Investing Billions - E60: Emerging Manager Alpha At Scale with Michael Downing

Starting point is 00:00:00 The most surprising data point to us was 70% of these emerging manager funds have an outlier. Now, we define an outlier as a company whose valuation is 30 times or more of what the valuation was when that small fund invested. Other people have different definitions of what an outlier is, but that's our baseline. 70% of those funds had a company that qualified under that definition. We look at emerging managers as $60 million and less in terms of size of fund, right? So if you've got a $20 million, $30 million, $40 million fund, that's an emerging manager. When endowments and pensions and traditional institutional guys look at that category, there's a physics challenge that just, it does not work for them. Typical

Starting point is 00:00:38 pension, your smallest check you can write is $50 million. That's not going to work. It's larger than the typical fund size, which is $30 million. Endowments, they require six years of track record. They don't do fund ones. And once again, they have a minimum check size that might be $20 million. So there are all kinds of physics issues that keep institutional guys out of this market. Tell me about your portfolio construction. We have this philosophy and thesis in terms of how we deploy capital into the small funds. We like to look at it as we're in the midst of this innovation super cycle. It looks a lot like 2008 to 2011. You have a depressed kind of macro environment where there's plenty of negative news and plenty of negative signal where people have been risk off for the last 15 to 18 months, very similar to 2008.

Starting point is 00:01:21 At the same time, you have a fundamental innovation super cycle. In our case today, it's AI, defense tech that's starting to really move markets and create opportunities. For more ideas on how to raise venture capital in this market, make sure to subscribe below. Let's start with the capital extension program. We announced with Sidecar the launch of the capital extension program. The emerging manager category is one where we spend a lot of time. We have a fund that allocates part of its capital to investing in emerging manager funds, small sub $50 million funds. And part of that capital goes into direct investments. What we heard over and over from these managers is one of their biggest frustrations is they invest at the earliest stages in companies that end up being outliers and growing and scaling to large sizes, but they don't have any capital to continue to invest in those companies when they do subsequent financing rounds, a Series A, a Series B,

Starting point is 00:02:14 a Series C, et cetera. The capital extension program is basically one where small fund managers or syndicate leads can come to us when there's a later stage round or follow-on round happening in one of their portfolio companies. We will actually provide that manager the capital to participate in that follow-on round. We do it in the form of an SPV on sidecar, and we split the carry with that manager or syndicate lead. Effectively, what we're trying to do here is help these small managers punch above their weight and recapture a lot of that value that historically has been given up to later stage funds that end up taking the vast majority of those investments that occur in those companies. So let's say you invested in the pre-seed of Uber,

Starting point is 00:02:54 you're a $30 million emerging manager. How would someone partner with an MDSV? Here's a real use case. We have a small fund manager who contacted us. In 2018, they were investing out of a fund that who contacted us in 2018. They were investing out of a fund that was all of 600K. And so obviously they were writing very small checks into companies. One of the companies that they wrote 50K check into, fast forward, is now doing over 100 million in ARR, is growing very quickly, and is getting ready to do a Series D. This is obviously a later stage round. That fund manager has already done very well on their 50K check, but they have the opportunity to put more capital in that company. And we're

Starting point is 00:03:30 pulling together $2 million, basically giving them the $2 million to invest in that company and splitting the carry with the manager. As you said, $2 million, what is the range of checks? Yeah, we created pretty specific parameters here, although we're seeing what the market is asking for and adapting as needed. But we basically said, look, we're willing to write checks as small as 200K all the way up to 5 million for these opportunities. These are not pre-seed deals. These are not even seed deals. Those are the deals that we expect these syndicate leads and emerging managers to do on their own. These are mostly series A through series D companies. And how late will you go? Series D is the latest stage company we've seen so far that's come through. And that'll probably

Starting point is 00:04:10 be done at a $1.5 billion valuation. So that's probably as late as we would go. I'm sure you have a lot of fund managers that are interested after this podcast. Hopefully, we'll 10X you. But even before then, I'm sure you have hundreds of opportunities. That's how you got the name. That's where the 10X came from. Yes, exactly. Trademark. Let's say you have hundreds of opportunities. That's how you got the name. That's where the 10X came from. Trademark. Let's say you have hundreds of opportunities. What is your first filter?

