Commentary: Challenging the GP commit – one size doesn't fit all

It's time to rethink the general partner commitment for venture funds. While most general partners adhere to the traditional GP commit of 1% of total committed fund capital, there is no particular rhyme or reason behind the percentage.

Potential limited partners in a venture fund have a clear interest in ensuring that the fund's GP is focused on stewarding their capital and generating returns, and the standard solution to ensuring this focus has been to invest alongside GPs who are putting their own money into the fund, theoretically aligning incentives when a GP is calculating risk and making decisions. While it all sounds reasonable in theory, the standard 1% GP commit is arbitrary at best — and creates significant barriers to progress at worst.

Prior to 1996, the federal tax implications for a fund depended upon a minimal investment of the GP's capital, defined by the Internal Revenue Service as the lesser of (x) 1% of total fund capital or (y) $500,000. Today, the GP's capital investment is not relevant to its tax classification as a fund. However, in order for GPs to avoid their carried interest being taxed as ordinary income vs. long-term capital gains, many GPs still follow safe harbor, according to a Wilson Sonsini Goodrich & Rosati report.

The 1% standard, established over three decades ago, has unfortunately evolved to become market expectation. And while it may sound like a small percentage, consider that with a $100 million fund, 1% means $1 million of invested capital is coming directly from the GP. This is only feasible when the GP is independently wealthy or otherwise well funded. Otherwise, 1% is far too simplistic a standard because it doesn't account for the varying amounts of capital available to an increasingly diverse pool of GPs.

Emerging managers, despite typically raising smaller funds, may not have 1% to contribute. The reasons for this vary, including, among others, no prior entrepreneurial or exit experience, not a spinout of a venture fund with promising carry on the horizon or lack of independent wealth.

The biggest concern then becomes: Does the 1% commit act as a barrier to potential opportunity? Answer: of course it does. Requiring emerging managers to commit large amounts of capital to their funds, despite their personal financial circumstances, unnecessarily penalizes those not from an affluent background. (And, to be fair, the majority of new firms are led by those outside the venture bubble, not spinning out of established venture firms with the additional security they offer.) This, in turn, prohibits many exceptional managers from getting a shot at starting their firm. It also creates a suboptimal dynamic: no LP wants their GP drowning in debt in order to build a firm. These barriers also affect the industry at large: the data shows that more diverse GPs are backing more diverse founders. Inversely, fewer diverse GPs means that fewer diverse founders may receive funding.

The question of the GP commit (is it appropriate, how much should it be) is highly nuanced. For some GPs, 1% may feel immaterial. For others, it could require taking on a second mortgage. The concept of "skin in the game" can be defined as something far beyond the GP commit for emerging funds as well; "skin in the game" for those funds is all of the time and attention the GPs spend to ensure the success of their fund, opportunity cost for setting aside other endeavors, and reputational risk should the fund perform poorly. The conversation needs to evolve, not around whether the 1% GP commit is a reasonable standard, but whether a standard is reasonable at all.

Arguably, the GP commit to a fund should be what is appropriate and meaningful for the GP. The actual amount doesn't determine "skin in the game," but rather the significance of the commit to the individual GP. So long as the percentage demonstrates alignment with LPs and incentivizes a focus on responsible, thorough decision-making for the fund, it is reasonable. As a result, this may mean that the most prudent way for LPs to create meaningful and robust alignment with certain emerging GPs is to be comfortable with a 0% GP commit for the first (or more) fund(s), assuming the GP is comfortable with the personal tax implications.

On the flip side, the 1% may not be a large enough GP commitment to demonstrate adequate alignment and thus a higher percentage is warranted. In other words, it's not a one-size-fits all standard, and should vary depending on the individual GPs. This also means that LPs need to start thinking in the long term and become willing to evolve with the funds in which they invest. As the GP raises more capital and grows increasingly wealthy over time, the expectation is that they increase their GP commitment. This feels like a far more reasonable and inclusive path, one that more LPs need to take now.

Courtney McCrea, based in San Francisco, and Sara Zulkosky, Washington, are co-founders and managing partners at Recast Capital. This content represents the views of the authors. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.