Why is it so hard for VCs to raise Fund II?

A few weeks ago I met a VC who was in the process of raising his Fund II. When I asked how it was going, he made a comment like,

"Yeah, we'll see. I'm not sure it's gonna work out. Raising Fund II has been almost impossible."

I was floored. I assumed that Fund I would be the hardest fund for a VC to raise.

But I was dead wrong. Not only is Fund II often harder to raise compared to Fund I, it can take much longer to complete.

To dig into this subject, I interviewed Hustle Fund GP Eric Bahn, who has led the charge on our firm's fundraising efforts. He shared so many critical insights that I'm splitting this article up into two parts.

Today we'll cover part 1: The Problem.

  • Why Fund II is so much harder than Fund I
  • What "TVPI" means, and why it's important
  • A big hairy problem happening right now

Next week we'll cover part 2: The Solution.

  • Why it matters who you raise from
  • How long it'll take to raise Fund II
  • Advice about closing your fund

Let's get started.

Why Is Fund II harder than Fund I?

When you're raising your first fund, you're basically selling investors on a dream.

You're sharing your story, your vision, your thesis for the fund. You're explaining how you're different from all the other funds out there, and where your incredible deal flow will come from.

It's kinda like a pre-seed startup raising their first round. You don't have results yet, but you've got decent experience and a vision for how it's all gonna go.

Sure, you may have some experience as working for another VC firm. You may even have an impressive portfolio as an angel investor. But the fund that you're launching is essentially at ground zero. So there's not much data the investors can dig into.

Fund II is a completely different beast.

Most VCs start raising Fund II about 2-4 years after they raise Fund I. And prospective investors for Fund II want to see what you've accomplished in that time period.

Here's the problem. Most early-stage startups take years to see significant progress. Most likely none of your portfolio companies will have IPO'd by the time you're raising Fund II.

There's a chance a few of your companies were acquired for a small amount of money – probably delivering you a return of 10x or less.

But it's far more likely that your companies are

a) still figuring it out

b) trying to raise a round

c) or have already shut down

This is the nut of why Fund II is so much harder to raise than Fund I. Investors want to see that your fund is doing well and returning money to LPs (limited partners).

But the reality is that that probably won't happen for a few more years. In the meantime, you need to raise Fund II in order to continue deploying.

Intermission where we talk about TVPI

Pause for a moment on Fund I vs Fund II. I wanna take a quick break and talk about something called "TVPI" and why it's important to know about.

TVPI is "Total Value to Paid In", which is a stupid way of saying "how much is your fund worth on paper".

Let's say you raised $1 million for your Fund I. You deployed that $1m into 4 different startups.... $250k investment per company.

When it's time to raise Fund II, you look at those 4 companies. Of those 4 companies...

  • Company A is now valued at $10m
  • Company B is now valued at $20m
  • Company C shut down
  • Company D's valuation hasn't changed

You whip out your TI-84 calculator that you somehow managed to hang on to from high school and beep boop boop you calculate how much your fund is worth based on these valuations and your ownership in the companies.

Let's say your fund is now valued at $3m.

To get the TVPI, divide the value of the fund by the initial fund size:

$3 million / $1 million = 3 TVPI.

Now let's clarify something. You haven't returned $3m to your LPs. TVPI is simply "paper gains"... the valuations are legit but you haven't returned that cash to your LPs yet because none of these companies have actually exited.

Still with me? Hang in there, we're almost to the point.

TVPI is an important part of your Fund II strategy. It shows investors that your fund is moving in the right direction, even if your earlier investors aren't seeing an ROI yet.

Ok. Now let's connect the dots and talk about a big hairy problem that's happening right now.

The big hairy problem

News flash: the market is tough right now. Founders are struggling to raise, and the ones that are successful are often raising at low valuations (relative to a few years ago).

This is a big hairy problem for investors who are trying to raise a Fund II.

Why? Because of the TVPI.

See, if you want to raise Fund II but you need a high TVPI to convince LPs to partner with you, today's marketing conditions are making that more difficult.

Most founders aren't able to raise. Some founders are raising at a very small increase in valuation. And other founders are raising on a down round – meaning their valuation today is LOWER than when they previously raised.

Which means that investors don't have a whole lot of data to prove that they are on the right track... even if their portfolios are chugging along at a decent pace.

What do we do?!

All is not lost for investors who want to raise their Fund II.

In fact, Eric offered three pieces of advice to emerging fund managers who are in this position.

Buuuut this email is getting too long. So you'll just have to wait til next week for part 2.