Startupland is all about getting big, fast. But for venture funds, smaller is better.
Funds below $250 million have outperformed larger funds significantly in recent years. Smaller funds delivered comparable or better performance in most periods, according to Pitchbook data going back to 2017.
Twilight of the Megafunds?
The boom years saw the birth of one megafund after another. A16z even raised a $4.5 billion crypto fund in early 2022, just as crypto markets were falling apart.
Today, we’re 8 quarters into a severe downturn in tech. If companies can raise money at all, it’s usually a lot less.
Deal sizes are down significantly, with late stage deal sizes falling nearly 40%.
Fewer, smaller deals mean those giant funds lack opportunities. When deal sizes are small, what do you do with billions in capital?
Founders Fund wisely cut its fund size by half, from $1.8 billion to $900 million. Others should follow suit if they want to preserve their returns.
Do VC’s Care About Returns?
But returns aren’t really the goal for a lot of big VC’s.
Venture funds generally get a 2% management fee every year, no matter what. Good performance or bad, that money rolls in.
On a small fund, it’s barely enough to keep the lights on. But on a $4.5 billion colossus, that’s $90 million a year hitting your account no matter what.
Let’s say you 2x that fund. That’s a rotten return for LP’s, but the fees are juicy.
At the typical 20% carry, you clear $900 million in performance fees and another $900 million in management fees over 10 years. That’s a whopping $1.8 billion in fees for a crappy result.
Misaligned Incentives
Let’s compare that with a smaller fund.
If I started a $1 billion fund and 3x-ed it, a solid return for LP’s*, I’d see $400 million in performance fees. I’d also rake in a tidy $200 million in management fees, bringing me up to $600 million.
I performed great! But I actually made over a billion dollars less than the guy who just hoarded capital.
The incentives for LP’s and GP’s** are not aligned. The LP wants good returns, but the GP just wants more assets under management.
No wonder we’ve seen so many big funds in recent years!
Picking a Venture Fund
If I go to a car dealership, the salesman’s job is to sell me the most expensive car possible. He doesn’t care about selling me the right car for me, or finding me a deal.
I can still do business with him, but I have to know his incentives.
In venture capital, the GP’s incentive is to hoover up as much money as possible and sit on it. Especially at a big name fund, he has no reason to care about returns.
Look for managers running smaller funds with a strong track record of returns. A good VC should produce at least 15% a year — the minimum you should accept for so much illiquidity and risk.
Wrap-Up
In our country, we want everything to be big. But sometimes, small is beautiful.
I hope to see more small, nimble venture funds out there racking up great returns for LP’s.
What do you think of VC performance? Leave a comment and let us know!
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More on tech:
New York Just Behind SF for Venture Deals
AI Compute Cost Is Going to Zero
Early Stage NYC Startups Struggle Through Venture Downturn
*LP stands for Limited Partner. They’re the investors who put capital into the venture fund. They’re usually endowments, pensions, other institutions, and wealthy individuals.
**GP stands for General Partner. These are the people who run the fund, invest in startups, and take the fees.
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