Starting point is 00:04:30 There's a few different filters we look at. We tried to publish these on the page about the capital extension program so that people know the general parameters for what works and what doesn't work. Number one, what we're looking for is this is for software and technology companies. This is not for, let's say, a game studio or real estate deals or any other thing that falls outside of technology and software, number one. Number two, when we talk about confirmed outliers in a portfolio, generally speaking, what that looks like is they're doing, call it 10 to 12 million in revenue, recurring revenue or gap revenue a year. There's a growth rate that's at least 1x to 1.5x per year in terms of how fast

Starting point is 00:05:07 the company is growing. The financing opportunity that the manager brings us needs to be an actual financing opportunity they've negotiated and secured. So it's either an upcoming round that's a series B or series C or whatever it may be, or it could be a safe or a convertible note that's occurring between those rounds. Anything outside of that, like secondary, is not what the program's intended. How much of that signal is the lead investor? It's less important to us, quite honestly. What we do look at probably most closely is the product category, the technology category, and then the growth rate of the company.

Starting point is 00:05:40 We've learned a lot of lessons over the years around product market fit and N plus one growth and what kind of growth you need to see on a quarter to quarter basis and annual basis that would validate that a company is a true outlier and that they have a lot of growth left in them. And so that's probably the biggest area where we really zero in and try to understand what that growth rate is. How big of a capital pool are you drawing for for this program? Yeah. So we created a dedicated pool of 50 million to support the capital extension program. And just to give you kind of an overview on the structure here, we have a primary fund, which is our venture capital fund. Out of that fund, we make investments in emerging manager funds, and we also reserve capital to do direct investments. Before we publicly launched the

Starting point is 00:06:21 capital extension program, we got a dedicated pool of $50 million. That's just to support these deals. How much of this $50 million is left? I'll give you the real breakdown here, which is a little surprising even to us. We launched it a week ago. We got 23, I think maybe even 24 as of this morning, opportunities that came in to us. The team immediately dug into those opportunities. Right now, it looks like four of those are ones we're definitely going to move forward with. Across those four, the average

Starting point is 00:06:51 size is somewhere between one and a half million to two million. If we do all those, call it eight million of the 50 will be gone. Now, I will tell you the 50 was based on what we projected would be the demand for this. And so we will adapt as we see opportunities come through. But one point that may not be obvious in how the capital extension program was launched is we look at this pool of emerging managers as this incredible untapped resource that have proven themselves to be incredibly adept over the years at identifying great companies at the earliest points. But the real kind of injustice in the market that's occurred here is 98% of the capital that those emerging managers raise stops at the seed fund. Meaning even if they

Starting point is 00:07:35 have an amazing outlier and a great company that's growing, they very, very rarely invest beyond that. The average check size that we've kind of researched across 400 plus funds, the average LP check size that they get is 200K from usually a high net worth individual. And so if your average LP is a high net worth individual who gives you 200K, and all of a sudden you have a $5 million opportunity to follow on in Stripe or whatever the company is that's doing incredibly well, you can see how unreliable that methodology would be to be able to actually continue to invest in those companies. What we're trying to do here is really formalize a program to help these managers accrue more value, get more of that

Starting point is 00:08:15 return that historically they've been giving up to the seed funds, series A funds, and all the bigger guys who are out there. How big of an opportunity set is this? Just to give you a little bit of background, over the last few years when we created our fund that really does rely on and invest in this emerging manager category, we did a huge amount of research across all these funds that were in market and some that were coming into market. We also created an online community called The Promontory

