20VC The Framework LPs Use To Assess Emerging Managers, What Concerns and Excites LPs in Potential Opportunities & The Current State of Seed Today with Hunter Somerville, Partner @ Greenspring Associates

In this episode of 20 Minutes VC, Harry Stebbings interviews Hunter Somerville, a partner at Greenspring Associates, discussing the venture capital ecosystem and the role of Limited Partners (LPs). Somerville shares insights from his journey from a non-finance background to becoming an LP, emphasizing the importance of assessing Micro VC managers and the dynamics of fund size and strategy. The conversation delves into the challenges and strategies of raising micro funds, the impact of multi-stage funds on early-stage markets, and the nuances of fund allocation and management. They also touch upon the rise of direct secondary investing and the complexities of GP-led restructurings. Somerville highlights the importance of having a long-term perspective in LP-GP relationships and the need for venture firms to plan for generational transitions. Throughout the discussion, the significance of track record evaluation, strategic LP selection, and economic sharing among firm partners is underscored.

• Harry Stebbings discusses the focus on venture capital and Limited Partners (LPs) in the ecosystem.
• Mentions the guest, Hunter Somerville, a partner at Greenspring Associates.
• Greenspring Associates is highlighted for its portfolio and fund investments, including notable companies and venture capital firms.

We are back for another week in the world of the 20 minutes VC with me, Harry Stebbings at H debbings 90 96 with two B's on instagram and it would be great to see you there. And as you know, we obsess on all things venture here at the 20 minutes VC, but we can never forget the money behind the money.

Harry Stebbings introduces the podcast's theme of venture capital and the importance of LPs.

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• Hunter Somerville did not initially plan a career in finance, focusing on international relations, history, and legal studies.
• He worked at a law firm but decided against a legal career, opting for an MBA.
• Somerville gravitated towards the behavioral aspects of finance over quantitative modeling.
• His venture into alternative investing began with an internship at Camden Partners.
• He joined Greenspring Associates about eight years ago and is now a partner.

Yeah, not at all. I actually didn't even think about being in finance when I went and got my undergrad at University of Pennsylvania.

Hunter Somerville shares his unconventional path to becoming a partner at Greenspring Associates.

• Somerville expresses his passion for the micro VC sector.
• Greenspring Associates has a dedicated micro fund of funds.
• The micro VC landscape is described as crowded and complex, but also exciting.
• Micro VC funds provide smaller, more flexible investments that suit early-stage entrepreneurs.
• The challenge lies in sorting through the numerous funds to find the most promising ones.

Yeah, this is an area of passion for me. I'm a big fan of micro.

Hunter Somerville discusses his enthusiasm for the micro VC market and its importance for early-stage ventures.

• Multi-stage funds are increasingly participating in early-stage investments.
• Somerville believes there is room for both micro VC funds and multi-stage funds in early-stage investing.
• Active seed managers are still seen as valuable for their hands-on approach with entrepreneurs.
• He emphasizes the importance of micro VC funds securing significant ownership and cost positions.

Yeah, I think you've seen that for a while and you're continuing to see that.

Hunter Somerville acknowledges the trend of multi-stage funds investing earlier but asserts the continued relevance of micro VC funds.

• The possibility of market shrinkage due to LP overallocation has been anticipated but not yet observed.
• Raising a micro fund is not considered difficult, contributing to the continued growth of new funds.
• Somerville suggests that the barriers to raising a micro fund are low, especially with support from high net worth individuals and a few institutions.

Yeah, I mean, we've been predicting this for a while now, and I think maybe you've seen a little bit of it over the past year.

Hunter Somerville comments on the anticipated but not yet realized contraction of the micro VC market.## LP Exposure to Micro Firms

• Limited Partner (LP) exposure to micro venture firms has increased significantly.
• Micro firms return to market more frequently than other venture asset classes.
• There is a growing amount of unrealized exposure for LPs in micro funds.
• Saturation is occurring among LPs, making it harder for micro firms to raise subsequent funds or scale.

And by the nature of where micro firms are investing, you're going to have more and more unrealized exposure, which means you can't continue to deploy into more and more micro funds as much as you'd like to, being that there's always new interesting ideas that are coming out there.

This quote explains that the inherent investment strategy of micro firms leads to a build-up of unrealized investments, which in turn limits LPs' ability to continue investing in new micro funds.

• Spinout funds from top firms typically have an easier time fundraising.
• The ease of fundraising depends on the seniority and track record of the individual leaving to start the new fund.
• Senior partners from established firms can raise funds efficiently and under the radar.
• Junior or mid-level individuals from firms may find it more challenging to raise funds due to unclear track records.

There's a big access premium. Most people don't know that they're even happening until after they've been announced, because what happens is the partner that's spinning out to do a dedicated operation goes to their closest LP relationships, some of whom they've worked with for a while, or that they know separately and get it done pretty efficiently.

