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This article was originally published at Forbes.com 

In this Part II of a two-part series, we identify systemic problems with the current institutions that fund venture capital (VC) groups and propose how to change this archaic system. This builds off of Part I where we discussed the gender disparities in venture capital, and how solving for those issues creates great financial opportunities for investors, as well as assuring our country’s economic competitiveness.

 

In Part I of our series, we talked about the value of women investing in women-run VCs as a first step towards fixing the gender imbalance of the 99% male “true VCs” in venture capital — and thereby unlocking the higher financial returns of women-led companies. Although this is where we see the beginning of the solution from our personal experience at True Wealth Ventures, individual investors alone can’t move the needle far enough. This Part II delves into what it is really going to take to achieve industry-wide change, which is not being discussed amidst all of the “lack of women” in VC.

The vast majority of investment dollars in the venture capital industry come from “institutional investors.” These are organizations such as pension funds, university and nonprofit endowments, foundations and other financial institutions. They deploy capital as limited partners (LPs) to venture capital funds’ general partners (GPs) to invest in early stage, high growth companies to earn an investment return. According to PitchBook data, last year institutional investors accounted for 75% of all U.S. VC deal flow versus family offices. The current investment policies of these institutions perpetuate a cycle of investing that not only immortalizes the gender imbalance, but also results in missing out on the financial outperformance of first-time, smaller and diverse VC funds.

Because institutional investors are fiduciaries of other parties’ money, they, understandably, have strict policies around how they choose fund GPs. These large LPs face limited manpower to execute due diligence (sometimes one person per billion dollars under management), making ongoing relationship management for each individual investment challenging while deploying large pools of capital.

Therefore, they generally set a minimum investment size in the tens or even hundreds of millions, and often don’t want to or cannot be more than a certain percentage of a given fund (to avoid taking a controlling interest). This means they don’t even consider smaller funds (e.g., less than $100M), and most first-time funds are smaller. (Note: This is partly due to a chicken-and-egg situation of these institutional investors not investing in smaller funds and an SEC limit of a maximum of 99 accredited investors per fund, regardless of investment size.)

According to Preqin data, the ability to predict future fund performance based on historical performance has not panned out. In fact, over 15 years (2000-2014), the data has demonstrated the outperformance of first-time funds in comparison to legacy funds.

In practice though, these institutions typically invest in a small group of established funds because they can point to the fund’s reputation and past performance. In other words, they only invest in the same fund managers and well-known funds, which is currently estimated to be 99% male VCs. When they do consider first-time funds, they traditionally require what’s known as an “attributable exited track record” of returns. Which translates to GPs who’ve already worked at prior firms as the investment decision-makers and long enough for the underlying portfolio companies to have been acquired or IPO’d (traditional funds are 10-12 years long to accommodate for the time it takes for the portfolio companies to exit.) Do you see the conundrum? With only 1% of the investment decision-making VCs in the industry being women, that makes for very few who can spin out to form a new firm and qualify under these criteria. Not to mention that the institutions also want the partners of the new firm to also have worked together for a significant tenure at a prior fund.

These factors all compound to inhibit new and diverse GPs from entering the venture capital sector at any scale. Unfortunately, even the institutional investors who have “emerging manager” or “minority manager” programs have these challenging fund size and track record restrictions. If institutional investors don’t change their approach, the current gender imbalance won’t change for decades — and these institutions will continue to miss out on the financial benefits of diversity. This is a missed financial opportunity since the data shows that newer funds, smaller funds, and investments in women-led companies (in which gender diverse GPs tend to invest), all outperform.

So, what do we propose these institutional investors do?

  •   First, truly engage in programs focused on new and diverse managers by dedicating resources to diligence and invest smaller size checks into newer, smaller, and more diverse funds. Their resulting return rates should be higher, and by helping to scale these funds, they can help grow these financially outperforming opportunities.
  •   Incorporate a new set of criteria to assess the viability of the new firms’ GPs (beyond exited track record.) These criteria should include the GPs technical, operational and entrepreneurial accomplishments, which may have better correlations with choosing successful portfolio companies and supporting them to a successful exit.
  •   Challenge established VC funds by demanding more transparency from all GPs into their diversity strategy — such as requiring performance metrics on the gender impact of their investments. We proposed how gender impact could be standardized and measured in this Kauffman Foundation-funded work we have been supporting, both in the number of women partners making investment decisions at the VC funds and women-run portfolio companies.

 

 

Sara T. Brand is the Founding General Partner of True Wealth Ventures, an early-stage VC fund investing in women-led businesses in consumer health and sustainability sectors. She is also the co- founder of (512) Brewing, the largest draught-only, self-distributing microbrewery in the country. Sara was previously in venture capital and management consulting in the Bay Area, as well as in a variety of strategic and operational roles in large tech companies. Sara holds a PhD and MS in green design and manufacturing from UC Berkeley and a BS in mechanical engineering from UT Austin.

Kerry Rupp is General Partner at True Wealth Ventures, an early-stage VC fund investing in women-led businesses in consumer health & sustainability. She teaches for the NSF I-Corps program, mentors startups, and consults on innovation and strategy. Kerry was previously CEO at DreamIt, a Top Ten US startup accelerator and VC fund. She founded Holiday Golightly, a group travel service for women. Kerry holds an MBA from HBS and a BA from Duke.