Deal Warehousing refers to the practice in venture capital where a fund manager reserves potential investment opportunities for a yet-to-be-closed fund. The goal is to pre-secure lucrative deals that demonstrate the capabilities of the manager to make good investment decisions. Central to this approach are two types of deal structures – Pipeline Deals and Portfolio Investments.
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What is Deal Warehousing?
So, what is deal warehousing, you may be asking yourself. Simply put by Richard Gora, Attorney at Gora LLC:
It can be beneficial to warehouse a portfolio of deals and have them in storage when launching a VC fund.
There are essentially two categories of warehouse deals:
(i) Pipeline Deals: The second are deals that you plan to invest in as a venture capital fund, provided the founder has agreed to hold an allocation for the firm. These deals are done post-closing of the fund after LPs have met their capital contributions.
(ii) Portfolio Investments:The primary type of warehoused deals are companies in which you personally have equity, whether as an angel investor or advisor. You typically incorporate these deals at the stage of fund formation and their value can be used as part of your capital contributions.
Pipeline Deals occur when a fund manager establishes a strong relationship with the CEO of a target company, aiming to synchronize the closing of the investment round with the closing of the fund. This strategy requires asking the CEO to hold a position for the fund even if the round is closing.
Describing to LPs
Managers share pipeline deals with Limited Partners (LPs) by describing the business and its potential, without disclosing the name of the company. This provides a sense of confidentiality while still enticing potential investors.
“We are in discussions with a promising startup in the renewable energy sector, which has demonstrated a 200% growth in their market share over the past year. With their disruptive technology, they are projected to secure a sizable percentage of a $50 billion market over the next three years.”
A Portfolio Investment is when a manager personally invests in a company and then transfers this investment, at cost, into the fund after its closing. The main goal here is to have the investment marked up before the transfer, ultimately benefiting the incoming LPs.
Sharing with LPs
Unlike Pipeline Deals, the information about Portfolio Investments is disclosed in full to the LPs. The intention is to get LPs excited about the opportunity, by presenting them with the potential benefits of investing in the fund.
“We’ve personally invested $1 million in Tech Innovators Inc., a fast-growing AI firm which has already marked up to $1.5 million within a short span of six months. Given their wide acceptance in the tech industry, this translates to an attractive opportunity for LPs in our upcoming fund.”
Appeal & Benefit of Deal Warehousing
Deal Warehousing holds a strong appeal for Limited Partners, both before and after the first close of a fund. This is largely due to its potential for impressive returns and the strategy’s fundamental role in portfolio-building.
The primary benefit of warehousing deals is to de-risk the fund by enabling LPs to participate in marked-up deals at lower valuations. Typically, when your personal angel investments (which you’ve moved into the fund) get marked up in future rounds, LPs will reap the benefits of the markup as members of the fund. This in turn de-risks investments into your fund from the LP’s perspective.
Furthermore, warehoused deals are a great signal to LPs of the caliber of your deal-flow and enable you to demonstrate congruence to your pitch and thesis. Having warehoused deals that have been marked up valuations in later rounds which also fit your thesis is an exhibition of your ability to perform as a fund manager.
Before the First Close
Prior to the initial fund close, Deal Warehousing provides insight into a fund manager’s strategic prowess and proactive approach. It offers tangible proof of the manager’s ability to establish relationships and secure investment opportunities, especially through Pipeline Deals. Also, the preview of potential Portfolio Investments, complete with hypothetical growth numbers, stirs enthusiasm among LPs, assuring them about the fund’s prospective yields.
After the First Close
Post the initial fund close, the allure of Deal Warehousing for LPs persists. Pipeline Deals, timed to coincide with the closing of the fund, present LPs with chances for immediate deployment of capital and co-investment opportunities. Portfolio Investments, transferred at cost into the fund, often provide markups that help the fund to avoid initial negative returns due to fees, called the J Curve.
Target Deal Warehouse Volume
There is an ideal number Portfolio Investments and Pipeline Deals when closing a fund. With too many Portfolio Investments, the managers are being too generous and will exceed their General Partner Commitment. With too many Pipeline Deals, the managers are spending too much time on opportunities that they will unlikely be able to invest in after the first close. The desired targets are:
1-3 Portfolio Investments
A new manager, ideally, should target transferring between 1 and 3 Portfolio Investments aligned with the fund’s Thesis into the fund at the time of the first closing. A coherent set of investments on day one will attract LPs interested in the stage and sector of the Thesis. These investments should ideally be in companies that have already experienced a markup or are anticipated to undergo rapid growth, thus providing positive returns from day one.
As a general rule of thumb, the minimum transfer of a previous angel investment into a VC fund should be a $25K position at cost. A transfer should never be less than 10% of the target investment amount of the final fund, so, if a fund is planning to invest $1 MM, then the minimum transfer should be $100K.
3-5 Pipeline Deals
When closing a fund, a new manager should ideally have between 3 and 5 Pipeline Deals ready to go, all adhering to the fund’s Thesis. This allows the manager to quickly demonstrate competency and share good news upon closing. These initial deals will be closely examined by LPs in future closings to evaluate the fund performance. They also “operationalize” the fund and demonstrate the viability of the fund’s Thesis.
