There are few sacred cows left in venture capital. When I started in early stage venture, founder liquidity/secondary, venture debt, unpriced rounds, party deals where no one takes a board seat, and taking an entire round without syndicating risk and capital were all no-nos. Today, larger fund sizes, the rise of professional angels, and a surplus of undifferentiated capital has shifted the landscape, put more power in the hands of the entrepreneur, and made the once extraordinary ordinary.
One sacred cow still exists: regional venture firms are viewed pejoratively by institutional LPs and data suggests regional investing (defined as non-Bay Area or non-national) does not generate returns sufficient to justify the fees, lack of liquidity, and duration risk. "If I can't get into a tier one Bay Area firm, I don't want to be in the asset class" goes the refrain.
As a co-manager of a regional fund, largely focused on Montana, the history of regional funds and the reasons behind their relative lack of success is important for me to understand and process. Before addressing where/why "this time may be different," let's visit the reasons why people believe regional funds are troublesome:
regional funds constrain deal selection and constraints on a system impact system health and performance
regional funds tend be to generalist in nature and force GPs to source, evaluate, and manage deals across a wide variety of industries
the top deal in a region may be the 10th deal in the overall market. In the Bay Area, if a deal is the best deal in the local market, one may reasonably assume that it is the best deal in the country in that space. The best deal in MT may be that, but it may not be absolutely the best deal.
regional funds may have initial early success given a "backlog" of neglected opportunities but then the size of the market creates adverse selection issues where there are not enough absolutely good new deals to put capital to work and generate returns. Or, if a regional fund is successful early, it may raise a fund too big for the local market, which leads to strategy drift and a new class of (national) competitors
professional management is lacking the local market and it is hard to recruit great people to non-core markets.
national investors will not travel to regions until companies reach ~$10m in revenue, forcing the local market to fund the seed, A, B...etc
regional funds run the risk of the best deals in their market being cherry picked by national players leaving, again, adverse deal selection available to the fund
How can one best manage the risks of regional venture investment? In talking with veterans of the regional model, the following safeguards and best practices emerge:
when investing regionally, strive to syndicate a regional deal with tier one national co-investors who are able to provide a more "global" view of the uniqueness and capabilities of the deal in question. This allows the "best" regional deal to pass a higher level of "best," in this case a national bar. Syndication reduces the risk of unintended regional ignorance.
invest less in projects and more in regionally-based serial entrepreneurs who you are able to back across companies
invest and partner with the local community to create a dynamic ecosystem full of the talent and best practices that fuel quality company creation
find ways to effectively promote deals and leverage relationships to get national investors to pay attention
develop a industry expertise and invest nationally in promising companies in that sector. Take a two pronged approach - serve as a generalist in your local market who can source, lead, syndicate, and manage the best companies (independent of sector), and invest nationally in a vertical where you are able to develop a competitive industry practice that lends value to non-local syndicates and entrepreneurs
double down on your winners
raise capital from those with a positive, pre-existing bias to your region
Whenever markets seem to ignore gravity, people begin to discuss the "new normal" and make the case for why the old rules no longer apply. I am mindful that the new normal often looks wishful thinking when the market turns south. In regional investing, I am curious to see IF talent, technology, and capital become more geographically fungible. Will the success of Orem, Provo, Boulder, Portland, etc, create a new model of regional investing, sized correctly for the local market opportunity, that generates returns that challenge the long held negative view of local investing? Or will the traditional risks noted above continue to challenge the viability of the local model?
For those working in regional venture capital , I'd love to hear what you have to say and welcome comments on what you view as the risks and the opportunities for regional venture capital. The pitfalls are clear, but as with all challenges opportunities exist for mindful, thoughtful people to manage risks and deliver results.