Investing Billions - E52: StepStone's Hunter Somerville on How to Scale LP Capital

Starting point is 00:00:00 When you're doing direct investing, we're taking board observation. We're sitting alongside of the GPs that we work with that have been involved in these companies going back to seed in Series A. You see how they interact with founders. You see how they're helpful. You see what they bring to bear in terms of recruitment assistance, customer introductions. All of that reinforces how we would then evaluate the fund when they come back to market. What are private equity funds looking for in 2024? There were just too many companies funded in every subsector. Good private equity firms are going to start putting some of these together and catalyze some of these companies to actually get to $200 million of top line.

Starting point is 00:00:32 As you see multi-stage funds get bigger and go both earlier stage and later stage, how do you compete against the Andreessen Sequoias of the world on the direct side? So for more ideas on how to raise venture capital in this market, make sure to subscribe below. Well, Hunter, I've been really excited to chat. Welcome to 10X Capital Podcast. Thanks, David. How did you come to work at Greenspring and now at StepStone through the acquisition in 2021? Went to University of Pennsylvania undergrad, had no idea what I wanted to do. Thought I was going to go to law school, worked as a paralegal, hated it, decided not to.

Starting point is 00:01:06 Got my MBA instead and then stumbled upon an internship at a firm called Camden Private Capital in Baltimore, where I did a multi-strategy fund-to-funds occupation, investing in buyout, mezz, distressed, and venture. Ended up loving venture the best and tried to find a way to do it in the mid-Atlantic area. And there was a great growing firm called Greenspring, where I had a friend that I had known since I was six years old, a gentleman named John Averitt, who recruited me to come over and join in 2011. We're now partners together and best friends at the firm. So it's been a cool journey to do this alongside of him and began as an

Starting point is 00:01:39 associate in 2011, eventually became one of the partners at the firm. And then about three years ago, we combined forces and joined StepStone as the venture growth group going forward alongside of three partners that they had working there in that effort before us. At StepStone, you have a team that goes across multiple different asset classes, investments, funds, directs, secondaries. Tell me about the strategy behind that. The StepStone itself is a public company that does all different asset classes. So there's real estate teams, credit teams, infrastructure teams. We are the venture growth group.

Starting point is 00:02:10 So that's all that my team does. We don't focus on any of the other asset classes, but each of the asset classes is able to benefit from the shared services that StepStone offers. And so that's how it effectively functions. Within the venture growth group itself, we do direct fund and secondary investing. And we've been doing that going back to 2001 under Greenspring. So we always felt like it was important to have the same team doing fund, direct and secondary investing. And we felt like it made us better in each of those three areas. So we've continued that on a go

Starting point is 00:02:39 forward basis as part of StepStone. You have different competition in your different classes within venture. There's not that many people that do all three of those areas. On the secondary side, it's not something you see very many of the funds do, although perhaps that's changing with some of our GPs adding or thinking about doing secondary specific strategies. On the direct side, being that we generally lead price and structure rounds, we'd be theoretically competing against anyone that does expansion mid-stage. On the direct side. And then fund-to-funds wise, there's a handful of viable venture-specific fund-to-funds that continue to be out there and active in that category. Not really the same competitive set in each of those areas.

Starting point is 00:03:18 We don't define ourselves as a fund-to-funds. We define ourselves as a multi-strategy venture platform that does all three of these areas through different strategies led by the same team. You're doing directs, you're doing fund-to-funds, you're doing secondaries. Tell me about how you learn across those asset classes. When you're doing direct investing, we're taking board observation, we're sitting alongside of the GPs that we work with that have been involved in these companies going back to seed in series A. And so you see how they interact with founders, you see how they're helpful, you see what they bring to bear in terms of recruitment assistance, customer introductions, et cetera. So whatever you would get from a reference call where a founder is generally

Starting point is 00:03:52 inclined to say good things, unless the VC has been horrible to deal with for some reason, we actually see that in action. So it's much more tangible and gives you real proof points outside of just relying on reference calls. And so all of that reinforces how we would then evaluate the fund when they come back to market. And we evaluate whether they've been the go-to partner for a founder or whether the value add they say they bring is actually true and actually actionable. And so it reinforces each part of our diligence effort across the different areas. As you see multi-stage funds go, you know, get bigger and go both earlier stage and later stage, how do you compete against, you know, the Andreessen Sequoias of the world on the

