Venture Capital: Is Bigger Better?
Venture capital is a risky asset class. So it would seem to be prudent for investors in venture capital to focus on the largest funds.
After all, by definition of their size, large funds have convinced other investors regarding their skill. This is social proof. Large funds should benefit from their additional management fees being deployed for additional resources. This is economies of scale. Large funds should get higher quality dealflow. This is network effects.
Altogether, this is the power of a strong brand. The expectation is that size and quality are related.
Let’s inspect the data. One of the most comprehensive recent studies was done by Silicon Valley Bank on 590 venture capital funds in the US using data from Preqin covering funds of at least US$50mln in size with vintage years from 1981 to 2003.
There was was a clear difference in performance. Large funds, defined as >US$250mln, struggled to generate attractive returns, with only 3% returning at least 3.0x while smaller funds, defined as US$50-250mln, did much better with 22% able to return at least 3.0x. In addition, the gap was consistent across all measures of return. On the flip side, the risk of getting less than a 1.0x return was lower among small funds.
Since there is potential for some cycle specific issues to impact the data (large funds were mostly raised during 1999-2000, the worst time to invest), a second approach was used comparing fund sizes in each vintage year. The conclusions were even more skewed in favour of small funds. In this case, larger than median funds were never able to return at least 3.0x while smaller than median funds were able to return at least 3.0x during 31% of the time. Once again, the gap was consistent across all measures of return while the risk of getting less than a 1.0x return was lower for small funds.
Why do smaller funds have consistently higher returns and lower risk? The first point brought up by Silicon Valley Bank is better alignment with investors. “As the managers of such funds earn relatively less from management fees, they have a stronger incentive to focus on portfolio performance in order to generate wealth through carried interest.” (Weber & Liou, Silicon Valley Bank).
There are several other possible causes, many of which relate to the fundamental challenge that running a US$500mln fund requires extremely large, and rare, exits to make a difference while running a US$50mln fund allows for more flexibility in the size of exits needed to generate high returns.
Does this mean that all large venture capital funds are bad and all small seed funds are good? Of course not.
What it does mean is that, statistically, managers have to be exceptionally skilled to generate excess returns at large funds. In fact, the same team running a large fund would probably be able to generate higher returns at a small fund. Conversely, as small funds get larger than US$250mln, investors should start to become more worried about the negative impact of size on performance.
For investors in venture capital funds, these are some sobering conclusions. It means that playing it safe and investing in large funds is actually a higher risk, lower return proposition. Conversely, investing in smaller seed funds results in a better return and a lower risk of earning less than 1.0x. When it comes to venture capital, small is the sweet spot.