Starting point is 00:08:43 where it's basically an invitation-only community where small emerging managers can come in and connect with LPs and basically helps them fundraise, get checks from additional LPs for their fund. The most surprising data point to us was that 70% of these emerging manager funds have an outlier. Now, we define an outlier as a company whose valuation is 30 times or more of what the valuation was when that small fund invested. Other people have different definitions of what an outlier is, but that's our baseline. 70% of those funds had a company that qualified under that definition. And so we've also seen that at any given time, there's roughly 700 to 800 of these

Starting point is 00:09:21 emerging manager funds that are in market looking to raise money. There's another, you know, call it 800 to 900 funds might not be in market. So cumulatively, you're looking at universe of call it 1600 small emerging manager funds. Now, the other dynamic to look at here from a data perspective is, as we've all experienced, you have this added dynamic of there's new entrants coming into the market and there's other folks who are exiting the market. 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.

Starting point is 00:09:55 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 talent in over 150 countries from background checks to built-in contracts. You can manage the 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. Tell me about your team composition.

Starting point is 00:10:30 The basic team setup here, there's four partners at MDSP Capital. My background is I co-founded six different software companies over a 28 year period in Silicon Valley. One of my other partners is from the world of FinTech, was early at PayPal, then went to Facebook and helped them build their payments product. So within the partnership, we cover a few specific genres. Then we have a team of two analysts here who have particular expertise across B2B, SaaS, and deep tech. So we try to cover as many of the categories as we can. And then we have a slightly broader network of advisors who cover very specific areas. And actually, some of these advisors are investors and LPs in other small funds. So we have folks with an AI specialty or background. We have other folks who are in defense tech and other key areas.

Starting point is 00:11:15 So if we get an opportunity and it's in an area that we don't feel totally comfortable assessing, we've got folks we can pull in to help do that analysis quickly. So I send you an opportunity. It's the next Uber. It's Uber for Pets. And that's Series D. I'm giving you the very last million dollars in the entire round. It's a billion dollar round. I'm giving you a million dollars. What's the next step? What is the best way that a GP could interact with you? And we tried to make this as easy as possible, knowing that all these emerging managers are very time constrained. So we actually published a deal memo template, which is just a set of about 12 bullet points that

Starting point is 00:11:50 initially, if you just fill out those 12 bullet points, we can at least take it through the first filter and say, this is something we want to learn more about, or this doesn't fit the program at all. And that template is listed on the sidecar site. It's also on our website, which is mdsv.vc under capital Extension Program. And so that gives people an easy kind of guardrails for how to provide us the basic information. Once we get that information, we immediately respond to whoever submitted it, just letting them know we've got the info. As published in the announcement with Sidecar, we basically take five days to give them an answer on whether we want to participate or not. You can see the basic data points there, which are pretty simple.

Starting point is 00:12:28 One page. Yeah. We tried to keep it one page. Well, keeping it easy is part of the challenge here. I will give you an example of a real opportunity that came in last week. Immediately emailed the guy back, asked about four follow-up questions to the manager who has access to an amazing opportunity. They wrote one of the first checks

Starting point is 00:12:45 into. And tomorrow morning, we're actually doing a call with the CEO of the company. And it's only because this small manager, who, by the way, doesn't have a fund. He just does SPVs because he hasn't been able to raise a fund. We're doing a call with the CEO who's good friends with them, and the CEO just is going to answer some additional questions that looks like we will do that deal. So this is an important point. Part of our hypothesis in this program is the last 18 months, as I'm sure a lot of your viewers have experienced, has been unbelievably difficult for emerging manager funds to raise any money whatsoever. As a matter of fact, across, I mentioned the 700 funds that we're kind of tracking closely, across these 700 plus funds, over the last 12 to 15 months, we only know three who actually raised the targeted amount that

Starting point is 00:13:26 they were going after. Most everybody else is still in market, still raising, and most of them are adjusting down what that target is. Maybe they were going out for a $40 million fund. Now it might be a $25 million fund. Now that is what it is. The market is tough. LPs were sitting on the sidelines and not allocating money for a long time. But part of our hypothesis is many of those fund managers are going to proceed leaning on SPVs a lot more than they did previously. Deal-by-deal activity is a perfectly valid, perfectly reasonable way for them to push forward and make progress. Let me unpack that a little bit for the listeners, why that's going on. There's several factors. The first aspect is the denominator effect. What does that mean? That means that as private investments have continued to rise in 21, 22, and some of those marks have not been refreshed, institutional investors are