Starting point is 00:04:31 direct side? With each of them, investors in them have people in our network that are investors, so we don't view them competitively. The win-win for us is when we have a GP that's involved in a company, is really excited about it, and wants a partner that they can work with as a non-arbitrary third-party lead. We're looking for scenarios where they're typically already involved in the business, they want to put more to work, they want to co-lead, or they want to invest meaningfully above pro rata, where we can then come in and be that lead that sets the price, the terms, and the structure. Or a scenario where we could come in and do secondary and buy within the cap table of a company, either independently or mixing it with primary. And so it's all meant to be collaborative, not competitive with the GPs that we support. Tell me a little bit about that, about having a lead. what we were doing in 2001 to 2011, we were coming in investing a few million per round

Starting point is 00:05:26 as a non-lead. And we felt like we needed to up our game further and earn the right to lead. And we felt like the market was going to go in a direction where a lot of other entities, endowments, foundations, pensions, et cetera, were going to start seeing co-investing as a way to enhance their diligence or dollar cost average down on fees. And we wanted to be ahead of that trend. And that certainly happened. You saw everyone begin to implement co-invest as part of their strategy. And we wanted to begin to build a brand in the founder and syndicate GP community where we were viewed as a true viable lead. So we started doing that in 2011. And I think I've earned our right as a good partner over time with what we've been able to bring to bear through

Starting point is 00:06:03 customer introductions and generally being a good vetted partner to be seen in that light as a good partner over time with what we've been able to bring to bear through customer introductions and generally being a good vetted partner to be seen in that light as a true lead. But it wasn't something that was easy to do. I'm glad we were forward thinking and doing it ahead of time. And I think it served us well because fighting for scraps and a co-investment that's syndicated to an entire LP base means you're getting a few hundred K or a million or two, which really isn't interesting for our portfolio construction. So I think it was a smart, conscious move we made back in the day. You earned the allocation by pricing and leading the round. By being a good partner after the round as well, by having a reputation in the founder community

Starting point is 00:06:36 where we have a corporate and strategic network that we can bring to bear. We have a whole dedicated portfolio impact team that only does customer introductions. And we try to act like Switzerland by bringing the best companies in our corporate network or venture-backed companies we know through our funds or companies from our private equity and buyout part of StepStone that could be interesting customer introductions to founders as they continue to scale and grow. On top of that, we're vetted by the early stage seed and series A investors that work with us and know what type of integrity we have. And so when a founder is making a decision on who they can add, we can make the case we'll add on the top line with revenue. And we're not going to disrupt because everyone you work with already knows us and has extensive experience working with us.

Starting point is 00:07:17 What are some examples of the integrity that StepStone shows that other firms may not show on either the founder side or on the fund side? I'll start on the fund side. We try to be an inception stage investor with funds that we work with. And so we are very active on the smaller fund side of what we do. We've had an active micro VC strategy for a long time now. We have advisory and separate account clients that also invest in funds at the very beginning. We try to create goodwill with those funds as they're getting going. We make LP introductions to those fund managers. We try to help them construct an LP base that's really high quality, that's long-term committed to venture, that isn't going to be

Starting point is 00:07:54 fickle and coming in and out of the asset class based on cyclicality, which inevitably happens in venture. We try to be a very hands-on partner. We take advisory board seats on almost every fund that we work with. We're a go-to call on directs or secondaries within their portfolio companies, or even at the GP level if they consider doing strip sales, tender offers, or continuation vehicles. And so we didn't act with integrity in those kinds of scenarios. We sniffed out pretty quickly because we're that involved from a business standpoint in GPs that are getting going and scaling. If we think it's deserved and warranted, not everyone who's gotten bigger should have gotten bigger. And so I think it's very case specific. On the direct side of what we do, we try to be a full lifecycle provider. So when we come

Starting point is 00:08:33 in, we can be involved in a smaller way. We don't come in with a bunch of rigid rules. We don't demand a certain ownership percentage. We try to do what's best for the company. And we care also about the syndicate partners that are already involved. So it's a lot less disruptive. We're trying to maximize chemistry at the board level and at the company level and trying to be a good partner at entry and then afterwards through customer introductions and through being aligned with the existing people that have already made this business great. We're board observers. We're not full board members. We don't try to overly involve ourselves in governance. We want to be informed. We want to be able to scale as things go right.

