Being an LP in the heart of VC

An interview with Cendana Capital founder, Michael Kim

One of the best things we can hear from a founder is that while the fund manager was a smaller investor, they are one of the first people the founder calls for advice.

We spoke with Michael Kim, founder and managing partner of Cendana Capital, a San Francisco-based fund of funds focused on seed VC. Earlier this year Michael announced several new funds under the Cendana umbrella, including an $80 million primary fund that will continue to focus on investing in the best seed-stage funds.

We talked with Michael about his priorities for each fund, how his role has evolved since he wrote his first commitment, and his process when it comes to investing in first-time fund managers.

You recently raised a number of funds/vehicles for Cendana. Can you help us understand the priorities for each?

I started Cendana in 2010 and we have about $500 million under management. In April 2017, we announced several new funds that reflect our investment approach. The $80 million Cendana Capital III is our primary fund, which focuses on investing in the best seed VC funds. We have another $60 million in our managed account with the University of Texas endowment, which now totals $160 million — this invests alongside our primary fund. A new $75 million fund, Cendana Blackbird, is an overage fund, which means in situations where we can get additional allocation from our portfolio funds, we will invest from Cendana Blackbird.

So, for example, if our primary fund and the Texas-managed account commits $10 million to a portfolio fund, and the portfolio fund managers allocate $5 million more to us, it would go into Cendana Blackbird. A large corporate pension fund is the sole LP in Cendana Blackbird.

To leverage our ecosystem, we have a direct fund that invests in early growth-stage rounds of companies from our portfolio fund managers. We do this through Cendana Investments II, which is a $35 million fund that will invest about $1.75 million to 18–20 such companies.

Our prior fund had Series A and B investments in companies like Dollar Shave Club, Casper, Looker, LendUp, Honey and Drone Deploy. We also raised a $10 million managed account called Cendana Kendall, where a single family office is the sole LP. This fund is focused on much later stage opportunities from our ecosystem — think of pre-money valuations north of $1 billion.

How do you assess a VC fund manager? How has that evolved since you wrote your first commitment?

One of our primary filters is portfolio construction — we think percentage ownership is paramount, and thus look for fund managers who lead their investments and get at least 10 percent ownership. The average VC exit is $100 million, so if you own 1 percent of the company at the time of exit, that may be a great multiple but the $1 million in proceeds won’t move the dial on a $50 million fund. If you own 15 percent, however, it does move the dial on a $50 million fund.

This is the fundamental advantage of seed VC fund — it has a more realistic path to a 3x return without needing $1 billion+ exits. I think this filter has served us very well, and we seek concentrated portfolios with high ownership from portfolio funds. Our average fund is now $75 million in size, making 25 $1 million initial investments and holding $50 million as reserves. We take the same approach with our own portfolio — we are high-conviction investors and seek to be among the top-three largest investors in a portfolio fund, largely with $10 million to $15 million cheques. This helps us maintain an important role with our fund managers, which in turn helps us secure great direct investment opportunities.

Since we started Cendana, we have evolved our portfolio construction in two ways. First, we started a pilot programme where we will invest up to $1 million with fund managers we like a lot, but don’t have high conviction about some element of their story. This could be geographical, or sector-related, or investment approach.

For example, we didn’t have high conviction about the Boston or LA ecosystems, but really liked NextView Ventures and Mucker Capital, respectively. Over time, we started to really like the opportunity set in those locations, so we ultimately made a full commitment to their next funds. Also, we were interested in the hardware space, so made pilot commitments to Bolt VC and Root Ventures. Ultimately, both became larger commitments in their next funds.

Secondly, we have now carved out a segment of our portfolio for pre-seed funds. We have been involved with K9 Ventures and PivotNorth Capital, but with the emergence of newer groups claiming to institutionalise the friends and family rounds (say $500,000 initial rounds), we decided this year to carve this out as a specific category, where we make $5 million to $7.5 million commitments to such funds like Notation Capital.

You do a lot of first-time funds. Talk me through how your process differs there.

Many of our initial investments are to first-time fund managers, but all of them have been active investors. This has been historically the playbook for our fund managers — raise $2 million to $6 million using their own capital plus some friends and family, build out a portfolio, then raise a larger institutional fund.

A core part of our diligence is to talk to the founders of the portfolio companies, and we ask them if the fund manager had more capital, could you see them leading the seed round for your company. For the first-time funds that we have backed, like Forerunner Ventures, the answer was absolutely yes.