This quote highlights the competitive nature and exclusivity of fundraising for spinouts by senior partners, who leverage their existing LP relationships to secure funding quickly and discreetly.

• Micro VCs have varying approaches to scaling, with some preferring to remain focused on the seed stage.
• Others view micro VC as a stepping stone to building a track record and scaling to larger funds.
• LPs closely analyze and assess any strategy drift in funds, requiring a clear rationale and belief in the fund's ability to compete at a larger scale.

But strategy drift is analyzed and assessed in detail by LPs and there needs to be a reason for that movement and a belief that you'll be capable in doing it, and then a belief in your ability to build a brand, to compete against a number of great brands already in existence.

This quote emphasizes that LPs scrutinize any changes in a fund's investment focus, and such changes must be justified and supported by the fund's potential to succeed.

• Track record is a critical factor for LPs when evaluating venture funds.
• LPs look for projected performance, not just past performance, to anticipate future success.
• Understanding the underlying companies and their potential is crucial for LPs in assessing funds.

You can't just look at performance as is, is a lagging indicator. What you need to build a view on is what projected performance can look like five to seven years from the point of assessment.

This quote clarifies that while past performance is important, LPs must also consider the future prospects of a fund's investments to make informed decisions.

• There is a debate about the sustainability of scaling in venture capital.
• Some argue that venture capital is broken due to managers scaling assets under management (AUM) and relying on management fees.
• Accountability may lie with both managers and LPs in allowing the scaling of AUMs.

And I think to the extent that they're a great partner to entrepreneurs are able to have that kind of ball control, then you will see the continued emergence and raising of opportunity select and growth funds.

This quote suggests that if venture capital firms can be effective partners to entrepreneurs and manage their investments well, the emergence of specialized funds that focus on growth opportunities is justified.## Shortage in Market for B Round Investors

• There is a perceived shortage of dedicated B round investors in the venture capital market.
• B round investing involves companies with typically zero to 5 million in revenue, which still carries significant risk.
• B round funds experience a higher loss ratio, which contrasts with the late-stage and growth stages where mitigating loss rate is crucial.
• B round investing is less metrics-driven in pricing, making it challenging to balance risk and reward.
• Some firms, like Scale or OpenView, are effective in B round investing, but it's not common.
• A round groups are increasingly preempting B rounds or seeking flexible partnerships to build positions in their winners.

"Yeah, I think there's definitely a shortage of dedicated B round investors. It's called the treacherous b for a reason, because you're investing where there's generally not a ton of revenue. I mean, it's changed as everything has been pushed out from seed to a, but I'd say zero to 5 million most typically."

The quote explains the scarcity of B round investors, highlighting the stage's inherent risks due to lower revenue figures and the necessity for investors to balance risk and potential returns.

• The loss ratio is a significant consideration in venture capital, especially at the B round stage.
• High-performing investments can sustain some losses if they are offset by substantial wins (five to ten times return).
• A strategy aiming for moderate outcomes combined with a high loss rate is not viable.
• Median performance in venture capital is generally poor, so aiming for exceptional outcomes is critical.
• An appropriate loss rate for B round investments is difficult to pinpoint but should be lower than in earlier stages like A round.

"And if you're able to identify really high flying investments that can end up being five to ten x's, and you're not playing for more of a banded two to four x, then you can sustain full write offs or return of capital that's less than a one x and few investments within your portfolio."

This quote discusses the importance of targeting high-return investments to compensate for inevitable losses, emphasizing the need for a balanced portfolio that can withstand some underperformers.

• Direct secondary investing refers to buying shares from employees or departed employees of a company.
• As companies stay private longer, it becomes more acceptable for senior management to achieve partial liquidity.
• Direct secondary investing can be beneficial for all parties, allowing management to focus on larger outcomes without immediate financial pressures.
• Secondary buyers can play a critical role in providing liquidity, especially in situations where employees transition out of a growing company.
• Selling into growth rounds or pseudo IPO rounds is increasingly viable, with less concern about signaling issues.

"And it all goes back to the fact that companies are staying private longer within the venture asset class. And I think it's increasingly become acceptable for there to be some level of partial liquidity, at least at the senior management level."

The quote explains the rationale behind direct secondary investing, which is driven by the extended period companies remain private and the growing acceptance of partial liquidity for senior management.

• Successful early-stage venture managers of the next decade will likely be adept at navigating the secondary market.
• Selling majority but not full positions during mega growth rounds can be advantageous for seed investors.
• The decision to sell positions is nuanced and dependent on individual circumstances, such as the investor's involvement level and board position.

"I think definitely on the micro side, it's something that people should be actively doing, and I would even consider selling majority positions, not full positions, into these mega growth rounds."

The quote suggests that active participation in the secondary market is advisable for micro investors, particularly when it comes to selling majority stakes in growth rounds, while considering the specific context of each investment.