Starting point is 00:09:09 And we want to be helpful when things become more challenging. We do that alongside of GP partners that we have those trusted relationships going back to the fun side of our business. And you mentioned flexibility on your ownership percentage. There's this religion of I need to own 20, 25% of a fund in order to make my fund math work. Why are you guys contrarian on that? No, I'm probably not contrarian on that because every fund that we meet with, I hammer them on that ownership percentage. So I don't want to act holier than thou.

Starting point is 00:09:34 But I think that that matters at seed and series A. I don't think that that matters when you're coming in at C or D or when you're buying secondary. At that point in time, you need to find ways to access the very best companies at the most compelling prices you can do so. And we have a number of tools in our toolkit that allow us to be flexible and think differently than others. We identify an asset that we love. We could find a way to do it structurally in like six different ways. We could lead price and structure around. We could come into a company through a vehicle that one of our managers is setting up. We could do a continuation vehicle that is heavily dependent on that company and get exposure that way. We could buy secondary from employees,

Starting point is 00:10:09 departed employees, angels, older preferred shareholders, or seed investors. We could do a strip sale with the microgroups we work with and get exposure that way. And so coming in and thinking about it the same way a seed and series A investor would doesn't make any sense for our direct and secondary practice. It's leveraging our platform to maximize as much as we can get in companies we think are working at prices that we think make sense. And we can find better pricing because we can do it through different structural entry points. So you mentioned a lot of different secondaries. Let's unpack that for the audience. Tell me about strip sales. A strip sale would be a scenario where we come in and we buy a third of an entire

Starting point is 00:10:45 GP's portfolio. So they decide that they probably have a very good TVPI. They don't have as strong of a DPI. This is something that people are extremely conscious of in this environment. You have an M&A window that is becoming increasingly difficult with regulation and with people being less active, particularly with last round pricing, you have an IPO situation with a higher bar when it comes to scale, profitability and growth than you have historically. And so people's options for generating liquidity are increasingly coming down to private equity and secondary. And so the strip sale oftentimes makes sense for organizations that aren't registered, that can't pursue a continuation vehicle, but want to convert that TVPI into DPI. So there we become the new beneficial owner of a third of an entire portfolio.

Starting point is 00:11:30 And they take those proceeds, distribute that back to LPs, and that would effectively convert the TVPI into DPI, allow them to still ride the upside of the remaining 70% of every company, and not force them to sell one or two assets in a direct secondary sale. So a strip sale has increasingly become a more active tool in the toolkit on the secondary side. How do you make sure that you're not holding the bag due to illiquidity yourselves? Yeah. So, I mean, we're doing strip sales generally in years like eight to 10 of the life of a fund. So these are pretty far along. We're duration sensitive, but we're not rigidly duration along. We're duration sensitive,

Starting point is 00:12:09 but we're not rigidly duration sensitive. We would think about hold periods on those typically being like four to five years. And so there's always a long tail in venture. Most funds exist past year 15. And so the timing is important on when you'd come in. Ultimately, what's going to move the needle for us as a buyer is whether the one or two assets that we have the most conviction around get sold in that time period for a price that's higher than what we're buying in at, needle for us as a buyer is whether the one or two assets that we have the most conviction around get sold in that time period for a price that's higher than what we're buying in at, inclusive of the discount that we're buying in at. Those are the dynamics that we have to either be good or bad at. And I think a lot of people are tempted by doing this in this market, but the pricing around these assets is all over the place. And understanding what appropriate value should be