One of the best things we can hear from a founder is that while the fund manager was a smaller investor, they are one of the first people the founder calls for advice. This speaks to the fund manager’s credibility to help their portfolio companies and suggests that had they had a $50 million fund, they could have led the seed round.

When you have conviction in a new/first-time manager team, how do you help inspire conviction in your fellow LPs? Or is it up to that manager themselves?

Similar to a lead investor for a financing round, we spend a lot of time helping the fund manager raise their fund. We are not social proof investors, so often times, we are the first institutional LP to commit to a new fund manager. We will work with them to identify LPs that we know who could potentially be interested, and then make the introduction, talk with them about why we think that group is special, and share with them our investment memo and due diligence. Almost none of our LP friends share their investment memos with us, which is too bad, but we are happy to do so — we are partners with our fund managers and want them to succeed.

How can LPs and GPs build the most mutually beneficial partnership? Or should they just ‘stay out of the way’?

I think the best startups don’t need much help from their investors, notwithstanding what VC say about adding value. That said, I do think our portfolio fund managers add substantial value in terms of identifying milestones needed to raise the next round, helping refine the product roadmap, helping build the core management team, introducing key partnerships and customers and generally being there for the 11pm call for advice. Similarly, we try to play that role for our portfolio fund managers — helping them think through the right LP base, the appropriate sizing of the next funds, thinking about reserves for follow-on, potentially doing secondaries to monetise their positions, interviewing potential new GPs who may join the team, etc.

Since all we do is seed VC funds, we can share best practices with our fund managers and I think they appreciate that insight. Also, I think our trusted advisor role helps our direct investment programme in terms of deal flow.

Some of the supply-demand asymmetry on the best managers can lead to making decisions with less-than-ideal data. We’ve seen some recent high-profile cases where this hasn’t worked. How do you strike a balance between performance, demand and transparency?

I think there are a lot of LPs who really don’t do their diligence, and recent stories in early-stage VC reflect that. I think we are very focused on off-list references, and we have a very broad and deep network that allows us to do that. For example, we have three advisory boards totaling 26 people who are deep into the early-stage VC world that provide us, among other things, substantial insight to specific people. We also have a number of portfolio fund managers who are in the trenches daily, who know a lot about other GPs. So, I do think we have access to some very good insight about potential fund managers.

How do you look at the European VC fund landscape versus that in the US? Are LPs more or less risk averse than their US counterparts? Do you see different types of capital pools showing up in each market?

We have spent a lot of time with non-US early-stage fund managers; I think more than half of the groups we have met with in our seven years have been non-US fund managers. I mentioned portfolio construction being a critical filter for us; another one is ecosystem, which for us is along three vectors — high-quality entrepreneurs, high-quality co-investors and a tonne of local follow-on capital.

It’s this third vector that most ecosystems outside of the Bay Area and New York City/Boston are lacking. However, in the past five years, the European VC ecosystem has improved — along with Index, Accel London, Balderton and some other traditional Series A and B investors, you now have Felix Capital, Mosaic, BlueYard, among others that are local $150 million+ Series A funds.

We are thinking through whether European VCs indeed have a different mindset about risk, but early-stage VCs in Europe can certainly help their portfolio companies move to the US and let these companies grow. It’s easier now than ever to port these companies to a different geo, but the home geos themselves are getting better.

There has been a lot of talk recently regarding initial coin offerings (ICOs) as a means of raising capital for startups. Can methods like this really disrupt the VC model of fundraising in the near future?

Fundamentally, tokens don’t have equity ownership in the underlying companies, which means the market value of such tokens are based more on trading dynamics. Almost all of the token offerings so far have been for groups that have some utility to the crypto ecosystem, and it will be interesting to see if non-utility based tokens are a viable path for fund raising. I think for now that early-stage funds should be wary of investing in pre-ICO tokens but if they do, they should have an algorithmic plan to existing — for example, selling 25 percent of their position if there is a 10x, etc.

We’re delighted to announce that Michael will be joining us on stage at this years investor forum, Venture, which is held alongside Web Summit on November 6. Over 100 LPs and 500 leading GPs from the top funds globally will also be in attendance.

You can find out more information, and confirm your attendance right here. If you have any questions you can reach out to me, Declan Kelly, via twitter.