Investing Billions - E74: How the $4B Kresge Foundation Invests into Venture - Venus Phillips

Starting point is 00:00:00 It seems that as many GPs have gotten larger, they've sort of forgotten about the idea of being a partner to your LPs, where it's just sort of take these terms, take this timeline, and LPs don't have much room to negotiate or advocate for themselves. And so just remembering that good times come and go, there's easy fundraising environments and difficult fundraising environments. And we all have to maintain that partnership mentality throughout it all in order to be able to invest consistently over the long term with the same partners. Have you ever seen LPs get kicked out of funds? And if so, why does that happen? It typically happens when... For more ideas on how to raise venture capital in this market, make sure to subscribe below.

Starting point is 00:00:34 Venus, I've been excited to chat ever since our friend Jordan Gibas made the introduction. Welcome to 10x Capital Podcast. Thanks. Thank you for having me. It's my pleasure. So let's talk about the Kresge Foundation. So what is the mission for the Kresge Foundation? The Kresge Foundation was founded just over 100 years ago by Sebastian Kresge, who owned a series of five and dime stores that eventually became what we know today as Kmart. And over the course of his lifetime, he gave the majority of his net worth to the foundation in order to support the well-being of mankind. And so for the first 80 years of our history, we did that through capital challenge grants, which really helped build the nonprofit infrastructure throughout the United States. So think of capital projects like building buildings for auditoriums

Starting point is 00:01:08 or libraries. If you look across different university campuses around the U.S., you'll see the Kresge name on a lot of their buildings because of that. But over our last 20 years, when our current president, Rick Rapson, joined, we took a look at those endowments, many of which had grown larger than ours, and wondered, is that the best impact for our capital? And so at that point, when Rick joined, we shifted to an urban opportunity framework. And so now our mission is to really use grant making and social investments to expand equity and opportunity in America's cities. And we do that across the areas of health, human services, education, arts and culture, the environment in American cities. We do it nationally, as well as in our own backyard of Detroit and in the cities of Memphis, New Orleans and Fresno.

Starting point is 00:01:44 You're at J.P. Morgan, you're at University of Chicago, you're at these prolific brands, and you had to share your pick of where to go. Did it influence your decision-making that you were working at a foundation versus just a different asset manager? Was it a competitive advantage for Kresge to recruit you? I love that question. You did a nice job kind of walking through my background. And what I will say is that at my most recent role, which was at an automotive company, I really enjoyed the team and the work that I was doing, but was feeling a pull to do something more mission oriented. And so I had missed being in the foundation endowment space. And so I went and looked for something where I could feel that the

Starting point is 00:02:11 organization's values aligned with who I am as a person. And fortunately, Kresge was right down the street and perfectly aligned with who I am. So I've been here for five years now and absolutely love it. You mentioned Detroit. Steve Case famously had the rise of the rest and that whole movement. What does the Midwest need to really invigorate it, especially Detroit? I would say Detroit's been on the trajectory for making that comeback, you know, with having investment in not only, you know, improving real estate in certain areas, but really giving the local communities access to that. So that involved bringing jobs to the area, that involves job training, that involves access to other things that make for a healthy and just society, whether it's affordable housing, access to accessible and affordable health care, and of course, great schools. Do you believe in the broken windows theory, which basically is how New York was cleaned up

Starting point is 00:02:51 by making small acts reverberated through the ecosystem? Is there a broken windows theory equivalent to Detroit? As I reflect on that, I think that there are small acts that can affect change. In fact, oftentimes those small acts that you wouldn't expect necessarily reverberate can be some of the most powerful. And so something that may be as seemingly small as, for example, building out the riverfront in Detroit. What that's done is for each small project of taking the riverfront from being a very industrial sort of ugly place with these cement silos. Now the Detroit River is full of parks where families from all over the city, all over the metropolitan Detroit area can come and have access.

