Investing Billions - E55: Eric Sippel - Lessons from Investing in 45 Venture Capital Funds

Starting point is 00:00:00 Let's talk about GPs first. When going into the space, that sort of assumes that they're doing their fun one. And if they don't have already have a really good network, they probably don't belong in venture. So let's start there. Eric, I'm really excited to chat. Thank you to Ariana Thacker. Thanks so much. Pleasure to be here. Eric, how did you come to start investing in emerging managers? I've been investing in the alternative asset class for more than 30 years. I started off as a Wall Street lawyer 38 years ago, working with our firm's private equity

Starting point is 00:00:37 fund clients, moved out to the West Coast in 1990, where I co-led a nationally recognized hedge fund law practice and a venture practice. And then I left, become the chief operating officer of what became a multi-billion dollar hedge fund firm, where among other things, I was in charge of our venture practice and also helped seed a few other managers while in that position. We were lucky enough to close down about 14, 15 years ago. Since then, I've been running my own family office and investing in alternative managers and spending most of my time, probably 85% of my time in the

Starting point is 00:01:11 venture space. Just to give a sense, how many funds are you in? What's your check size? Give me some numbers. I get to invest capital and I get to invest time. Let me start with the time. So I try to act as a coach or a mentor where everywhere where I've invested capital, plus many instances where I actually have not invested capital. So that's sort of a starting point. But where I've invested capital, I probably invested capital in about 45 different venture managers. And my typical check size, I have two check sizes, my core investments, and that's $250,000. And the other is for what I call pilot investments, and that's for $100,000. And that's below everybody's minimum always. And because I can

Starting point is 00:01:51 be so helpful as a coach or a mentor, I have never had anybody not waive their minimum for me. When you go from pilot to core, what determines whether you upsize your pilot investment to a core investment? I have to believe that they will consistently be top decile performers. Leading indicators that you look for top decile performance. What are those leading indicators? I have a framework that is four parts. Part one is, and I don't usually get all four parts.

Starting point is 00:02:18 When I get all four parts, I get very excited. I want to get at least three of the four parts. Part one is I am looking for a space that is relatively inefficient, where there's a mismatch of capital and opportunity. I think hard science, spinning out of university, stuff like that. The second area is I'm looking for a GP experience. At least one GP has to have at least five years of operating or founder experience. And at least one GP, it could be the same GP, has to have at least five

Starting point is 00:02:45 years of investing experience, investing other people's money in a manner similar to mine, meaning that angel track records probably aren't good enough. Third is I'm looking for what I call the three S's, the craft of venture investing, sourcing, selection, and stewardship. How do you find your deals and win those deals that you find? How do you choose which companies to invest in? How do you help companies both before you invest and after you invest? And then lastly, I look at portfolio construction. I'm looking for funds that are going to own large percentage ownerships for their check in their companies. What skill or learning do you hope that the manager gets by managing outside capital? One is angel checks are typically

Starting point is 00:03:23 small. And so they're not necessarily predictive of winning and getting on cap tables at a much larger check size. So that's probably the first thing. The second thing is when you invest other people's money, and remember, I come from being the COO of a large firm. So I sort of have lived this experience. When you invest other people's money, it is just a different stress level

Starting point is 00:03:44 because there are inevitable challenges every step along the way when you're an investor and your ability to cope with that and your ability to size your portfolio appropriately and your ability to know when to follow on to various different companies. So those are things that I think you get investing other people's money. Which one of those is most critical as a GP in your opinion? I'd say the sourcing and winning. You have a very interesting model. You like to help. You like to provide value add. And you like to get to know people a vast amount of time before you actually invest.

Starting point is 00:04:12 Tell me a little bit about that. So I said I invest both time and money. And I get back both financial and emotional return. My financial returns for my portfolio are really excellent. There's also something else to it. I was lucky enough, as I said, to retire 14, 15 years ago. There's also something else to it. I was lucky enough, as I said, to retire 14, 15 years ago. I do not need to get paid. And so when I coach or mentor, no one pays me a dime. You don't get a piece of the carry or anything. Just a question

Starting point is 00:04:34 of kind of how you want to be remembered. Why are you here on this earth? I think we should all be here to make the communities in which we live in better and to help. And that's how I want to be remembered. Somebody who's really sort of rolled up their sleeves and helped and made the ecosystem better. Given that you're looking for financial as well as a personal return, does your criteria differ than most financial-only investors? I will not write a check unless I believe I'm going to get top quartile returns. I just won't do it. So my underlyingwriting criteria might be slightly different than other financial investors.

