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In 2012, the Kauffman Foundation released a report titled “We have met the enemy and he is us”. The report highlighted the lack of performance within venture capital and placed culpability on the investors (LP’s) of venture capital funds.
One of the key findings in the study was compelling data that venture funds <$250MM performed significantly better than venture funds >$250MM — Based on the report, 83% of large funds ($250MM+) exhibited a return multiple of less than 1.5X, while only 54% of sub-$250MM came in at a multiple of 1.5X or lower (clearly a huge delta, although perhaps a bit of “we suck less”).
The smaller is better message was heard loudly by LP’s as in the following years the venture market experienced both a significant downward shift in the size of funds from many brand name venture funds and a rapid growth in sub-$100MM venture funds as seen below (Prequin data).
Along the way, the narrative of “small funds are better” morphed into a belief that attaining venture returns was only marginally challenging for small funds.
Purely from a mathematically perspective, small funds certainly appear have a less daunting path to returning a multiple of investor capital. A notion that resonates strongly when considering the paucity of large exits over the last decade.
However, the actual analysis is significantly more complex.
First, it’s important to acknowledge that the risk/return calculus is quite different for small funds as compared to larger funds.
Firms who raise sub-$100MM funds are predominately seed-stage investors (or Micro-VC’s). As a function of an investment thesis focused on seed investing, these portfolios typically have longer liquidity cycles and more risk than the portfolios of larger fund investors. When adding in the startup risk elements of investing in a first time fund and/or first time venture capitalist, an acceptable “venture return hurdle” is higher for Micro-VC managers. The same LP’s who happily would accept a 1.5X-2X cash return multiple from large, established fund managers usually look for 3X+ net multiple for smaller seed funds.
As the data from Correlation Ventures shows, the most successful funds are those in the 90th percentile of their given vintage year.
Yes, while being top quartile performer keeps you in the game, the best firms consistently have funds that are in the top decile.
For Micro-VC funds, being in that top decile means fund performance of a minimum 3x+ net.
If that’s the case, what does it take to achieve a good venture fund return for a Micro-VC fund? Over the years, we’ve heard many managers state that because their fund is small, large unicorn-y exits aren’t required.
To test that, let’s walk through the math of a typical $30MM seed venture fund (the average size of a new sub-$100MM US venture fund in 2016).
Note that the 2% management fee is annually paid over a 10 year fund life.
Now, let’s make some basic assumptions on portfolio construction (based on what we most commonly see):
30 companies in portfolio
Average initial check size of $400,000
Average post-money valuation at initial investment of $7MM
Average initial ownership ~5.7%
Let’s assume for a minute that the fund manager has done a great job in following on in the right companies to the extent fund capital allows, and total dilution per successful exiting company is only 25% off initial ownership, bringing ownership at exit of the portfolio companies at ~4%. We’re also assuming little/no recycling which sometimes happens.
With this in mind, a 3x net multiple is provided if the fund realizes $2.6B in aggregate enterprise value! Certainly a huge number, and when venture skew is factored in, returning 3x net from a 30 company portfolio requires well-timed luck along with smart investing.
Of course, there’s nothing wrong with luck in venture.
The key is finding how to mitigate the role of luck, while maximizing the impact of it when it is presented.
While the math above may be intimidating, there are strong reassurances as history has shown us that small funds that do well, tend to do VERY well. Firms such as Lowercase, Baseline, Forerunner, Felicis, and K9 have top-decile funds that will ultimately far outpace top-decile performance of large funds.And there will be many others.
For managers that are starting funds, it’s simply important to understand the mathematically realities, and adjust their investment decisions accordingly.
Just because a fund is small doesn’t mean it’s going to be easy. But when things line up, the returns can be out of this world.
Now, time to go get into that top decile.