Starting point is 00:14:13 overweight on their private markets. That means they sometimes not only can't add to new managers or even existing managers, sometimes they literally have to sell via secondary. So there's just less dollars going after new relationships. The second aspect is closely related. In down markets like this, LPs tend to focus and tend to cut managers and focus more on quality. In bull markets, there's more of an openness to experiment and to see kind of these high risk, high returns. But in bear markets, you have more concentration. That translates in terms of much less supply by some factors. I believe we chatted on the liquidity podcast. It went down something by like a third or fourth the amount of capital that was deployed in 2023 because there's less demand. Some emerging managers are not able to

Starting point is 00:14:54 raise at all, and most emerging managers are raising less capital. That's absolutely right. And thus, you have the situation where for many of these managers, maybe they're going to close a much smaller fund than they thought. But either way, everybody's going to be leaning on SPVs to simply make progress over the next 12 to 15 months. And then hopefully things change and they're able to raise their funds. We also know one other thing, which is an important data point. Across the 700 plus funds that we've analyzed and tracked, call it 50% of the capital is coming from family offices, typically a single family office, maybe 47% from individual high net worth investors, and a tiny 3% to 5% from what we would call institutional investors. And by that, I mean fund to funds mostly. Endowments aren't-

Starting point is 00:15:42 3% to 5% of capital of the 700 emerging managers? Exactly. How do you explain that? We look at emerging managers as really kind of 60 million and less in terms of size of fund, right? So if you've got a 20 million, 30 million, $40 million fund, that's an emerging manager. When endowments and pensions and traditional institutional guys look at that category, there's a physics challenge that just, it does not work for them. Typical pension, your smallest check you can write is $50 million. That's not going to work. It's larger than the typical fund size, which is 30 million. Endowments, they require six years of track record. They don't do fund ones. And once again, they have a minimum check size that might be 20

Starting point is 00:16:18 million. So there are all kinds of physics issues that keep institutional guys out of this market. And so there's just a series of challenges around fundraising that hopefully will get better over the next 12 months. For the time being, SPVs are going to be more important. Partnerships are going to be more important, which is one of the reasons why we've pushed capital extension. So tell me a little bit more about MDSV. So this is just a $50 million pool of capital that you have. What's the problems out there? Our core venture fund, which is a $25 million fund, focuses on investing in emerging manager funds and doing direct investment. Then we created this separate $50 million vehicle just for the capital extension program. Our kind of investment thesis and how we approach this is based on 20 plus years of being

Starting point is 00:16:59 operators and investors in Silicon Valley. The partnership invested in many small funds over the years and leaned on those small funds as kind of the tip of the spear to find out about great companies and great entrepreneurs and founders that lead to further investment. We institutionalized that a bit with MDSV Capital, not only put together the dedicated capital for this, we created the promontory online community for these managers to connect with LPs. And then we also do a series of events, Emerging Horizons, which is a summit for emerging managers where they come together and they get to meet LPs. We just had a dinner last week in Palo Alto where we had one of the senior product executives

Starting point is 00:17:38 from OpenAI come and speak. And at that dinner, it was a group of family offices from Silicon Valley and a small group of emerging managers who attended. So trying to support that ecosystem and create more kind of forward progress between LPs and GPs is a big part of our strategy here. Tell me about your portfolio construction, the $25 million is going into small funds. We have this philosophy and thesis in terms of how we deploy capital into the small funds. We like to look at it as we're in the midst of this innovation super cycle. It looks a lot like 2008 to 2011. You have a depressed kind of macro environment where there's plenty of negative news and plenty of negative signal where people have been risk off for the last 15 to 18 months, very similar to 2008. At the same time, you have a fundamental innovation super cycle. In our case today, it's AI, defense tech that's starting to really move markets and create opportunities.