Starting point is 00:05:08 Some might have more detailed underwriting. Some might have less detailed underwriting. I do not in any way write a check without feeling really confident in the financial investment. We'll continue our interview in a moment after a word from our sponsor. Most businesses use up to 16 tools

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Starting point is 00:06:01 What would keep you from investing for non-financial reasons, if anything? I think the person's a jerk. I don't get along with them. I don't think they're open-minded to coaching. A lot of that bleeds into whether I think they're going to be top quartile or not. I think people who are jerks, outperformance is not sustainable. I think people who are not coachable or not open-minded, ultimately their financial performance is not sustainable. They sort of bleed into each other. You also mentioned off-camera the criteria that you like GPs that spend a lot of time with founders before they commit. Can you explain that? Absolutely. So I talked about my three S's. This is a selection. I think there's two different pieces to that. One is the founder-GP relationship

Starting point is 00:06:40 is a long-term marriage. And in 2020, 2021, maybe even some today, there were these shotgun marriages where GPs would meet a founder and within two days they'd commit. You wouldn't even decide if you want to have a long-term relationship with a girlfriend in two days. So I really like four weeks at a minimum. My favorite is when people take more than a year when they know a founder. They really get to know them. They get to know there's a relationship there. There's mutual trust built on both sides. That's sort of the first piece.

Starting point is 00:07:11 The second piece is I don't think you can do adequate diligence on a company in a week or two. There's just too much out there to learn. You have to give time to time in order to make good decisions. How long do you need to date a GP before you decide to commit? I'm not quite as disciplined on that. My preference is long period. Some of my favorite GPs are ones where I was coaching them for six months before I decided to commit. Those are some of my favorite relationships because I really know the GP very well. But I have to be honest, I have a really small check size. I am not going to take up a lot of GP time when they're at the outset necessarily.

Starting point is 00:07:48 I'll make commitments as quickly as three or four weeks. What is it that you find that GPs have the most issues with and where are you able to provide the most value? It really depends on the stage of the GP. So I'll just go through various stages. When they're out marketing with their deck, it doesn't matter whether it's a fun one or a fun three or even a fun five. There is typically GPs are not very good at explaining the GP fund fit and in particular relating what their superpowers are to make it a GP fund fit and really triple clicking on the three S's.

Starting point is 00:08:18 So that's sort of at the outset. There are a lot of GPs that struggle with when to follow on and what does the portfolio construction look like? There are lots of GPs that struggle with what happens if I raise too small of a fund? What if I'm oversubscribed and how do I deal with that? This person is not working out. How do I sort of ask them to leave the team? There's such a range, but those are some of the things that come up a lot.

Starting point is 00:08:43 In terms of dealing with follow-on, what do you counsel GPs in terms of what their follow-on strategy should be? I break the world into four tiers of companies. Tier was one, two, three, and four, and they're not equally weighted. So tier one companies, a quarter of the companies are not tier one companies. Basically 5% of the companies are tier one companies. Another 25% or so would be tier two, and then tier three and tier four. Tier four companies are not getting funded in any environment. And if you are a GP, you should not fund follow-on capital to tier four at all. Tier one companies are home runs.

Starting point is 00:09:14 Assuming that the round makes sense, when I say the round makes sense, the valuations make sense, particularly in 2020 and 21, there have been some really value-destroying rounds by tier one companies. Assuming the round dynamics make sense, follow into tier one companies, absolutely. I think the sort of art here is tier two versus tier three. Many GPs are not lucky enough to have tier one or tier two companies. And so they're forced to put their following capital into tier three companies. That's just a substandard fund. If you have both tier two and tier three companies, I always recommend to GPs to follow into the tier two companies in a fairly heavily way and not to fund the tier three companies. It's going to be a huge time suck. It's going to be maybe a one,

Starting point is 00:09:59 two X return. And that's just not going to move any needles for anybody. The other component to follow on strategy is how well do you know the company still? Follow on investing in the private capital world is like insider trading. You should know what's going on inside of the company. You can make these decisions as to whether it's a tier one, a tier two, tier three, or tier four company. If for whatever reason you do not have that information because you are not close enough to the company, then you really should be careful about following it into companies. For my GPs, because they are so strong on adding value to their companies,

