VC top-up funds: Extra ordinance

The journey that ended with Chinese online package tour operator Tuniu listing in the US took eight years. Capital poured in from venture capital firms, strategic players and sovereign wealth funds as the company built the scale required to get traction with American investors.

Gobi Partners was prominent at the beginning but less so at the end. The early-stage investor backed Tuniu's Series A round in 2008, contributing $3 million. Another round, worth $10 million, followed two years later with Gobi committing $5 million in order to prevent its 20% stake being diluted. In 2011, Tuniu pocketed $50 million as Highland Capital Partners, Rakuten and Sequoia Capital joined the investor roster. Gobi wanted to participate but could not due to a $15 million cap on its deal sizes.

By the time Tuniu completed a Series D or pre-IPO round last September, its valuation had jumped 75-fold since the first round. Needless to say, Gobi did not feature. Even as a public company Tuniu continues to tap private equity and strategic investors. Hony Capital led a $148 million investment in December, and then last week HNA Tourism put in $500 million for a 24% stake.

We are thinking about raising a top-up fund but there are a lot of concerns in terms of fund size, structure and conflicts of interest for LPs - Ken Xu

"Early-stage investors are quite passive in a sense that we can't continue to participate when a company raises Series D or E expansion round, going up to more than $50 million. It's a pity because we miss some great opportunities because of our small fund size," Ken Xu, a partner at Gobi. "We are thinking about raising a top-up fund but there are a lot of concerns in terms of fund size, structure and conflicts of interest for LPs."

With an increasing number of start-ups staying private longer and fueling their growth with ever larger investment rounds, traditional VC funds often don't have the capital to stay involved on a pro-rata basis all the way to exit. As a result, an array of sidecar, annex, top-up, and opportunity funds have emerged in China's VC space over the past 24 months, extending firms' reach into later funding rounds. It raises the question of whether the fundraising dynamic has changed forever, or just for now.

Top-up time

A fixture on the US venture scene, top-up funds fall into two categories: down time and good time. The first are used when the main fund is running out of money, exits have yet to come, and the GP needs additional capital to support companies. The second, very much the story of the last two years, are sidecar vehicles formed when there are ample VC opportunities and robust LP demand for exposure.

"We weren't forming a lot of ‘overage funds' - funds designed specifically to supply additional capital to the most promising of a VC fund's investments - in the US for quite some time. We did some in the late 1990s and we have done some at other times when the market has been very strong. To be honest, it's a recent resurgent trend even in the US and if you look at today's VC market, the same conditions that affect the US affect China as well," says Jordan Silber, a partner at law firm Cooley. "We have started to see some of the China funds, particularly the dollar-denominated funds, raising ‘overage funds.'"

This phenomenon goes hand-in-hand with escalating valuations. Competition for VC deals is becoming more intense as non-traditional venture investors - including private equity, hedge funds and mutual funds - enter the market. It has prompted concern among early-stage GPs that fear they will not have enough firepower left to back winners. "The companies are like their babies. They just want to keep supporting the entrepreneurs and prevent their stakes being diluted," one LP observes.

In China, though, sidecar vehicles are popping up across the industry, with seed, early-stage and growth-stage investors on the fundraising trail. Earlier this year, DCM, Qiming Venture Partners and Banyan Capital reached final closes on a top-up fund, an annex vehicle, and a co-investment fund, respectively. These came several months after each GP raised a core venture fund.

Terminology can be loosely applied, but an annex vehicle is generally seen to differ from an opportunity fund in that it focuses only on follow-on investments in portfolio companies from a certain fund. While an opportunity fund may share this purpose - both allow LPs to retain exposure to businesses once they have grown beyond the scope of the main fund - these vehicles have been known to pursue separate later-stage deals as well.

For Qiming and Banyan, the driving factor was faster-than-expected exhaustion of the capital in their main funds that was held back for follow-on investments. Qiming raised a $75 million annex fund tied to its third fund, which closed at $450 million in 2011 (it has since raised a fourth vehicle). "When we raised the fund in 2011, we didn't anticipate that the rounds would become so big and absorb our reserve so quickly. That's why we raised the annex fund," says J.P Gan, managing partner at Qiming.