Starting point is 00:03:22 It's a beautiful space where kids can play on splash pads and things like that. And because you have different families from different walks of life coming together in many, many ways, it's helped with community relations as well, because you have people who may not necessarily have interacted with one another, realizing that they all want the same things for their families. So let's talk about venture. So 20% of your portfolio of your endowment of roughly $800 million is in venture. What is your venture strategy? Really, we look for partners. And I truly mean partners who across cycles can produce returns that exceed those in the public markets. And naturally, the question then is, well,

Starting point is 00:03:51 how does that manifest across style and sector, stage, geography? And really, all of that is a fallout of us looking for good people. We try not to take outsized bets, though, in any of those spaces, though I would argue that China is one of those outsized bets for us. China, that's very contrarian. Why are you investing in China today? Why invest in China today? I know that it's kind of a controversial topic, especially in the investment community. But the reality is that it's still the world's second largest economy, $18 trillion. China has surpassed the 27 countries that make up the European Union, $16 trillion. And so this economy that's already quite large is projected

Starting point is 00:04:21 to grow at, let's say, anywhere between 4% to 6% over the next few years and even become the world's largest economy within the next 10 years. And so it makes sense to be engaged in that economy in whatever way makes sense. And that theory is supported by the fact that China has a growing middle class, expanding capital markets, and really attractive public market valuation. We also look at the private markets as well. That's what I cover. And so that's what's closest to my day-to-day. And we see really attractive upside there. So just two years ago, Chinese or greater China IPOs accounted for 89% of the global

Starting point is 00:04:48 IPO proceeds. And so for all of those reasons, this is a large, important market within our investment ecosystem. And so something that we need to pay attention to. Now, I don't want to highlight all of that without highlighting the risks. So we're definitely mindful of the high debt levels. China's debt levels are roughly three times their GDP. There's a real estate overhang where there's been so much supply and this real estate income really makes up for,

Starting point is 00:05:08 let's say, 40 to 50% of the Chinese government's financial income. And so when you look across the board at that, those risks are something that we've got to be mindful of in terms of how it could have knock-on effects into the capital markets. So we've been spending quite a bit of time in India lately mapping out that landscape. We first mapped out India and BC 15 years ago. There's 800 players today and half of them came out in the last five years. And so it's a market where you're seeing people opening new firms, you're seeing capital coming in so quickly. And so there's enough firms now that you've got real sector specialists with five to six billion in dry powder sitting on the sidelines right now. It seems like a lot for where the market stands today. And

Starting point is 00:05:40 so it's a market that we're keeping an eye on and hoping to maybe identify one or two good players that we think can take advantage of whatever may come to bear there. Why go to China and India? Aren't there enough opportunities in the United States? For us, especially from a venture perspective, it's all about having access to premier venture capitalists. And if it's helpful, I can kind of walk you through what I mean by that, how we got there in our portfolio evolution. So when Kresge first brought its investment team in-house, it was about 20 years ago, we inherited a consultant portfolio. And so we had very large firms. They're all multi-stage, multi-sector, and truly not premier in any way. And so we knew that we had to find some of those premier relationships, and it would take time in

Starting point is 00:06:13 the U.S. But in China, it was happening. We had access to them. We had people who were native, a person who was a native Mandarin speaker on staff who was really able to go in and get access for us there. And so in 2007, we made our first two investments in China and have been active there ever since. And it was really about being able to access those premier relationships while we were still trying to work that out in the U.S. as well. And it's really borne fruit for us. You mentioned your venture strategy has evolved. How has that evolved and what mistakes did you make that you've changed since evolving your venture strategy? I mentioned it started off by sort of moving early into China in 07. And around 2010, between 2010 and 2012, within the U.S., we started seeing single GPs starting smaller funds.

Starting point is 00:06:49 And that was really coinciding with Amazon Web Services coming out and making it much, much cheaper to start a business than it had been historically. And so let's say in 2012, they had really reduced the cost of starting a new software business, for example, by 90%. And so a venture capitalist could start a much smaller fund that targeted software entrepreneurs. And we were seeing some really good partners come out of there. We met with more than 50 different GPs trying to identify a handful of partners that we could work with. And so that's where our micro VC strategy came from that we had at the time, where we invested in five to seven startups where the GPs had come out of larger firms, hoping that we might be able to identify the next one or two premier VCs. Your strategy seems to be very self-aware, which is you were maybe a little bit late to the game to get the top firms at the time. And now you're taking a

Starting point is 00:07:33 step back and saying, how do we create a sustainable strategy to access top quartiles? That's a perfect characterization. And I think the answer to that changes all the time. And we're always constantly trying to figure that out. You really had to take a long view for ecosystems like China and India. When you go into these markets, which year do you expect to kind of become an incumbent and get access to all the top funds? As I mentioned, we invest in people most importantly. And so we're agnostic to where that person is within their life cycle, whether it's a

Starting point is 00:07:56 fund one, two, three, four, five. But what we have realized, though, is that in order to get access, often you have to be invested in fund one or fund two. What's tricky there, though, is that it's usually around funds three, four and subsequent funds where you really see, is this person a consistent, strong performer? So for us, getting it early is quite critical. You would size your commitment accordingly, just knowing that there's risk that you're taking for investing in a fund one or two. But it's important to be there because by the time that fund family starts proving itself around the third or fourth vintage year, you may have already missed the boat.