Starting point is 00:18:36 We were very active investing in early stage companies in the 2008 to 2011 period. Our only regret from that time period is that we didn't invest in more of those companies because many of those companies ended up being generational outliers for us. And so we have a sense of urgency right now to deploy capital across small funds that are in specific categories. We have a cluster of AI-related and enterprise AI-related managers. We have a small cluster of defense tech-related funds because we think that's an important movement that's happening right now. We have a cluster of deep tech-related small emerging manager funds. We think deep tech is a category that's been wildly underfunded.

Starting point is 00:19:14 We actually believe that the sweet spot is somewhere between 20 and 35 million in terms of size. And we invest in fund one, two, and three. Typically, we usually don't go beyond fund three. When you look at the emerging manager funds as a category, there's a very significant amount of the return that comes truly consistently out of fund one. Out of that 25 million, how many fund managers are you looking to deploy? Out of this current fund, we'll be deploying across 20 to 22 managers. And then there's some capital in that fund that's reserved to do direct investments as well. We've already made eight commitments to managers. So we're in that process. We will probably have all 20 of those managers wrapped up by Q1 of next year in terms of who those

Starting point is 00:19:55 commitments are. Again, philosophically and based on our own experience back in the 2008, 2011 timeframe, we believe that the pre-seed investments that occur over the next 36 to 48 months are going to be incredibly important in terms of being in the outliers that are going to define this whole innovation super cycle that we're in right now. We kind of look at this as, you know, there's a lot of close comparisons to the whole kind of market shift that we went through in that. What are your LPs looking for you to do in that $25 million fund? Is it just maximizing alpha? Is it giving exposure to venture? origin of their wealth is technology. And so they understand some of these basic principles that we're talking about right now. The basic concept of there's no better way to access outlier type companies than having an army of specialists who focus in certain areas like AI or defense tech or

Starting point is 00:20:57 deep tech who can uncover and find those companies more effectively than a couple of junior people running around town. I'd love to say that we invented this methodology. We did not invent it. There has been a handful of large families here in Silicon Valley who have been doing this in a kind of manual fashion for 15 plus years. But what we've done is we've kind of structurally formalized it and added some heft where we're looking at a huge amount of these small emerging venture funds. We're rolling out programs like capital extension. We're creating community amongst these guys and helping them raise their funds by bringing in other LPs. Will you do a fund manager? Let's say they raise a $5 million fund and they're still running their company.

Starting point is 00:21:36 We haven't done that yet, but we would certainly be open to it. And by the way, our smallest fund investment is a $5 million. We never anticipated that there would be a $5 million fund out there. And so we would certainly consider it. We haven't done it yet, but I think you have to be open to those kinds of things. I mean, institutional investors have problems with a lot of the concepts in the emerging manager space. This notion of being able to look at six to eight years of track record and being able to dig through there.

Starting point is 00:22:03 I mean, you probably know this, but when we meet new funds and new managers, fund one, you know, we oftentimes get like a random set of spreadsheets, you know, here are my past investments. And I did this one as an angel and this one as an SPV and it's across four different platforms and, you know, scribbled a spreadsheet. So that kind of, you know of fluidity doesn't go very far with institutional folks. I'll tell you one other interesting data point as well. We recently met with an institutional LP here in Silicon Valley who manages about $40 billion. And they said, in the last three years, we started to see all these great numbers about emerging managers. Our LPs said, hey, we got to get involved in that and we need to invest in

Starting point is 00:22:45 that. Keep in mind, they manage $40 billion. And so they went and they decided to invest in six small, like $30 to $40 million funds. What they found really quickly was that the administrative overhead dealing in capital calls and reports and other kind of administrative minutiae basically swamped their team of 15 people who, by the way, had billion-dollar positions in other investments. But these six small fund investments completely flooded them with activity that they had to do just to monitor and take care of those investments. So this is just to speak to some of the structural challenges that are present with institutional folks investing in this part of the market. Michael, I want to apologize. I got so excited about Capital Extension Program that I didn't even ask about your bio. Tell me about those startups and tell