Starting point is 00:10:33 they typically do have that, quote, inside information. Just to play devil's advocate, why wouldn't you put all of your capital into, quote, unquote, tier one companies? Why would you even go to tier two companies? What's the rationale? You are assuming that you have an unlimited amount of runway to put money into tier one companies. Most funds have one or two, and you can't put all of your follow-on capital into that in terms of just those companies won't necessarily take it. Number two, as I said, tier one companies have to be careful about round dynamics. Number three is tier two companies drive returns. With the power law, your tier one companies, they'll return the fund. That's fabulous, but you're not going to have more than one or two of those in a fund. If you want to get 3X net to your LPs, you need to get 4X gross on your MOIC. And those tier two companies are

Starting point is 00:11:19 going to get you there from one or 2X up to three or four X. Off camera, you mentioned something pretty peculiar. You said no man crosses the same river twice, not the same man, not the same river. What did you mean by that? We are a product of our lived experiences. And so what I am today and who I am today is very different than who I was 15 years ago. I've gone through a lot of different experiences and learned a lot of things in the last 15 years. At the same time, the environment has also shifted. So the environment today is very different than it was 15 years ago, very different than it was 20 years ago or five years ago, two years ago. We as LPs, when we're evaluating GPs and GPs, when they're evaluating companies, need to sort of understand

Starting point is 00:11:56 that combination of the environment shift and lessons learned and lived experiences. One of the things that you mentioned is you've always regretted straying from your strategy. Aren't there times to really veer off strategy and capitalize on an idiosyncratic opportunity? If your strategy is broad enough, it should be able to capitalize on the idiosyncratic opportunity. So that's number one. Number two is you can't be dogmatic about your strategy as being really narrow. I look at the returns from those funds and they're fine. But the reasons why I was hesitant are the reasons why those funds are maybe top half, not top 40. As an LP, is it also errors of omission that keeps you up at night, or is it more errors of commission? What keeps me up at night are the errors of commission.

Starting point is 00:12:43 There are a lot of really well-known funds. An example, Andreessen Horowitz, Initialized, Lux. None of these people remember talking to me, but early on, I passed on all of them. Sure, my financial returns would have been higher if I had done that. But at the same time, that would have strayed from my decision-making process, in particular, fund size and where firms wanted to go. So those don't keep me up at night at all. What keeps me up at night is the capital that I actually have, because I have a limited amount of it,

Starting point is 00:13:10 if it underperforms or worse yet, if I lose money. I haven't actually lost money in the venture space. I've lost plenty of money in other asset classes. And do you mean on a single fund or a single vintage? I mean on a single fund. So you've never had a sub 1.0X fund? In venture, correct. That's great.

Starting point is 00:13:28 Congratulations. Thank you. There's a lot of what that goes into that. Let's be clear. You've had several. I know 5 to 10X as a person I know of. I know you've had a 14X. What has been some of the patterns among your highest performing funds?

Starting point is 00:13:40 Looking back at those fund managers, did those fund managers have something different, something idiosyncratic that your other fund managers did not? I am always surprised within my pool of managers. I am always surprised by those that are top decile versus top quartile versus top. The ones that I had the most conviction in going in, they're often top quartile, but it's unusual for them to be top decile. The top decile ones are ones I also thought would be top quartile, but I didn't think they could be top decile, and they are. The ones that are multiple vintages top decile, tell me about those. My venture portfolio is primarily pre-seed, seed, or secondaries.

Starting point is 00:14:20 And that's how I express my sort of growth investing is through the secondaries. I have a little bit of A with specialists, and I prefer specialists sort of generally. And that's how I express my sort of growth investing is through the secondaries. I have a little bit of A with specialists and I prefer specialists sort of generally, and I have no primary investing through B and above. That's sort of the universe in which I'm playing. And so what are the common characteristics of multiple top decile funds? I'd say they're seed stage funds. And when we say top decile, I'm measuring by TPPI. I'm not measuring by IRRs because secondary funds have amazing IRRs and much shorter return period. But it's seed stage funds. It's firms that have large ownership for reasonable size checks.