The first close normally does not have enough capital to support multiple investments at the target deal size, and the manager should invest in a minimum of 2 or 3 deals after the first close. It is common for the first investments of a new fund to be 50% to 75% of the target deal size.
Timing of Warehoused Deals
Timing plays a critical role in the execution of Deal Warehousing. With Portfolio Investments, the manager is expected to transfer all related investments from the time of the earliest investment until the time of closing to avoid the perception of cherry picking. For Pipeline Deals, getting the timing right is important so that the manager does not leave the potential investment in limbo if a closing is delayed. Here is the standard timing:
Portfolio Investments: 6 to 18 Months
In terms of Portfolio Investments, the ideal timing would be to make these personal investments at least six months prior to the fund’s close. This allows time for the investment to appreciate in value, aiming for a markup before it is transferred into the fund at cost. Such a timeline also provides a buffer for any market fluctuations or unexpected delays in closing the fund, while still ensuring potential benefits for LPs.
Pipeline Deals: 2 to 4 Months
On the other hand, Pipeline Deals should ideally be arranged a couple of months before the fund’s closing. The aim is to align the fund’s closing with the closing of a financing round for the target startup. However, as fund closings can be challenging to predict accurately, a couple of months offers a practical timeframe to maneuver any delays or advances in the schedule. This approach ensures the deal remains relevant and offers immediate potential returns upon closing the fund.
Risks and Rewards of Deal Warehousing
While Deal Warehousing offers valuable benefits, it also carries potential risks. Understanding these risks and rewards is key for fund managers to navigate the complex venture capital landscape.
- – Unattractive Deals: There is a risk that warehoused deals may not appeal to Limited Partners (LPs). This can happen if the deals do not align with the LPs’ investment criteria or if they do not see a potential for high returns.
- – Circumvention by LPs: LPs, once they are aware of the warehoused deals, may bypass the fund manager and directly invest in the deals. This not only denies the fund potential profits but also can undermine the manager’s authority and rapport with LPs.
- – Timing Mishaps: Deal Warehousing is a timing-sensitive strategy. Any miscalculations or delays in closing can have adverse effects on the deals in the pipeline, potentially harming the manager’s reputation and trust with LPs.
- – Early Deal Flow: Deal Warehousing allows fund managers to secure early deals for a new fund, which can generate positive returns. This can attract more LPs to the fund and set the stage for a successful investment portfolio.
- – Demonstrated Capability: By executing Deal Warehousing effectively, managers can demonstrate their capability to make strong investment decisions. This bolsters the confidence of LPs in the manager’s strategic and investment skills.
- – Thesis Execution: Deal Warehousing allows fund managers to show how their fund’s investment thesis is tactically executed with actual investments. This tangible demonstration can further appeal to LPs and foster trust in the fund’s strategic direction.
Best Practices for Deal Warehousing
Under the Investment Advisers Act of 1940, venture capital fund managers are bound by duties of care and loyalty to the individuals whose money they are managing called “fiduciary duties”. In short, complications can arise when transferring personally held assets into the fund, as it can form conflicts with a fund manager’s Duty of Loyalty, which states that “fund managers must not subordinate their clients’ interests to their own.”
To avoid such complications, it is advised that fund managers do not “cherry-pick” investments from their portfolios when choosing which companies to transfer into the fund. Instead, fund managers should transfer companies based upon the fund thesis which was marketed to limited partners whilst additionally disclosing said risks and conflicts.
Finally, when adding companies into the fund, it is advised that fund managers do not “mark-up” valuations of said companies and instead place them into the fund at cost.
Deal Warehousing Tips & Tricks
Venture capital fund managers engaging in Deal Warehousing can benefit greatly from a clear strategy and execution plan. Here are five insightful tips to guide you in your Deal Warehousing venture:
- Look for Markups: It’s advantageous to identify deals that have a high chance of experiencing a markup within a 6 to 9-month timeframe. This proactive approach can provide immediate value to LPs and demonstrate your ability to select promising investments.
- Avoid Cherry Picking: To maintain transparency and integrity, all related portfolio investments initiated after the date of the first investment must be included in the transfer. This mitigates any perception of selective inclusion and underscores your commitment to fairness.
- Don’t String Along Founders: Openness and clear communication with the founders you’re working with is critical. Make sure they are well-informed about your plans, intentions, and progress updates, which in turn, can foster trust and strengthen your working relationships.
- Create a Narrative: Each deal in your warehouse should help illustrate your fund’s Thesis, strategy, and process. Weaving a compelling narrative through your selected deals can captivate LPs and validate your investment philosophy.
- Test Your Processes: Utilize Deal Warehousing as an opportunity to assess and fine-tune your networking, sourcing, assistance, and deal completion processes. Learning from this experience can enhance your effectiveness and set the stage for future success.
Deal Warehousing is a crucial strategy that provides an edge to new fund managers in the competitive landscape of venture capital. It facilitates the procurement of promising deals, fosters strong relationships with target companies, and offers impressive potential returns. However, it’s essential for fund managers to thoroughly understand the timing intricacies and manage the inherent risks while striving to maximize the rewards. Successfully implemented, Deal Warehousing can set a venture capital fund on a promising path, ensuring a solid portfolio foundation and a successful launch.