E652 | Lea Strumberger, KfW Capital: How Europe’s Largest Public LP Thinks About Opportunity Funds

0:00Welcome back everyone to another EUVC episode. I am pleased to have Leah Stromberger, Senior Investment Manager at KFW with us, which is, of course, one of Europe's largest and most mission-driven limited partners, deploying roughly$400 million annually, if I'm not mistaken, into VC and venture debt funds. Leah was advised to bring on the podcast by Hampus Jacobson from Pale Blue Dot, because he was thinking through opportunity funds. And he said, Andreas, I have met no one in Europe or the States with as thoughtful an approach to opportunity funds as Leah. Maybe he didn't say it exactly like that because he would never disregard all the other people he got advice from.

0:43But he advised very much that I talk to you. So Leah, here we are talking about opportunity funds. Pressure is on, I would say. Thanks, I'm both. Yeah, but thanks for inviting me. It's a pleasure to be here today and to talk about. opportunity, friends. Before we start the show, a quick note. If you're building or running a fund, you know it takes the right partners. At EUVC, we only work with sponsors we truly believe should be part of your tech stack. Please do take a moment to hear about them. And if you do, reach out, mention EUVC. It's the best way you can support what we do. Thank you so much.

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2:57This show is not investment advice and the hosts of this episode may be invested in the funds and companies featured. So tell me first and foremost, I just want to understand the KFW mandate to do opportunity funds. Maybe you can talk a bit about that. Yeah, as you said, KFW Capital is one of the largest LPs in Europe so far. We were founded in 2018 in order to strengthen the German and European ecosystem and to foster innovation, entrepreneurship and long-term economic growth. And therefore, we have different mandates. we invest out of and since last year we have this new opportunity fund facility which is one of the building blocks of the german future fund which is the 10 billion initiative in order to strengthen exactly this to foster innovation in europe by that we are also looking for late venture and growth investing for us growth and late venture is series b plus because a definition sometimes vary when you talk to talk to investors and people what we're actively looking for is late venture funds and what we also want to to also catalyze is that late stage funding is coming out of europe and not only from the u.s funds therefore and during the last years we saw more and more funds, setting up opportunity fund strategies.

4:30We also saw more and more GPs becoming platforms with various strategies. Some of them have early stage and late stage strategies, but some of them also started with these opportunity funds. And therefore, we set up a mandate. We started investing out of it last year. I think we invested in six opportunity funds so far. It's all GPs that we already invested in the main funds. I think for us, this is very important because we already know the managers. And by that, we have access to later rounds. Can you share the names of any of those six? I think they're not all disclosed, but one of it is Norskin Opportunity Fund.

5:19Another one is Notion. And I think the other ones are not disclosed yet. not sure that these two I can mention. Beautiful. Okay. So then you nestled an important point in what you said, which was that nomenclature tends to vary a little bit depending on who you talk to when fund managers present their opportunity funds. That means that it can vary everything from we only invest in the winners in our portfolio to we invest in anything late stage and we call it an opportunity fund. Could you say a bit about how you think about that? Kind of also maybe some words of advice to managers that are thinking about opportunity funds and maybe either they should stick to normal nomenclature or less branded nomenclature.

6:09Sure. So I think when it comes to opportunity funds, there is two cases. There's one case where GPs decide to set up a new structure in order to only back winners in their existing portfolio. Meaning that 100 % of the fund, of the opportunity fund they raise, goes into existing portfolio companies. This is, I would say, a classic opportunity fund. Then there is this other case where managers decide, okay, we are backing the winners in our portfolio. But over the last few years, we also saw so many companies, Either some we declined when it was too early, but we stayed in close contact with and they are developing very well, but we couldn't invest out of our early stage fund.

6:58So this could be a new external opportunity for the opportunity fund. And of course, through their network, they also get late venture deal flow, which they can then do. So we have these two cases, either the 100 % existing portfolio, but then we also have some funds that mix also exterior opportunities. And then of course, we have this completely separate strategy, like the growth fund strategy that is targeting only outside opportunities. And how do you think about the two? Let's stick to opportunities because growth is a chapter of its own, but how do you think about those two, the standard opportunity funds, so to say, and the more opportunistically adjacent?

7:45both can be can be fine because and it also depends on the amount of portfolio companies that the managers already have if it's a fund manager that only has a first fund generation and they have 20 portfolio companies I wouldn't advise them to do an opportunity fund because when in the opportunity fund when they target 10 portfolio companies they need to have to pick 10 out of 20 portfolio companies and I assume in venture you don't have 10 winners out of 20 companies so you need to have a certain pool of investments where you can pick from and when you have this 100 % existing portfolio strategy you don't have this investment pressure because Because we as LPs, we don't expect them to invest all of this money.