Starting point is 00:14:55 They're concentrated. They add huge value to their companies. All the things from my framework, those are things that really lead to sustained outperformance. You mentioned IRR versus TVPI. I found the one LP base in venture that seems to care about IRR more than any other is family offices. Do you care about IRR? I spend 85% of my time, but only 15% of my capital in the venture space. I have 85% of my capital is devoted to investments where IRR matters much more, like real estate or private equity or the like. So start there. IRRs go down the longer you hold something. And what I really want is to compound my wealth. I'm a taxpayer. And so I would rather a business

Starting point is 00:15:37 or an investment have a lower IRR and a much higher return multiple before tax and not having any tax paid than I would in terms of having to regenerate it over and over and over. If I have a good business, I want to own it and have it continue to compound capital. If it's growing value, however you want to define that,

Starting point is 00:15:55 at over 20% per annum, I want to hold it for as long as possible. QSBS, Qualified Small Business Stock Treatment, which further compounds those. You said something very controversial about sourcing, picking, and value-add, something that shouldn't be controversial, but actually is. You said value-add is the most important. The common wisdom around venture capitalists is that you need to get on the right rocket ship. That's what matters. Why is the common wisdom wrong? And why is value-add such a big driver, in your opinion, to VC portfolios?

Starting point is 00:16:21 Number one is you de-risk the company by adding lots of value. Number two is you develop a much stronger relationship with the founder, which predicts sourcing because the stronger relationships you have with the founder, the more likely they are to refer other founders to you and to talk about you in a really positive way. Number three is you're more likely to win deals because when you go and you're pitching a company and they go and talk to some of your founders, and if your founders rave about you, of course, they're going to want you on the cap table. And number four is your network is much broader and deeper. And so when you go and you have to decide and pick, you need to do diligence

Starting point is 00:16:59 and you can rely on your founders and people your founders introduce you to if you have a really strong relationship. The way you develop a strong relationship is to roll up your sleeves and help. Inherent trade-off between portfolio size and value add as well. Absolutely. So that's why I like concentrated positions. You can't really roll up. And again, portfolio size is per GP. And so if you have four GPs, you can have four times as many companies as if you have one GP. The more concentrated your portfolio, the easier it is to add value to your companies. In terms of your own sourcing mechanism, you're one of the most networked LPs that I know. How do you manage that? What is the best practices in terms of how you find GPs? The best practices for sourcing GPs is two things. You need to be

Starting point is 00:17:40 helpful to other people in the ecosystem. So as an example, I have really good relationships with some endowment CIOs, with some fund to funds, with other family offices. And I know the kinds of things that excite them. And where I am already an LP, I will not refer funds or GPs to other LPs unless I'm an LP. But where I'm already an LP, where I know there's a good fit, I will make an introduction to that other LP. That is helpful to that LP. That is helpful to the GP.

Starting point is 00:18:11 So it's sort of a win-win. But if it's good introduction, they will often send me things that they find really interesting. They think I would like, and they know what I like. That's one. The second one, which is harder, is because I am so value- add to my GPs, they go out of their way to make introductions of people that they really respect, that they think I would to me. And I always take those very seriously as well.

Starting point is 00:18:34 You're one of the most non-zero-sum thinkers in the space. I think of myself also as a non-zero-sum thinker. In the cases that you've been very helpful to GP, how often do they not reciprocate? Let's do positive, neutral, and negative. And negative is where I get nothing. And they sort of, what I will call ghosting me after I have invested, other than what they would send out

Starting point is 00:18:54 every six months or 12 months. That happens probably 10, 15% of the time. And it's also where in their life cycle. So the neutral is where they start off being friendly and nice. There's some flow back and forth. I mean, they're certainly not referring people to me, but that's not what I'm looking for in a relationship per se. It's not transactional in that way.

Starting point is 00:19:17 But they're really not relying on my mentoring and coaching, but the relationship is good. And maybe another 10 or 15% start that way. But after I've been in an LP for seven or 10 years, or even five, six years, there are many firms that sort of transition to that. They've gone to fund four, fund five. They don't need my coaching. We have a great relationship. If I picked up the phone and called them, they'd be delighted to talk to me. I'd visit them, whatever. That's another 15% of the time. So maybe I'm at 25, maybe I'm at 30, 40%. And then the other 60, 65%, I'd say is really positive and strong. Is it a psychographic that you see within top people or is there a different dynamic with LPs versus GPs? I have great relations with all the LPs that I think of in my network.

Starting point is 00:20:01 There are definitely a handful of them that I think of as being particularly strong. And they're the first ones I think of when I want to send things to. And I know that they send lots of things to me that are really good. So I must be high on their list too. Definitely breaks out a little bit more concentrated on the LPs. If you said, you know, the negative, a neutral and the positive with LP relationships, when you've been helpful, how would you categorize that for LPs? I don't have any negative relationships with LPs because I don't really care if they ghost me. I meet them and then I never hear from them again, or I send them something and I never

Starting point is 00:20:34 hear from them. I don't care. So there's 0% there in the negative simply because I just, as I said, I'm indifferent. The neutral, that's probably like 80%, 85%, and 10% or 15% is in the really positive. By popular demand, the 10X Capital Podcast has officially launched our newsletter, powered by Icaria Labs, a full-service content marketing firm that's partnering with us on the newsletter. 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.