Banyan's capital-raising has been even more concentrated. The GP, which spun out from IDG Capital Partners in 2013, closed is debut fund at $206 million in early 2014, raised a $362 million second vehicle 12 months later, and then three months after that raised $100 million for follow-on investments in Fund I portfolio companies.

"What we found in 2014 was that it might be the best time in 10 years for VCs to invest in high-quality companies. We deployed out debut fund quickly and didn't have enough in reserve to support our portfolio companies," says Xiang Gao, a co-founder of Banyan.

GPs also raise sidecar funds in parallel with main funds, for a variety of purposes. Morningside Venture Capital first introduced a top-up vehicle alongside its third fund in 2014. It raised $412 million across three vehicles, including an entrepreneurs fund that allows members of the Morningside network to co-invest in deals. A similar approach was taken for Fund IV this year: $400 million for the core fund, $200 million for a special opportunity fund, and $60 million for the entrepreneurs fund.

The GP says this structure primarily exists because of LP demand - in particular, the need to accommodate endowments and sovereign wealth funds.

"We want to keep those long-term institutional LPs in our fund but we don't want their large check sizes to impact the performance of the main fund - which is a small, early-stage fund. A special opportunity fund solves this issue, and it doesn't create added pressure for us to deploy capital when it is unnecessary to do so," explains Ken Shi, a managing director at Morningside.

Although the special opportunity fund is intended for follow-on investments in existing portfolio companies such as smart phone maker Xiaomi, online real estate platform Aiwujiwu and online healthcare business Guahao - each of which is valued above $1 billion - it is now used to pursue separate later-stage deals as well. Shi notes that the proportion of the fund earmarked for these investments is very small.

"We will only invest in companies where we know the entrepreneurs well. We might miss the opportunities to invest in Series A, and then we will come later using the special vehicle," Shi adds.

The LP angle

When the main fund is raised first and the top-up fund comes later, a GP would normally require permission from LPs to proceed with the latter vehicle. If the LP is convinced by the explanation of why a top-up fund is necessary and that the GP can execute the strategy, the next question is whether the GP has the bandwidth to manage multiple funds at the same time and retain the same level of focus. Another consideration is whether the top-up fund might be favored over the main fund.

Typically, top-up funds only charge management fees on called capital, whereas the main fund charges fees on committed capital. A GP might therefore be incentivized to deploy the former more quickly than the latter. The top-up fund might also receive more attention because it contains a handful of high-performing companies that are going to account for the bulk of the carried interest.

"Conflicts of interest between different funds are an important consideration, especially if they have different LP bases," says Mingchen Xia, a principal in Hamilton Lane's fund investment team. "How do you allocate the economics or resources in the different funds? It could potentially lead to conflicts."

Newly-established Sourcecode Capital is an example of a GP with different LPs in its main and annex funds. Having close its debut fund at $100 million last year and deployed half the corpus, the firm decided this year to raise a $40 million annex fund. It includes new and existing LPs, and the terms are the same as for the main fund.

"LPs in the annex fund want to invest in fewer companies but ones with clear growth prospects. All portfolios are selected carefully from the existing pool," says Yi Cao, founder and CEO of Sourcecode. "We haven't had any complaints. Existing LPs were invited to participate in the annex fund and then we turned to new LPs. The annex benefits LPs in the main fund because it increase the capital we can invest in portfolio companies and therefore the influence we have on them."

Industry participants suggest two key ways in which the risk of conflicts can be minimized. First, have clear investment rules, such as a stipulation that the top-up fund can't commit to a particular company until the main fund has invested a certain amount of capital. Second, the GP could raise both funds at the same time.

Morningside and Shunwei Capital Partners both did this and GGV Capital appears to be following suit with its latest fund. The Sino-US firm closed its fifth fund in April 2014 at $620 million and then a top-up fund of $457 million for follow-on investments in companies from Funds IV and V closed in May of this year. The GP is now looking to raise $1.1 billion simultaneously across three vehicles: a $600 million core venture fund, a $200 million top-up vehicle, and a $300 million early-stage fund.