8:43Because in most of the times, a management fee is on invested capital and not on committed. So if they see any opportunities, they can call the money. If not, it's also fine for us. But in the cases where they also include external opportunities, they of course can do active sourcing. But then they also should have maybe people in the team that have the expertise for late venture investments. Because it's different if you're a seed investor or if you're a Series B plus investor. And therefore, we need to see different setups. Could you expand a bit on how you diligence the two opportunities when they come to you as an Epic LP?

9:33it depends if if it's a more emergent manager meaning it's their second or third fund generation and they come to us and say listen we were thinking about an opportunity fund because we see some companies in our portfolio that have we really great outlook but like we cannot allocate more money into them because of our allocation limits but we also see so many other opportunities due to our network then it definitely makes sense to structure this as like the majority of their allocation should go into the existing but they can from our requirements they can invest up to 40 percent in external opportunities and so this is not more than 40 percent because otherwise it wouldn't be an opportunity fund anymore from our view.

10:27Yeah, but then we also require that the team set up can cover it in terms of expertise. And if they don't have any late stage experienced investors in their team, they should maybe hire one. Let's continue down the vein of how an LP thinks about this. What are the pitfalls that you as an LP really look into and try and make sure it's not the case with an opportunity fund? So the good thing is for us that the risk to invest in an opportunity fund is already mitigated because we can look through the portfolio. We have the insight. We are going line by line through the companies and top to the managers.

11:10So the due diligence is a bit, it's not a blind pool where we invest in. So we can see, do we think that there is opportunities in the portfolio that could be a good addition to the ops fund, which is one thing that is really good. But then, of course, we have to believe in the manager to have the ability to pick the right ones. And also to, of course, pick good outside opportunities. But this is the same risk that we have when we invest in flagship funds and normal main funds. How do you think about opportunity funds versus co-investments and SPVs? So I think for the managers, they need to put in more effort to do SPVs for every single investment.

12:04I think for them, it's easier to just set up a complete structure to cover all this. Also for other LPs, SPDs are also fine. So it's not that there is something against it. I think for many GPs, an opportunity fund is a good trial to explore the growth segment. And some of them start with raising an opportunity fund in order to build up their late venture strategy and then maybe to build an entire strategy around it. So I think it's a good starting point. How do you think about the capability of an early stage manager to continue doubling down at the later stages? Yeah, that's an interesting question.

12:53and we will see we just we just started investing in the in the first fund so and some of the opportunity funds we backed already have a track record in opportunity funds such as notion where they already proved kind of that they and that they are able to pick to pick the right ones but then when it comes to new managers that just started their first generation of opportunity community funds, it is always that first time risk that you have. One thing that always, and I might get in trouble here, but one thing that always bothers me a bit is when managers say we make the decision to follow on as a follow on investor, basically, that they need someone else to lead the round.

13:43And if someone else leads the round, we will come in. I'm always like, that's not what I'm paying you for. I'm paying you for being thoughtful and willing to make a judgment and take a bet. And that's the insight that I'm bagging. So why would I bag you to then outsource your decision basically to Index or Balderton or anyone else? How do you think about that strategy? I mean, that's an interesting view because one of our requirements for the opportunity funds is that there has to be an external lead investor that makes at least 25 % of the round and is therefore increasing the round because we want to make sure that this is not just a continuation vehicle or to rescue some of the portfolio companies running out of cash.

14:31So of course, they have to make their own decisions and they have to really believe in this company to also do follow investments but um yeah you can see this from both sides but i think for opportunity funds it's the normal case that there is an external lead investor but still you have your own impression of the company and you just say you want to to follow and to use your parada rights um or sometimes even over parada depending on the round but in fact there has to be i think an external or a third party to prove that this is also a competitive deal. And maybe you can talk a bit about that because, of course, here we get into the continuation funds versus opportunity funds.

15:18And maybe you can say a bit why you've fallen on this second axis of not wanting to just do continuation vehicles. yeah so um as i said so for us this is more like a risk adjusted mean to back um to back later rounds and to um to strengthen the growth in in europe we also have like different requirements and set up some some um terms in order to to make sure that this is not a continuation fund but sometimes it's a bit tricky because one of our requirements says that it should not be a down round when the opportunity fund invests but sometimes it's also a very good deal because depending on when the early stage fund invested when it was like 21 22 this could still be a good deal and opportunity if the unique economics of the portfolio company have shown good traction.

16:20So, and then this is always something that has to be discussed in the ALPEC and we always require an ALPEC seed. I'm looking forward to interesting conversations because so far there's not that many deals happening in our existing Oxfant relationships, but yeah, will be interesting, I think. So just to clarify, nomenclature here, continuation funds are of course funds that you use as a manager to roll in assets that you don't want to sell to a third party, but instead you want to keep inside the firm's family, so to say. And this you're not really allowing for in your opportunity funds. Yeah, I think so.

