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The Ideal Number of Limited Partners in a VC Fund

Why having a very large LP base may not always be the best

Many new fund managers ask us, “What is the optimal number of LPs in a VC fund?” Having powered the launch of over 100 VC firms worldwide, we’ve gathered valuable insights into the ideal number of investors for new funds, which we believe to range from 20-30 LPs. Intuitively, one might think that having a vast LP base is always advantageous. However, this may not always be the case, as this article will explore.

We’ve seen a tendency from new fund managers to aim for an extensive base of investors. Unfortunately, this can sometimes work against the GPs and cause burdensome operational and administrative challenges. On the other end of the spectrum, having too few LPs can lead to those investors potentially having unhealthy influence and authority within the fund.

Table of Content

Opportunity Costs

When fundraising, it can be beneficial for new managers to set forth a clear plan of who they will target and understand the profile of investors they would like within the fund. For more information, refer to VC Lab’s ‘Ultimate Guide to Get LPs,’ which provides helpful suggestions for fundraising.

Too often, new fund managers focus on large institutional investors, which typically do not invest in new GPs or the relatively small funds they manage. At times, new fund managers also concentrate and spend time on investors who wish to invest relatively negligible amounts of capital which causes them to end up with an unnecessarily large LP base.

Combined, both can lead to an inefficient campaign and result in the fund failing to gain traction in its fundraising efforts. As capital allocators, fund managers can also garner an appreciation for the concept of ‘opportunity cost‘ in fundraising. Time spent on the discussed avenues of financing may lead to expending scarce resources and time in an un-optimal manner. Therefore, setting an appropriate ticket threshold can serve to benefit your time and help you focus on the right investors.

It can be provident for new fund managers to brush up on the decrees set forth by local regulators in their jurisdictions. This is because these institutions can often place limitations on the number of LPs funds can have without registering with authorities. Fund managers can strategize their fundraising efforts and develop a thought-out approach using this information. For example, some jurisdictions such as Luxembourg require extensive KYC and AML checks for LPs if they own more than 10% of the Limited Partnership. This can sometimes be a deal-breaker for some LPs as such processes require intrusive background and financial checks.

In the US, the Securities and Exchange Commission (SEC) requires VC funds that seek exemption from registration to follow specific guidelines, including avoiding general solicitation and the following portions within the Investment Company Act of 1940, which venture capital funds typically fall under. Consequently, having a large base of LPs may result in VC funds not gaining exemptions under the following sections in the US:

Section 3(c)(1) 

Fund managers that seek exemption from registration via section 3(c)(1) must ensure that the limited partnership consists of less than 100 limited partners for funds over $25m. Recently, the SEC changed regulations regarding the number of investors funds below $10m can have and increased the number to 250 limited partners. 

Under this exemption, limited partners must qualify as “accredited investors,” and fund managers must take reasonable steps to ascertain their accreditation status by conducting diligence on each investor. Accredited investor definitions vary with jurisdictions and local regulators; therefore, fund managers should check local decrees. In the US, the SEC, under Rule 501 of Section D, defines accredited investors as persons with a net worth of over $1m (excluding the value of the persons” primary residence) or have a gross income of $200k, or joint spousal gross income of $300k for at least two years in a row. More on accreditation requirements here.

Section 3(c)(7) 

To gain SEC registration exemption using Section 3(c)(7), funds must be comprised of “2,000 or fewerqualified purchasers, where each investor must own $5M or more in investments. Again, fund managers “must” take reasonable steps to ensure each investor’s status as a qualified purchaser.

Administrative Challenges

Taking into consideration the aforementioned regulations, fund managers who have an extensive LP base that exceeds the stated limits will be required to conduct individual diligence on the accreditation status of each investor. As you can imagine this can prove to be an operational challenge, especially when the focus of the fund manager is needed in other critical areas. Upon completing checks, fund managers will also require signatures from every investor to close the fund. Once again a broad LP base can cause friction for GP, who need to orchestrate an efficient process to co-ordinate with all of the LPs. 

Operational challenges

After closing, fund managers typically seek to keep investors informed by reporting the portfolio’s performance. Often they also have to manage individual queries regarding the fund and nurture long-term relationships with LPs by reporting on the performance of the investments.

Again, a more extensive LP base may mean that fund managers spend an un-optimal amount of time fulfilling their duties and accommodating LPs. There can be an opportunity cost in these scenarios as managers may not have enough time to evaluate startups, keep up to date with the ecosystem, and write checks on behalf of their investors. The bookkeeping tasks also increase with the LP base and should be taken into consideration by the GPs in the fund.

Summary

In the US, having a large base of LPs that exceeds SEC requirements can mean that such funds must register with the SEC. Typically, fund managers avoid registration as it can be a lengthy and complex endeavor. Additionally, fund managers must spend an exuberant amount of time navigating SEC regulations and conducting diligence on each investor with both of these registration exemptions. Consequently, fund managers should aim to have 20 – 30 LPs in their funds to run an efficient fundraising campaign.

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