Starting point is 00:08:22 You have your foot in the door and you start a relationship and the fund manager can start a relationship with you as well. We talked offline about you guys do first closes into fund ones, which is very cutting edge. What compels you to do a first close in the first fund? It would have to be some sort of economic alignment because as you mentioned, it is a lot of risk. That's why it's considered cutting edge. And so for us, there would have to be an economic incentive for us to do that. For example, a share in a management fee or carry. Part of the reason that economic alignment is so important is because it's really been highlighted for us over the last couple of years where we've seen GPs have just a really difficult time fundraising. And even though that may seem

Starting point is 00:08:50 just innocent enough, you can't raise enough money, just invest a smaller fund, it can lead to a few issues. So for example, you could see a very concentrated portfolio where you were only, you know, as you were fundraising, you were going out and committing to new deals, and maybe you only ended up raising enough capital for one or two deals. And that's not necessarily what LPs had signed up for. Or you end up with a more concentrated LP base where your first close only had a small number of LPs in it. And now you're asking them to contribute more because you couldn't get other people on board for whatever reason, whether it's because of LPs being overweight in private markets, and so they're pulling back on

Starting point is 00:09:16 their commitments, et cetera. And the last issue that we've seen too is people just not being able to deploy the fund at all. It being a combination of a difficult deal pipeline as well as a difficult fundraising period. And so we're willing to participate in first closes, but we're just very thoughtful about it. We have to be compensated for the risk that we're taking. Higher risk needs to be a mentor to high return. You mentioned something interesting, not being able to deploy capital, something unfamiliar to most VCs, but how much does it de-risk a strategy to see that the fund has had a first close, has made three or four on thesis investments? Does that help sway you more towards a second or final close?

Starting point is 00:09:44 It does, especially because it's going to reduce your J curve. You've already got some money in the ground there. You've seen that there's LP interest in the strategy. And so you'd feel better about having a larger commitment to it so that you're not sort of left holding the bag in the end. So you referenced spinoffs earlier. Tell me about why you're so bullish on spinoffs. I look at some of our peers will just go and invest in spinoffs because it's a superstar from a superstar firm who's now going and starting a young fund. And oftentimes we see these superstars come out and have very fast closes, which makes me curious as to the diligence process that LPs use in order to invest behind that individual. So for us, a spinoff can be phenomenal in terms of somebody who may have had a great track record at their prior firm that we can attribute, that we can attribute to them.

Starting point is 00:10:20 But also we're going to re-underwrite that person as though it's a brand new investment. Though we knew you within that shop that you were coming from, we still want to look and see, how are you being thoughtful about building out your firm? What is your competitive edge? And how are you building out your team? How are you building out your LP base in a thoughtful manner? We have to re-underwrite it because we really truly need to understand what that person's value add is. How should GPs build out their LP relationships in a thoughtful manner? A few years ago, where venture firms were starting and they may have had a corporate LP, for example, come in and say, here's a bunch of money and I'm going to give you a bunch of advice. And that GP really leaned into that corporate or handful of

Starting point is 00:10:54 corporates as because they're giving me this big check today, this is my LP base and didn't really have much thought around, will that be sticky capital? Are these LPs long-term partners or is this part of some short-term corporate initiative where they may only be your capital for one fund? Because you structured sometimes your fund terms and docs around making this a key relationship, it can make it difficult for a more diversified LP base to get. I'm very curious. You asked me to introduce you to one of the top three funds in the world, very difficult to access fund. And I was happy to give you a try, as I mentioned. Is there a strategy that Kresge Foundation has in terms of being a standby LP? Is there a way for you to build relationships with GPs as you try to access a very difficult

