Limited Partners (or LPs) are investors who back venture capital funds. When a VC raises a subsequent round, existing LPs might re-up into those funds. But sometimes they don’t.  

Plus, LPs don’t usually share the rationale behind their decision making. Luckily, I have some insights into this phenomenon. So let’s dive in: what makes an LP decide whether or not to re-up?

Why this matters today 

Get ready for some stats.

According to the Q4 2023 Pitchbook / NVCA Monitor report, venture capital funds raised went down by 62% in 2023 to $66.9B year-over-year, with just 474 funds closed last year.

This is roughly a third of the number of funds closed in 2022. Basically, LPs are backing a smaller number of funds than in years past.

What determines this?

In the long term, the answer is trivial. LP’s care about which funds are able to deliver DPI (Distributed Paid in Capital) or cash back into LP’s bank account.

All else being equal this is the only thing that LPs care about. Except here’s the thing…

Smart LPs realize that DPI is a lagging indicator‍

DPI is a lagging indicator. 

It’s a sign of how good a fund was 5, 7, 10, or even 12 years ago.  By the time an LP receives DPI, the fund is oftentimes an entirely different business – different strategy, different AUM, and sometimes even a different management team.

Smart LPs seek to find leading indicators of success‍

What leading indicators do LP’s look for?  The answer is Alpha. Alpha is the return that a fund receives without extra risk – the same risk / higher return or lower risk / higher return strategy.

This is the strategy that business school professors claim “shouldn’t exist” due to the Efficient Market Hypothesis, yet franchises such as Sequoia, Benchmark, and others have delivered Alpha over several decades.

So where does Alpha come from? 

Alpha comes from an unfair advantage, a systemic edge. One manager’s Alpha is not another manager's Alpha. In fact, in many ways Alpha only stays Alpha while it is inaccessible to others.

Sources of Alpha in venture capital comes from an advantage in one of three areas:

1. Sourcing
2. Picking
3. Winning‍

‍Sourcing:‍

Sourcing is the ability to see the most amount of high quality dealflow. The best sourcing funnels have to include both high quality and high quantity of deal flow.‍

Picking:‍

Picking is the innate ability to pick winners at a stage before other investors are able to pick winners. At the early stage, this is about “discovering” founders before other investors have discovered them.

Winning

Ultimately, nothing matters if you can not win the deal. Even if you have access to every single high quality deal, and you are able to identify the highest quality of deals, nothing matters if you don’t win the deal.

Now, there is often room for several investors in early stage rounds. But for later stages (Series A and beyond) winning becomes a zero sum game with top venture capital funds elbowing each other out in order to maximize their ownership.

So, what determines whether LPs re-up?‍

The answer dates back to the first time that you met an LP.  Starting with the very first meeting, LP’s are determining their level of confidence in your ability to deliver Alpha.

A high level of confidence means that you will be one of a handful of GPs that the LP automatically re-ups into.

A low level of confidence (or just enough confidence to get you over the fence initially) means that you are at high risk for not being re-upped in the future.

‍Three important things to look out for:‍

All things being equal (and they surely are not, see paragraph above) LPs ask themselves three important questions when considering a re-up:

‍1. Has the manager done what they said they would do?‍

If you, the GP, said that you were going to do 15 investments, and you did 40 investments, this may be an issue.

If you, the GP, said that you were going to write $250K checks, and all your checks were $1.5M checks, this may be a problem.

Fair or not, LPs will jump you against the original strategy that you laid out to them.‍

2. Are there early signs of success?

While some LPs may claim that they do not make decisions on early portfolios, it’s irrational not to. These early indicators could include metrics such as how many of your companies have raised new rounds of funding, how many name brands have invested alongside and after your investment, and other like factors.

While these indicators do not guarantee success, they help GPs secure that second and third check.‍

3. Has the team composition changed (dramatically)?

‍Has the team changed? Have these changes been to key personnel on the investment team?

‍The bottom line is:‍

Is there (still) Alpha in the strategy?

The rest is mostly noise – LPs providing faux feedback in order to preserve optionality and your feelings.

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‍Today’s article is a guest post by David Weisburd. David is the host of the 10X Capital Podcast, where he interviews top limited partners on why they invest in a fund (and why they don’t). Highly recommend listening to the podcast here and following David on Twitter here.