"Some GPs require lock-step commitments, meaning LPs must subscribe both to the main fund and to ‘overage fund' simultaneously, and in some cases in a fixed ratio - so whatever your commitment is, two-thirds of the capital is going to the main fund and one-third to the ‘overage fund'. This reduces the conflict of interest because everybody is in the same deal and in the same ratios. From a GP standpoint, it makes managing the capital easier. But it does reduce flexibility to the LPs," says Silber.

Strategy drift

GGV's investments range from early-stage to Series C rounds and industry participants say the structure for Fund VI delineates its exposure into different vehicles. Much like Morningside, by splitting the fund into three parts, no single component can become too big. At the same time, it does represent a broadening of the strategy. Rather than start at Series B or C, GGV will consider more Series A deals so it can enjoy the maximum value appreciation as the next generation of start-ups build scale.

Strategy shift - or strategy drift - is a concern for some LPs as they see top-up funds move towards later-stage investments. The suspicion is that GPs are simply taking advantage of a hot market to boost assets under management as a means of generating more fees.

"GPs have a variety of reasons for raising top-up funds. They may raise a separate pool of capital to target later or earlier stage investments, or increase investment in specific segment they see opportunity. In many cases, they simply raise additional capital when they can to gain more fire-power," says Sally Shan, managing director at HarbourVest Partners.

Shunwei raised $1 billion for its most recent China fund, split equally between a core vehicle and an opportunity vehicle. The firm said it not only wanted to make follow-on investments in existing portfolio companies but also back new companies seeking expansion rounds. "Based on what we have accumulated over the last few years in terms of industry resources and knowledge, we have the capabilities to invest in early- and growth-stage companies," Tuck Lye Koh, co-founder and CEO of Shunwei, told AVCJ at the time.

Clearly, investors were suitably convinced, and it comes back to the question of motivation and execution. A VC firm might have a very clear rationale for raising a top-up fund, for example, it has identified 10 companies within the portfolio that are likely to be outperformers and wants to back them through Series D and beyond. But it ultimately comes down to whether the GP is able to pick the right companies and has the capacity to guide them through later-stage growing pains.

A firm that wants to pursue a growth strategy alongside a venture strategy - with different companies in each silo - needs investment professionals comfortable operating in each field. Sequoia Capital has run China venture and growth funds for a number of years and has separate teams for each one.

"It is dangerous raising a fund if the companies aren't doing well. In the growth stages, the price-to-earning (P/E) multiples tend to be relatively lower. LPs are cautious that GPs shouldn't feel obliged to maintain ownership by raising top-up funds. If the company can't do well, then it won't do well even if GPs put more money into it," an LP observes.

It remains to be seen how far strategies can evolve before they become unsustainable, and the answer will vary by GP. "Chinese GPs will be one of two extremes. Weaker ones will be phased out from the market because LPs only want to invest in good GPs," says Gobi's Xu. "Those GPs will use top-up funds to accommodate more LPs, although sometimes these vehicles are not consistent with their core strategies. On the other hand, it gives the GPs more opportunities to try out new practices."

Some LPs say they would prefer firms to focus on a certain stage of venture capital instead of the full spectrum. However, to a certain extent they are pulled by the relatively rapid evolution of the Chinese market - a high-quality GP will win support for strategic shifts provided it can justify them in the context of changes in the broader VC ecosystem.

The caveat is that this momentum might just as quickly be turned on its head. If top-up funds exist largely because start-ups are raising larger private rounds, then their longevity is conditional on this market dynamic persisting. Not everyone is of the view that it can.

"I don't think this phenomenon will sustain. Top-up funds are market-dependent and there will be more of them if companies continue to raise larger rounds, but I doubt that," says one China-focused VC investor. "My guess is that you won't see many top-up funds in the next two years."

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Save this article  
• Send to  

• Topics
• Fundraising
• Venture
• Greater China
• GPs
• China
• Venture
• Fundraising
• GPs
• LPs
• Qiming Venture Partners
• GGV Capital
• Gobi Partners
• Banyan Capital