Starting point is 00:11:27 to access fund? We'll get right back to the interview. But first, to stay up to date on all things emerging managers and limited partners, including the very latest data on venture returns and insights on how to raise capital from limited partners, subscribe to our free newsletter at 10xcapitalpodcast.com. That's www.10xcapitalpodcast.com. It's incredibly important to build relationships across whatever asset classes or ecosystems you may be investing in. And the reason why it's so incredibly important within venture is venture is different than other classes in terms of the persistence of returns. And so knowing that there are shops out there that have proven that that we have not yet gained access to,

Starting point is 00:12:04 it makes sense to start building out those relationships or continue building those relationships and maintaining them because you never know when an opportunity may arise. And it's always good to not only have a strong bench, but also be a part of someone else's LP bench as well. You've been around the hoops. You have a lot of LP friends. Have you ever seen LPs get kicked out of funds? And if so, why does that happen? Yes, I've seen it. It typically happens when the LP is not managing the relationship in the way the GP would like to see it. One example of that could be as the GP's fund size grows over time, that the LP's check size would be expected to grow over time as well. And because many of these venture funds have grown much faster than many of our corpuses have, it's been difficult to keep up. And so I'm seeing more and more LPs being sort of pushed aside or not given access to future funds because their check side isn't keeping up with the growth in the fund size. Do you believe GPs should diversify across types of LPs like pension funds, endowments, high net worth? GPs should absolutely diversify. It's important to have institutional investors because that tends to be stickier capital,

Starting point is 00:12:57 you know, investors that will re-up with you for future funds. However, there could be periods where pensions, for example, need to de-risk and so allocate less to you based on the interest rate environment. There could be periods where foundations and endowments may be pivoting how they access a theme. So there could be a lot of groupthink. And so, you know, as LPs kind of follow the leader to invest in whatever the next new thing may be or avoid whatever they may have all of a sudden decided wasn't the best thing. It makes sense to diversify that base just because within different LP types, LP interest could add and flow over time. You obviously have not only a portfolio to manage, you have your time to manage. How much more attractive does a fund become when a top fund of fund is anchoring or investing in the fund?

Starting point is 00:13:32 Does that not make you want to focus more on the fund? Or are you always just making a first principles decision whether or not there's other investors in the fund? This is something that I was actively thinking about the other day, actually. And really, we're still looking at the principle. That's what's most important to us. We don't anchor ourselves too much on who the other LPs are. It can be helpful if there's another LP who we think does great diligence. Yes, we'll use them as a reference doing our reference checks. But really, we're not pushing too hard to follow any specific LP type when we invest. And what I will say about fund of funds in particular, a fund of funds is actually a large percentage of the LP base, especially if there's one fund of funds that takes up a large chunk of capital. I would consider that more of a risk than

Starting point is 00:14:07 anything else because as they need to rebalance, there's a very strong chance that they don't participate in fund two or three or whatever the next fund in the series may be. Is that 10% threshold? What number would you like to see at the higher bound? I would like to see a number where if that capital is gone, the strategy can still function. So 10% feels comfortable, depends on the strategy, depends on how big it is, how lean the firm is versus how deep the team has to go. But sure, we can go with 10%. But I would say in general, I just want it to be that if any one LP were to leave, that the strategy could still continue to raise. Just to play devil's advocate on that, you know, you might get hundreds of funds after this podcast, you'll double your deal flow, and you have to make

Starting point is 00:14:38 trade-offs between where you're willing to spend time or not. So wouldn't, you know, top tier LPs in the fund make it a fund that you'd be more likely to diligence even if you do come with your own decision making? When you look at sort of what helps you narrow your funnel, then yes, it does help. Because if they're pretty far along in their diligence and they're interested, then chances are there may be something there. And so, yeah, I might be more likely to take the call if there's other top tier LPs in there. But we also have to keep in mind that their priorities just may be different than ours in terms of structuring their portfolio, in terms of the types of partners they're looking for. And so yes, you might take that call faster, but it doesn't necessarily mean we're more likely

Starting point is 00:15:09 to invest. You're not going to invest because a top LP is in. You have to underwrite it yourself. Let's talk about something tricky. And a lot of GPs ask me about that, which is how do you run your co-invest? Let's say you have a hundred million dollar fund. You have several family offices, institutional LPs, you have foundations, pension funds, and you have $5 million of co-investment opportunity. What is the right way to run that process in a fair way to your LPs? What's most fair is in the beginning when you're fundraising and signing docs, getting to know what an LP's interest is and co-invest upfront. And then from there, offering a pro rata to all LPs who've shown interest. That way, no LP feels that they were disadvantaged versus another. And you're not going out and necessarily marketing to LPs who are never going to take a second look at it anyway.