Starting point is 00:12:44 becomes a pretty interesting challenge to navigate. What are the advantages of working within StepStone? For us at Greenspring, we were beginning to build a bigger international presence. We didn't have people on the ground, though, in the important venture ecosystems globally. As part of StepStone, we now have a team on the ground in numerous places in Asia. We have folks on the ground in a bigger way in London that allows us to cover Europe. And we have people in a smaller way and in other venture ecosystems that matter. So first and foremost, I would say that's one thing. We're now able to pull in the experience and networks of our private equity colleagues who increasingly have companies that could be

Starting point is 00:13:19 customers of venture-backed businesses or have funds that could be acquirers of venture-backed businesses. And secondary is one avenue to get liquidity in this tougher environment. The other is private equity. And because of the relationships that our buyout team has with those funds, very interesting in terms of what they can bring to bear in both of those dimensions that I just described. We have really interesting data resources where it's an interface for what we do on the research side that I think people always think are well done. It gives us more half in the middle around operations, gives us support in investor relations and what we do on that side. We have a large LP base. And while we like that to

Starting point is 00:13:55 be partner driven, it can't always be. So we want best in breed people that can interface and represent our brand well. All of those, I think, have upped our game further from what we were doing on the Greenspring side. You mentioned private equity buying startups. What are private equity funds looking for in 2024? I haven't done buyout since the Camden days. And so all I know is what I hear from my colleagues there. I prefer to stay a venture and growth equity expert. But I feel like what they're looking for are companies that are at profitability or very quickly will get to profitability that are still exhibiting a decent level of year over year growth, but certainly not demanding what the venture folks are looking for, which I guess is now more like 30 to 60 versus 75

Starting point is 00:14:35 to 150 a few years ago. And so it's businesses that have really proven out the unit economics. There were just too many companies funded in every subsector. So the good private equity firms are going to start putting some of these together and getting synergies from it and also creating more platforms instead of point solutions, which I think will increasingly become important and catalyze some of these companies to actually get to 200 million of top line so that they're viable IPO candidates instead of people trying to get there by growing 25 to 30 percent year over year with the runway situations that they have. So I'd love to see more companies pursue this thoughtfully and strategically. So let's switch to GPs, specifically emerging managers. What do you look for in emerging managers? This is an area that I've always been really passionate around because I love working with managers at the very beginning when they're small. The math is easier, obviously, if you're getting 10% to 15% ownership out of a fund size, the $50 to $150 million. And so there's purity to that. You're

Starting point is 00:15:30 not playing for a ton of multi-billion dollar outcome. I believe in it fundamentally from a portfolio construction standpoint. That being said, there's 5,000 or so groups out there doing small seed strategies. And so you need a team that can parse through and sort through the noise and figure out who the most compelling groups are. That's why we have an investment team, about 80 people doing this. I can't think of really anyone else out there on the LP side that's built that much depth in their team. And rather than just say, we won't talk to groups that are like this or characterized by this, we will have someone get on the phone with anyone that's doing venture or growth out there and begin to build a relationship. And then what we're tracking are the assets that they're investing behind.

Starting point is 00:16:08 Are they getting big ownership positions? Are they positioning themselves to evolve and lead over time? Are they able to get pro rata or super pro rata in subsequent follow-on rounds because the founder goes to bat for them? Because the diversified and series A groups certainly are not going to go to bat for them. And so it has to come from founder love. And in those scenarios, you start to see that the really good groups shine. And because we do so much direct and secondary investing, we actually know a lot of these companies and whether or not we think that they're compelling operationally or competitively versus other in their peer set. And if you see someone that's gotten great ownership in companies you respect and is able to show objectively that founder love through some of those indicators that I just described, that becomes someone very interesting.