17:03And I think most of this is more the case. So we don't see that many continuation funds. I think for these cases, most of the GP set up SPVs in order to ensure this. Yeah. Tell me, like just expand a bit on that, why you don't want to allow the VCs that you're backing to lead around entirely themselves. Just like I understand 100 % of what you said. My question to you is what was the discussions you had internally when you made this decision that, nah, we'll err on this side? What were the arguments? Because I could then, of course, when you say, nah, it's a way to ensure that we have an externally validated pricing and that we don't have people doing rescue operations for the existing portfolio makes a ton of sense.

17:49But on the other hand, we are betting on the managers to make the right decisions anyway. So why are you not wanting to entrust them with this decision as well? So I think what you said is the most obvious point actually. And I think we already trusted the manager to do the right decision when they made their initial investment. And of course, their aim is to not dilute from round to round. And so I think this is trust enough already. But of course, we somehow need to have some mean in order to make sure that this is a really good round and a really good investment. So I think this is actually the main point.

18:37And to be honest, most of the managers we were talking to, they already said this from the beginning. Of course, it will always be a third party pricing the round. So this was no discussion at all with the managers. If you look at normal VC math, you would also see that there is a lot of tendency to not necessarily only bag your winners in firms in general. So it's probably only extenuated if you have an opportunity fund where you get management fee on called capital, not on committed capital. So there's a lot of strong arguments. I just wanted to double click on it and understand it further. OK, anything when it comes to terms that an LP should be very aware of when you're looking at an opportunity fund opportunity?

19:22yeah so as you said mostly it's not an a-ram play because in most cases the management fee is paid on invested capital always depending on the strategy you decide on because if you decide to also invest in outside opportunities you can put more effort in it and you may hire one or two persons dedicated to this strategy and then it's also okay to call management fee on committed capital but what we always want to see is of course reduced fees so two percent management fee is standard for for like flagship strategies but for our opportunity funds we see more around one percent 1.2 percent on committed or invested depending on the strategy they are on And same with KERI.

20:17We want the managers to be mostly incentivized through their main funds in the KERI. Therefore, KERI is always below 20 % in the opportunity funds, at least in the funds that we invested. And this is also what we want to see. Leah, let me ask you a not easy question at all. So KFW is a bit of a market maker like IFO is in Denmark and EIF is across Europe. And that means that you have a lot of power. So how do you think about management fees? When do you think it is fair to pressure managers on their assumptions around the management fee? And when is it not? And same thing on Kerry. So I think for a management fee, we always look at the budget and we always discuss about the spending.

21:09with the managers and i think especially for emergent managers meaning managers from first to the third generation or so the two percent is really necessary because at least what we assume they have to they have to build up the team and the strategy they have so many costs also to um to build a brand in the market to get awareness but especially for a great team that they want to build so I think when it's the first three generations we're not like pushing for lower management fees but there's also funds sometimes that are increasing their fees by increased numbers of fund generations and this is always something we're pushing back because we can see they shouldn't get rich out because of the management fee but from the carry and this is what we always push for and try to negotiate also for the other LPs.

22:08And then let me ask you, like be devil's advocate here. Who are you to say to Notion or Norskin or Creandum or whoever? You guys, your management fees are too high. I think I know better what your budget should be inside the firm. You don't need it to grow. You don't need it to develop your teams. That's all just fluff and you're bagging it. Like what gives you the right as DLP to go in and negotiate that? I mean, we are a very, very large DLP. So we write very big checks. And I think this also gives us kind of negotiation power. But management fee is not the thing that we're discussing the most.

22:52We have more discussions around GP commitment, actually. This is our main point we are focusing on. Same with carry. Because carry is mostly like 20%. Sometimes they have super carry. For me, it's totally fine if they want to have like more carry when they reach 3x. There's not that many fans out there. Do you then think, we did an episode a year or two back with actually Christian from your team as well and Joe Schorch from Iceman, where they said, well, we're super happy to do super carry. like that would be awesome but then it should also be offset the other way around so if you want more if you do 30 % well maybe you should get less if you only do 10.

23:36Yeah so this is this is what we sometimes negotiate it's it's always like a big picture that we have and it's always a case-by-case decision and during the last two or three years supercarry is not really a thing anymore. It was in 2020, 2021, but now we rarely see it. And if, of course, we can discuss this downside carry, but yeah, it's not a big discussion nowadays. We're not discussing castles in the sky anymore. That is great. Okay. I do want to commend you for not discussing management fee and carry too much. I think it's a very bad practice, if I should be very honest, even on the later stage funds.

