Guest Blog – Max Branzburg, Clean Pacific Ventures
Despite cries to the contrary, the venture capital industry is not broken. The poor performance over the past decade leading critics to write VC off as “fun while it lasted” has been driven by an isolated segment of the industry: large funds. The red flags are ubiquitous, but LPs today insist on investing in underperforming, oversized funds. Small VC funds – as they have throughout the industry’s existence – continue to deliver superior returns to their investors. The successful small-fund model has been readopted by some VCs, but too many LPs, VCs, and entrepreneurs remain unaware of its historically exceptional performance and its present advantages.
Today’s best-known top tier VCs – Kleiner Perkins, Accel, Sequoia, Venrock – began their careers with double- and single-digit fund sizes (Gupta, Done Deals). Limited partners – impressed by those funds’ returns – sought to invest more in the asset class, and fund sizes grew. The average venture fund grew from $54M in the 1980s to $95M in the 1990s and to $180 in the 2000s. Today, there are more than 400 funds of $250M or more (Thomson Reuters). Limited partners – perhaps ignorant of discrepancies in fund performances – have driven up demand for large funds, and VCs have happily complied, earning hefty management fees on excessively large pools of capital.
Excluding Internet bubble-effected funds, the historical increase in fund size has been accompanied by a highly correlated decline in returns.
Figure 1: Historical VC performance as a function of fund size (funds raised in 1990s excluded)
While exogenous factors may have played a role in the asset class’s decaying performance, a closer look reveals that a shifting dynamic within the VC industry towards large funds is a leading culprit.
By recognizing the important differences between small-fund ($50M – $150M) and large-fund (>$150M) investment patterns, we can better discern which segment of the venture industry is broken. As it turns out, only 7% of the large funds raised between 1981 and 2003 achieved returns for their investors at or greater than 3x. By contrast, 24% of the small funds raised during that time achieved >3x returns. More than three times as many small funds as large funds achieved those successful multiples. Four times as many small funds as large funds achieved multiples at or greater than 5x (Preqin, as reported by SVB Capital). The portion of returns achieved by each fund size from 1981 to 2003 is shown below:
Figure 2: Distribution of VC performance by fund size (data from Preqin, as reported by SVB Capital; chart by author)
As large funds become more common, the advantages of the small-fund model become more overt. Smaller funds – like those upon which the industry was initially built – are inherently better positioned to achieve superior returns. Some reasons why:
1. Smaller exits can return the fund
The smallest “large fund” ($150M) that owns 10% of its portfolio companies and charges 20% carry must generate $5.4B of market cap to achieve a 3x fund-level net return.
If that portfolio includes 10 companies, each company must generate, on average, $540M. Consider that from 2000 to 2008, 83% of the venture-backed exits were M&As, at an average valuation of $110M (the 17% of exits that were IPOs averaged $407.1M). Every portfolio would need to be populated by a handful of YouTubes and Facebooks to make the math work.
Smaller funds make more capital efficient deals, own larger equity stakes, and are able to return their funds with more modest exits.
2. GPs profit by performing
A typical $500M fund charging 2% management fees earns $10M/year before making a single deal. Carry from a couple of successful exits might sweeten the pot, but management fees already do significantly more than just keep the lights on for large funds.
Smaller funds cannot survive on 2% management fees; their livelihood depends upon making good deals and taking a piece of what is returned to the investor. Their incentives are better aligned with those of their LPs, and exceptional performance is the mutual goal.
3. Specialized sector knowledge
Smaller funds tend to focus on particular industry sectors. A small cleantech fund might have 3 GPs with expertise in 6 different cleantech segments. A larger fund is less likely to have multiple GPs with similar or overlapping specialties and, consequently, more likely to make bad deals. Small, sector-focused funds can make better investment decisions and add more value as board members.
4. Flexible follow-on financing
Large funds like to control the financing of the companies they invest in. One way to attain control is to seed a company alone, essentially taking that company off the market for future financing rounds. Large funds may also make small (proportionate to the fund) investments in the seed round within a syndicate led by another firm, and – as a company matures – add much more capital, thus taking a much larger equity stake. By getting involved early, they essentially buy an option to load up on equity later. LPs can consult historical performance data to discover that this strategy has not given large funds an advantage over small funds.
Small funds are happy (and well-positioned) to lead deals, but they tend to invest alongside other funds, and they offer market valuations. The ensuing flexibility is highly desirable by entrepreneurs. Capital efficient companies can avoid the “load up” problem; by requiring less capital, they are less susceptible to large funds’ equity-grab.
The recent increase in fund sizes is likely attributable to an information lag in the wake of the Internet bubble, and we should expect funds to downsize as historical performance discrepancies become evident. While the advantages of the small-fund model seem especially applicable to the clean technology sector (in which too many companies are capital inefficient), a dearth of realized returns leaves LPs unsure of how to allocate their funds. Many of the most visible clean technologies require significant capital to reach profitability and do not fit into the venture model; those technologies will play an important role in our future, but they will not offer high quality venture performance. It seems clear that small cleantech funds are better situated to deliver exceptional returns to their investors.
Max Branzburg is an Analyst at Clean Pacific Ventures, a pure play venture capital fund focused on capital efficient cleantech companies.