Starting point is 00:16:50 You want to be in a fun one, a fun two, or a fun three. Then we need to prove our value to them and find a way to be a good partner, both potentially before and after. Other things we look for are more qualitative. We like people that have grit and grind, that push through doors to get things done, that view fundraising as something that's fun to do rather than something that needs to be done. You need to love that 360 experience. You need to love getting kicked in the teeth and coming back for more. You need to have that kind of fighter spirit, that chip on your shoulder, whether that was earned from life or through work or whatever, but that you just love this business so much that it's

Starting point is 00:17:25 clear this isn't a hobby. This isn't a lifestyle choice. You're going to do what is required to get it done. And you also have the EQ and the ability to build relationships that facilitates people actually wanting to give you money on top of all of that. We're able to leverage a reference network of a very large number of funds we work with across our platform, as well as the founder community from the direct and secondary side. So I would say that's our diligence approach. You mentioned sizing as a proxy for value add to portfolio companies. Tell me about that. We want to feel like you're the go-to value added source for a founder in the first two years of existence until they do a post seed or a series A round. And at that point,

Starting point is 00:18:02 you should become more of a confidant, a friend, a sounding board, someone the founder can call on the weekends when they're frustrated or scared by something that the diversified larger groups are doing and where they want an unvarnished opinion. In the first two years, you should be the go-to source. If you're the third or fourth seed investor, and then when I do a reference with that founder five years from now, and they don't remember you're in their cap table, which happens literally all of the time, or you're not seen as that key person at the very beginning. Those are indicators, I think, of you mattering to the founder. And then we can check it in other ways also. Where is Alpha in your data stack? We work with such a large number of funds through the different things that we do.

Starting point is 00:18:39 And so we view how we track everything in that way, because we're in so many funds, because we meet with so many funds prospectively, because we have a team that can do checkups with funds every three to six months. We start triangulating around what companies are working, what's interesting, and we've built infrastructure in order to track all of that accordingly. And so even on the direct side of our business, we have tracking lists that we maintain on a go forward basis where these are companies we want to talk to our GPs about every time we meet with them, or we go to an annual meeting, or we sit on an advisory board. It's not a reactive way to think about how we do direct investing.

Starting point is 00:19:13 It's really a proactive way. And that allows us to be an informed and collaborative participant with the funds that we work with. We'll continue our interview in a moment after a word from our sponsor. Most businesses use up to 16 tools to hire, manage, and pay their workforce. But there's one platform that's replaced them all. That's Deal. D-E-E-L. Deal is the all-in-one HR and payroll platform built for global work. Smartest startups in my portfolio use Deal to integrate HR, payroll, compliance, and everything else in a single product. Focus on what you do best. Scale your business and let Deal do the rest. Deal allows you to hire, onboard, and pay

Starting point is 00:19:50 talent in over 150 countries from background checks to built-in contracts. You can manage an entire worker lifecycle from a single and easy-to-use interface. Click the link in the show notes below to book a free, no-strings-attached demo with Deal today. So you meet with somebody in Fund One. Let's say you decide not to invest. How do you maintain a relationship with that fund manager? It's interesting because I talked, I think like three fund twos today, just in the course of my day. The interesting thing about fund twos in this environment is I think they're going to be really dependent on existing LP basis. You just don't see as many indicators in the portfolio as you would historically, you know, Most are held at like one to one

Starting point is 00:20:25 and a half X, and you haven't had as much follow-on activity because the level of A and B round activity is so muted. And even when it happens, it's at a much smaller uptick off of whatever the seed has been done at because seed activity has stayed pretty consistent and valuation hasn't improved. It's actually gotten slightly worse. And so when you're looking at a lot of these funds and trying to see those indicators that are on a fund two, it's just much harder than it ever has been. Where we become most active is typically on a fund one, where we leverage prior track record at a firm that someone spun out of, or where we've worked with a firm that they've spun out of, or where they've done angel investing that was significant and sizable and enough of a proxy that we could

Starting point is 00:21:05 get comfortable around to consider coming into their fund one. And then if we missed it at a fund one, it's probably more likely we're going to come in at a fund three than a fund two, because we're going to need more indicators on fund one and judge them more on fund one than on prior track record if we would have come in into fund one. Two ends up becoming a little bit of a valley of death in an environment like this, where you're trying to attract new investors and you don't have the indicators to show it. Partnering with us on a fund one becomes so important because we help you build an LP base that's going to be there for you when it comes time to raise a fund two.