24:23I really don't think it's a role for the LP to take in most conversations. That's how Sequoia has been able to build Sequoia. That's how A16Z has been able to build A16Z. I don't think we get to a better place in the European ecosystem by having our major LPs pushing lower fees on our managers that are trying to build awesome firms for the next generations. Either you're in it or you're not. True. Yeah. So I think for the main funds, totally true. But most of the funds, they just have 2 % management fee. I would say 90 % of the funds we see just up 2%. And this is what we mostly agree on. Yeah.

25:03And that's how it should be. Amazing. Okay. You said you mostly instead discuss TP commit. Yes. Let's talk TP commit. What are your points here? I guess you're too often seeing the GP commit not to be what you wanted it to be in the opportunity funds as well? So for our main funds, there's still like the 2 % GP commitment, which we would like to see. But since we're for the opportunity funds, it's also decreased GP commitment. It's mostly 1 % or so. It's just that the managers, they are incentivized through the main fund. And they should, of course, have the same interest in the opportunity fund.

25:48But it's more around 1%, I would say. Do you, and this is just a question, maybe we can do a shout out to our banks that are helping the ecosystem work. Do you think that we have good enough facilities for managers to somehow come up with their GP commits and successor funds? Because it is for many, they find themselves, even if they're successful, quite cash wrapped in the later years. yeah so i think this is a very very important question and there is always so many discussions also internally when it comes to um our dds and especially i because i work with so many more emerging managers because my focus is more on climate tech and impact funds and they are mostly not like too advanced in their in their fund generations and of course it's sometimes very very tough for them to bring in this these two percent and but we always look also at their individual backgrounds and always take this into account and we don't want the managers to stay awake during the night because they can't sleep because they have to to somehow find money for their GP commitment so this is not the case we just want that they are aligned with us and that they are adequately committed, but they should not have any bank facilities in order to commit to that fund because this is not what we're looking for.

27:17Not even in later iterations or generations? So in later generations, they are like in an ideal world, they already had carry distributions. Otherwise, their track record wouldn't be investable, I would say. So especially in the later generations, it's easier for the fund managers to commit, depending on if it's like the third fund generation or the A. So in the third fund generation, it can be tough, definitely, because DPI is still like not really there. Then we discuss and if it's a good relationship and we think that they're adequately committed, we of course also go below 2%. But it's definitely difficult, especially for, I think, because currently we're reviewing so many second timers.

28:11So the first fund generation is three years old and they just committed a huge amount of their personal wealth into the first fund. The second one would be tough. Do you, and I imagine that the answer is no, because you are a semi-public institution, so you're having issues being too creative. But one thing I love my dear friends at Isomer for is Joe is a mastermind in finding ways to help emerging managers get off the ground. And he even runs what he calls his cash for houses program, where they buy different stakes from the VC firms to enable them to then be able to come up with the capital for success of funds.

28:50Is that anything that you do in KFW? We don't see that very often, actually. and I wouldn't say no. I would say no. I wouldn't say no. No, personally, you flesh out. No, it's not even a facility. It's not something that you can do within the KFW mandate. No. Which is actually would be an awesome thing, right? Like if that was, because in the end, as you started out saying, KFW is put in this world to help seed the ecosystem. And too often do we see emerging managers struggle actually finding their finances to run their funds. Okay, so now let's flip this to talk a bit about how the GPs should approach opportunity funds.

29:32It's a very different discussion, of course. So maybe if we start first and foremost, if you were a GP that was thinking about, should I do an opportunity fund or not? What are the factors that you would advise them to be thinking? Either it's that you see so many great companies in your portfolio And I think, okay, funding environment is a bit tough at the moment, or I want to definitely not dilute into the next round. And I think what we see more and more is that they want to explore the growth space for their team and also to kind of build a platform. And then it really makes sense, I would say, to explore this, as I said, through an opportunity fund.

30:19and there it could be it could be a really good setup and it's not it's not a big risk for them I would say mostly it's existing LPs that enter into the opportunity fund because it definitely makes sense because they're already exposed through the main fund but often it's also often the case that for the main funds they were talking to LPs that were not able to invest in that but definitely want to start a relationship. And for these LPs, it might be a good opportunity to start investing into the opportunity fund and to build up the relationship to maybe double down then for the next main generation.

31:02Let's also talk about should you do only the existing portfolio or should you go for that 40 % allocation to opportunities outside of the portfolio? any advice on when it is prudent to stick to your knitting versus maybe also exploring their wider growth or is this purely opportunity driven by the manager like there's nothing that can be advised on here in general terms so i think if you have a large portfolio of investments you can pick from then it could make sense to do a hundred percent only and then you don't have to maybe hire some some new team members you just can do follow-on investments as you did before with your main fund and if your pool is large enough it definitely makes also sense to just do the hundred percent and existing portfolio companies also depends on what you're how you are perceived in the market maybe you are a brand for a certain topic and And then it makes sense and you get so many deal flow from like later stage companies, then it could make sense.