world.

As an industry, we need to recognize that GP finance IS personal finance – and support the next generation of fund managers. Only then can we honestly say we're fostering innovation at every level of the startup ecosystem.

I’d love to hear how other capital entrepreneurs are solving this cash gap. Who do you know that is addressing this?

(I’m happy to send you the spreadsheet. Just let me know.)