Starting point is 00:21:37 Is that one of your value adds, bringing in other LPs? We work with a very large number of LPs across our platform, many of whom are interested in what we do on the micro side that will leverage our research, that will ask for introductions. And not only that, but I try to be a good thought partner to GPs and connect them to people that we don't even work with, that I just respect in this industry that I think are good and that respect my opinion. And if I'm going to get involved with a fund at a fund one, you know, these are people that I've worked with for long enough or our other partners have worked with for long enough that they're going to see that as a really interesting signal. And instead of doing a 30 minute call, we'll probably really dig in and

Starting point is 00:22:12 try to evaluate whether we were right at step stone or not to even consider this. It just creates a higher level of attention, both within our existing LP base and within others in the community that we respect and trust as they think about putting that LP base together. I will even go through LP lists with our GPs and give them my opinion on groups, tell them my experience in working with others. It's that kind of tangible back and forth, at least with funds that are very early and beginning to transition from a high net worth kind of LP base to one that's more institutional. Some of the smartest LPs I know are really into investing in spinouts. Why is that? If you're doing series A or diversified firms, you've actually gotten to know this person, you have an existing relationship, and it becomes an access

Starting point is 00:22:54 play right off of the bat. You can automatically say that it's an access play on a fund one or a fund two. And people always like to act like they've gotten access and things and access certainly matters. But identification does too. You have to be good at both. You have to be able to sell yourself into a scarcity situation. You also have to be able to pick well when people aren't banging down the door to get into a manager. That can create even higher amounts of goodwill.

Starting point is 00:23:17 But going back to the spin out question specifically, I think in those scenarios, there's a lot to sink your teeth into. There's a lot of people you can reference with that you know within a fund and you know they're going to give you like the true skinny on what's gone on, why that person's leaving, whether they have a right to exist in their own enterprise. Oftentimes, they're not going to broadly market this to everyone in the LP universe. They're going to go to people where they have an existing relationship or where their partners have an existing relationship. A lot of these don't get seen by everyone out there. It's a very difficult market. Tell me about the market today. From a fundraising standpoint, it's obviously a much higher bar. LPs are over allocated to the

Starting point is 00:23:53 asset class. They have too much unrealized NAV. Another reason why they should consider doing something more proactive on the secondary side in order to have capital to invest in what many of us think will be very compelling vintages because of pricing and because of innovation cycle. For the time being, many are not adding new managers. And so for people that are on a fund one that are getting going, it's going to be tough. For people that are on a fund two and trying to institutionalize, it's going to be tough. Even for groups that are massive and large and have had historically tons of interest, they may have to adapt and shrink their growth efforts a little bit or recombine funds together instead of doing two things separately and think about what's truly palatable to the investor community in order to make things work in this environment.

Starting point is 00:24:34 That's what's tough on fundraising, on actual operational practices on the company side. It's moving from hyper growth to profitability and immediately proving out unit economics and making runway last longer. There's challenges all over the place. And for everyone who thought that this was fun and always up into the right and a momentum driven asset class, you're getting a cold slap in the face in this environment and a reminder that it shouldn't be easy to generate high upside returns like venture has been able to do in good times. It's very cyclical. Well, Hunter, you certainly did not disappoint. This has been an action-packed interview. I've really enjoyed it. What would you like our

Starting point is 00:25:08 listenership to know about you, about StepStone, anything else you'd like to shine a light on? I'm excited to get to know people doing new and interesting things. I try to be pretty open and receptive. Whatever you'll hear from me is candid and to the point. It's how I always try to live, and I think it's helpful. I appreciate people that are direct and unvarnished and try to be that type of partner. When I or the firm becomes your partner, you'll get our undying level of attention and energy to try to make you successful. We care that much. I appreciate you jumping on the podcast. Yeah, totally my pleasure. Thank you, David. By popular demand, the 10X Capital Podcast has officially launched our newsletter powered by Carrier Labs, a full-service content marketing firm that's partnering with us on the newsletter.

Starting point is 00:25:47 In our weekly newsletter, we will keep you updated on all things emerging managers and limited partners, including industry trends that are critical to know as an LP, VC, or founder. To subscribe to our totally free newsletter, please visit 10xCapitalPodcast.com. Again, that's 10xCapitalPodcast.com. We thank you for your support.

Investing Billions - E52: StepStone's Hunter Somerville on How to Scale LP Capital

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