Starting point is 00:15:47 So it kind of saves everybody's time and gives everyone a chance to underwrite it. Now, what I will also say, though, is what makes it a lot easier for LPs who may not be positioned to underwrite individual co-investments is to just already have that sort of JV structure within the fund. So allocating maybe a sleeve of the fund to being able to invest directly where all of your LPs can just automatically get this GP type key structure. How common is that? Not very. I've seen it in other asset classes. I would love to see it in VC. I think it would solve a lot of issues. I think LPs oftentimes shoot themselves in the foot by doing one co-invest and the odds in venture, especially if it's early stage of doing one company. It's not in your favor. And from the LP perspective, it's tough to budget allocating to future rounds in order to maintain your pro rata for that same company as well. Going back to the co-invest, let's say it's a $5 million Series A, and let's say you indicate

Starting point is 00:16:31 for $2 million, everybody gets cut back in a third. Does that make you excited? Is that a positive experience? And you're like, wow, I'm getting into a great company? Or does that make you pissed off? It's tough because you did all that work, right? And now you've got exposure to something that may not be as meaningful to your returns for your portfolio that you're responsible for as an LP. So that's what's challenging there. You're excited about having access to this great company, but then you're realizing that even if it knocks the cover off the ball, it may not make a huge difference for you. So the oversubscription is exciting. The sizing is to be, leaves much to be desired. One of the purposes of this podcast is to bring transparency in difficult situations

Starting point is 00:17:02 between GPs and LPs. How could we further bridge the gap between GPs and LPs? What would you like GPs to know from the perspective of an LP? From a venture standpoint, it seems that as many GPs have gotten larger, they've sort of forgotten about that idea of being a partner to your LPs, where it's just sort of take these terms, take this timeline, and LPs don't have much room to negotiate or advocate for themselves. And so just remembering that good times come and go, there's easy fundraising environments and difficult fundraising environments. And we all have to maintain that partnership mentality throughout it all in order to be able to invest consistently over the long term with the same partner. And any big negotiation, the power dynamics change multiple times in the same negotiation. You're very kind and very nice.

Starting point is 00:17:37 Is that an advantage or disadvantage to you as an LP? Well, the reality is I do. I like to get comfortable with people. And I think that's, you know, to your point about transparency, I think that's when you get the most transparent interactions is when people can get to know each other. Like I asked you, what state you're from? You know, like you get to know you to know more about people. You can be more comfortable with them and have more real conversation. And in doing that, it helps you get to the yes faster or the no faster or identify whatever the opportunities or risk may be beyond whatever is in the marketing pitch.

Starting point is 00:18:08 I've really enjoyed the podcast and the conversation. What would you like the listenership to know about you, about Kresge, and anything else you'd like to shine a light on? I'd say the thing I'd want the viewers to know most about Kresge is that we're an organization that seeks to build, and you can probably tell this from comments I've made throughout the podcast today, but seeks to build meaningful relationships with partners who we can be with for the long term and that we can be mutually beneficial to. To us, these relationships are not extractive. It's not just us saying, come give me returns, give me distributions, but really how can we help add value as well? Whether it's as someone who can dig in deep and really understand your strategy and then be a great reference for future fundraisers, or whether it's someone who can

Starting point is 00:18:38 be a good partner on your advisory board or whatever it may be. We just want people to know that we're here to have a bilateral, mutually beneficial partnership. Venus, it's a new relationship, but you've been really kind and a great friend. What's the best way that people could reach out to you or your team? Yeah, so investmentinfo at kresge.org

Starting point is 00:18:52 is where we like to see our incomings. And we've got some great people covering that inbox to make sure that anything that goes there gets into the right hands. Well, thank you, Venus. Really appreciate your time and look forward to sitting down in Detroit. Sounds great. Thanks, David.

Starting point is 00:19:02 Thank you. For more ideas on how to raise venture capital in this market, make sure to subscribe below.

Investing Billions - E74: How the $4B Kresge Foundation Invests into Venture - Venus Phillips

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