• GP led restructurings are becoming more common due to companies staying private for extended periods.
• Different LPs have varying tolerances for illiquidity, influencing their desire to remain invested in long-duration funds.
• Secondary buyers can offer fair prices for LPs seeking liquidity, which can impact GP-LP relationships.
• Restructurings can also serve as an opportunity for GPs to introduce new LPs and build future primary relationships.

"And lps of all different varieties have different tolerance for illiquidity and desire to stay into a fund into years, ten to 15."

The quote acknowledges the diversity in LPs' preferences regarding the duration of their investments and their varying needs for liquidity, which can lead to GP-led restructuring opportunities.## Importance of Attribution in Venture Capital

• Attribution is critical in venture capital to understand who is sourcing deals.
• It's not just about who takes the board seat but also about recognizing those who build networks and are known in relevant entrepreneurial communities.
• Understanding the role of individuals at different levels within a firm is crucial.
• Aligning career progression with economic rewards is a key consideration for capital allocators.

"And that's why we spend a ton of time on attribution. And attribution isn't all created equal because you want to know who's sourcing, even if they're not taking the board seat or monitoring or carrying it through."

This quote emphasizes the importance of recognizing the contributions of team members in sourcing deals, beyond just the formal responsibilities like board participation.

• LPs (Limited Partners) must strike a balance between being intrusive and understanding the layout of an organization.
• It's important for LPs to have a vision for the future and consider generational transitions within firms.
• Proper planning and communication are signs of a healthy firm capable of handling transitions.

"As an LP, you have to balance being too intrusive with getting a good sense for how a layout of an organization works and feeling comfortable around that."

The quote highlights the delicate balance LPs must maintain to gain insight into a firm's structure without being overly intrusive.

• Hunter Somerville's favorite book is "Great Expectations" by Charles Dickens.
• The character Joe the blacksmith exemplifies the importance of balancing ambition with the value of friends and family.
• The book serves as a reminder not to be blinded by wealth and status.

"My favorite book coming out of that class was great expectations and continues to be an important one for me to this day."

Hunter Somerville explains his personal connection to "Great Expectations" and its ongoing impact on his life and values.

• Placement agents are less common in venture capital due to smaller fund sizes.
• They can be useful for geographic expansion and diversifying LP bases, especially internationally.
• Placement agents may be more relevant for GPs (General Partners) who seek thoughtful LP engagement.

"Using a placement agent internationally in order to have that happen could be interesting, but I would say less common in venture just generally."

This quote discusses the specific circumstances under which placement agents might be beneficial in the venture capital fundraising process.

• Fund managers often overlook the importance of selecting the right LPs.
• The relationship with LPs is likened to a partnership or marriage, requiring alignment in mission and values.
• Diversity in LP types and geography is crucial for future fundraising and scaling.

"You really want to have people that are aligned in terms of mission values and people you like to be around and who are going to be flexible and thoughtful as you scale and evolve your business."

Hunter Somerville stresses the importance of choosing LPs who share similar values and can support the business's growth over time.

• LPs look for great unrealized positions with high ownership potential.
• Realized performance is appreciated, but the focus is on companies that can significantly impact the fund.
• The track record should demonstrate potential for substantial aggregate outcomes.

"We love to obviously see realized performance, but for most of venture, when you're making the assessment, you need to see great companies that could have big impact at the fund level."

Hunter Somerville outlines what LPs fundamentally seek in a venture capital firm's track record, emphasizing the potential impact on the fund.

• Michael Scott of Northbridge is highlighted as a first-time fund manager who executed well.
• He took a thoughtful approach, focusing on diversity and building long-term relationships with LPs.
• His process was gradual and considerate, reflecting a strategic mindset.

"We backed his first time fund and I think what he really did well was not rush the process, think about diversity by category and really get to know the people he was going to work with for the long term."

This quote provides an example of a first-time fund manager, Michael Scott, who successfully navigated the fundraising process with a deliberate and inclusive strategy.

• There is a tendency for GPs to be complacent with existing investors, which may not always be beneficial.
• A focus should be on long-term oriented investors who are more than just capital providers.
• Non-performing partners are often kept for too long without a metrics-driven focus on improvement or transition.

"Just because someone's backed you in the past doesn't mean you necessarily need to continue to have them back you at that level, there should be more of a rigid focus paid to that."

Hunter Somerville challenges the common practice of automatically giving existing investors similar allocations in new funds, advocating for a more critical evaluation.

• The most recent fund investment was in Amplify, chosen for its disciplined approach and strong team.
• The decision was influenced by Amplify's team expansion, sector diversification, and partnership value to entrepreneurs.
• Previous relationships and evaluation of the team's performance at Battery Ventures played a role.

"We're big fans of Sunil and Mike. We got to know them when they were at battery. We made the mistake of not doing their first fund, but were able to position ourselves to do their second and now their most recent fund."

Hunter Somerville shares the reasoning behind the recent investment in Amplify, highlighting the importance of the team's track record and strategic fund management.