Starting point is 00:21:03 To subscribe to our totally free newsletter, please visit 10xcapitalpodcast.com. Again, that's 10xcapitalpodcast.com. We thank you for your support. As you mentioned, you're in hundreds of funds and you've seen a lot of different market cycles. How would you advise either GPs or LPs to build their relationships

Starting point is 00:21:21 and to build their ecosystem? Now let's talk about GPs first. When going into the space, that sort of assumes that they're doing their fun one. And if they don't have, already have a really good network, they probably don't belong in that.

Starting point is 00:21:34 So let's start there. But if they do have a really good network, then what I would recommend is just continue to extend it, like continue to do good things for other people. And when you do in 10% of the cases, good things will come back to you. You don't know where or how, but the more good things you do for people and the more you sort of act when no one was

Starting point is 00:21:56 watching, you act appropriately, then you will develop strong relationships and it'll come back at you. You do quite a lot of diligence and you have very specific views on what you like in data rooms and what the best practices are. You open the data room and you're like, you know, there's angelic voices singing and you see that it's the perfect data room. What is the gold standard data room that you like to see from emerging managers? The data room is there as an archive to back up what you're saying in the deck and what you're saying in your meetings. And so start with that conceptually. Let's talk tactically what that sort of means.

Starting point is 00:22:31 We talked about GP fund fit at the outset in what's in a deck. I kind of want to see more about the background of the GP than what might be in the deck. I want to see the three S's. And so I want to see investment memos where they talk about sourcing and they talk about selection. Links to articles, videos, and podcasts, a good due diligence questionnaire, the video replays and slides from AGM, a portfolio construction spreadsheet, a track record spreadsheet, of course, the legal docs, of course, the audit financials from previous funds. What I'm looking for conceptually is how does this person think about the venture world? How do you handle

Starting point is 00:23:06 references? Only off-list. On-list references are much more difficult to get at their real truth. You mentioned I had an extensive network and at this point I do. Invariably, I have 10 or 12 or 15 touch points when I meet a GP with founders through other GPs or through other GPs who have invested with them or whatever, other LPs who may have also done extensive diligence. I love when I can piggyback on a fund of funds that does extensive diligence and I can listen to either read their memo on founder references or just listen to them summarize their founder references. Those are things that really are helpful to me.

Starting point is 00:23:42 What is a reference that sounds bad, but you think is positive in nature for a VC? Something that can sound bad, but actually isn't. When a founder says they were really helpful at the beginning, but over time they faded away, combine that with the GP's assessment that that company was going to be a tier four company, let's say. I think good GPs actually really limit their time on tier four companies and frankly, tier three companies as well,

Starting point is 00:24:09 because they only have a finite amount of time. How should GPs look at their portfolio construction when it comes to their time allocation? Same way they do with capital. The tier four companies, and to a lesser extent, the tier three companies, suck up all of your time. And that's not where you get your return.

Starting point is 00:24:24 So focus your time on the tier one, tier two. Eric, you've allowed me to really get tactical and granular on your portfolio. It's very much appreciated. What would you like people to know about you, about your family office or anything else you'd like to share with the audience? I really believe that we're here to help the ecosystem, that each of us should play a role in helping the ecosystem. Emerging managers are critical to the startup community and to, therefore, to the success of technology. And we need to each sort of play our part. And like people knows that I'm playing my part. The other thing, which is totally off topic from this, is I am the chair of the San Francisco Barrier Goodwill. And most people don't know our mission, which is

Starting point is 00:25:00 to employ and train more than a thousand people who have barriers to employment or otherwise wouldn't be employable. People who are formerly imprisoned, recovering addicts, veterans, immigrants where English is second language. We are really sort of helping that community. And what I'd really like people to know is what our mission is. I really appreciate you jumping on the podcast and sharing so many decades of wisdom with myself and the audience and look forward to meeting in the Bay Area or New York very soon. My pleasure. Take care, David.

Investing Billions - E55: Eric Sippel - Lessons from Investing in 45 Venture Capital Funds

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