Starting point is 00:23:28 me about what lessons you bring to being a fund manager. Going back a ways, I co-founded six different software companies over about a 28-year period since 1994, focused on the digital media space. I think the companies that people would know is back in 1997, I co-founded a company called Sonique that was one of the first companies that let people listen to MP3 files on their computer when we were back in our 20s. We sold that to a company called Lycos. Co-founded a company in 2002 called GoFish,

Starting point is 00:23:55 which was one of the early online video platforms. That company grew very, very quickly pre-YouTube. We took it public in 2006. More recently started a video company called Tout in 2009. That was a kind of distributed online video platform. Back in 99, started a company called Music Bank. That was one of the first legal subscription services to music in partnership with the music industry. So I spent a lot of time building companies as an entrepreneur, you know, out of the six companies that I co-founded. Thankfully, three were acquired. One we took public. Had two that blew up on the

Starting point is 00:24:25 tarmac before they could take flight. So having been at the kind of absolute trench level engagement of how to build tech businesses, that's been helpful as an investor. How many angel investments did you make before you started deploying other people's capital? I made just over 60 personal investments before actually managing capital for others. Back in 2008, after being the CEO of a publicly traded company for a couple of years that we, one of my companies, decided that I was not going to start another software company and I was going to create an accelerator in San Francisco and just invite cool entrepreneurs to come in and build their companies in that accelerator. That was called Kicklabs in 2008, which was awesome.

Starting point is 00:25:03 And we had some great companies who came through there, probably the best known is Wish that went on to do quite well in the e-commerce space. Quite a bit of involvement and especially, you know, back when there weren't a lot of tools and technologies to help you do this. AngelList was like transformative, who also used to hang out in my incubator back when they were an email newsletter. You know, now we've got Sidecar, we've got AngelList, we've got all these great technologies and tools to make that whole process work smoother and easier. 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

Starting point is 00:25:40 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. To subscribe to our totally free newsletter, please visit 10xcapitalpodcast.com. Again, that's 10xcapitalpodcast.com. We thank you for your support. AngelList, Carta, Sidecar has created the rails for this kind of decentralization of venture, but you're providing capital to empower this, which has been missing for many years. The feedback we got last week when this announcement went out is people are saying, hey, you've created the opportunity fund for syndicate leads and for emerging manager funds out there. That has definitely stuck. And it is, and that's what we've created.

Starting point is 00:26:26 We believe that this part of the market, this often overlooked and undervalued part of the market, which is emerging managers, could actually represent a far more influential and far more powerful part of a longer life cycle of returns in these companies. But up until this point, they just participated pre-seed and seed, and that's the end of their participation. We don't think it has to be that way.

Starting point is 00:26:49 There's certainly a very strong need for this product. What would you like our audience to know about you, about MDSV Capital, anything else you'd like to discuss? We're currently right now looking at small funds, emerging manager funds across all categories, all verticals and themes. And so I would welcome any and all fund managers to send their information to us. We very aggressively look at fund ones, so we don't have any issue with a first-time fund. And then I would say secondarily to the community of syndicate leads and emerging managers that are out there, the capital extension program is cranking away. We already had a big first week. Before you reach out to Michael, please take a look at this criteria in terms of stage,

Starting point is 00:27:27 revenue growth. And Michael, I really enjoyed this conversation. I really appreciate you jumping on the podcast. Look forward to meeting in Palo Alto or New York City very soon. And thanks for jumping on. Hey, thanks, David. Appreciate it. Thanks for listening to the audio version of this podcast. Come on over to 10xCaval podcast on YouTube by typing in 10xCaval podcast into youtube.com and clicking the subscribe button. On the YouTube version of this podcast, you could see the graphs, visuals, and key takeaways that accompany every episode.

Investing Billions - E60: Emerging Manager Alpha At Scale with Michael Downing

There aren't comments yet for this episode. Click on any sentence in the transcript to leave a comment.