Over the years, there have been several excellent analyses of the ideal fund size for a venture capital fund.
The work that stands out the most is a detailed study in 2010 by the folks at Silicon Valley Bank -in which they found that sub-$250M funds signifigantly outperform their larger brethren. This piece is a must-read.
They looked at 850 funds and found that only 5% of funds over $250M have ever distributed greater than >2.0x capital (so-called DPI) to their Limited Partners. That is a pathetic statistic for the venture industry.
The brain-trust at HBS (Felda & Josh Lerner) came up with similar data that shows that the optimal fund size is $200M or so (credit to Todd Hixon of New Atlantic for the graphic):
There is alot of wisdom in these data sets gathered over 30 years of venture returns.
…which is why it is so odd that 2011 was the year of the return of mega-fund.
Mega is Back – But Is This Time Different?
According to the NVCA, $18B was raised by VC funds in 2011 – a seemingly great headline number – up 32% over 2010.
But what belies that number is a jaw-dropping number of firms raising mega-funds in the past year or so:
1) Bessemer $1.6 billion
2) Accel (growth + early): $1.35 billion
3) Sequoia $1.3 billion
4) J.P. Morgan Digital Growth $1.2 billion
5) Khosla (growth + early) $1.05 billion
6) Greylock (growth + early) $1 billion
7) Kleiner Digital Growth $1 billion
Only three things can explain this:
1) LP’s have gone mad
2) Returns of large funds have fundamentally changed since the SVB and HBS data sets
3) We are in the midst of another period / trend in VC that might again end badly
Part of this rush to mega-funds is clearly driven by the strong later stage (but still largely paper) returns that many of these funds have and will realize from investments in Groupon, Facebook, Twitter, Zynga, and other recent digital media IPOs.
My full spreadsheet of IRRs and multiples from these later round investments is here. The returns in these late rounds are much better than you might think – except for that last round in Zynga which doesnt look so good right now.
So these firms did what any good investor would do – they leveraged (largely unrealized) momentum to raise mega funds when the wind was at their backs. Yet another grand venture experiment in progress – one for which we won’t know the outcome for another 10 years.
Back to Fund Size – New Numbers
Now back to fund size – the existing analyses mentioned above all look at funds across the history of venture capital. The problem with this approach is that in the 1980s and 1990s, almost all funds were sub-$250M - certainly all of the good ones.
That also means that the record breaking 20-30x (!) funds that Matrix, Sequoia, Benchmark, and Kleiner had in the mid-90s are part of this data above and probably move it quite a bit.
So what is the optimal fund size when focusing on funds from 2001-2011 vintages – looking solely at IRR – since some of these funds are still in the J-curve to look at DPI?
The results actually don’t change much – small is still beautiful – with a caveat that requires explaining.
Two fund size ranges emerge as the optimal based on this data set of several hundred funds.
$400-$450M AND $100-$150M – across all quartiles and the top quartile funds.
Bruce Booth wisely pointed out to me the following caution when looking at this data:
Since there are only 8 to 50 funds per sub-group in this data set, the outperformance (or underperformance) of one or two funds can move the needle for the group quite sigifigantly – and in the case of the $400-$450M range, Accel’s 2004 $400M fund that is currently rumored to be valued at 12.5x – largely due to Facebook’s 95% contribution to the TVPI of this fund – probably is moving the IRR needle quite a bit as well.
So with that caveat – I still stand by the rule that small is beautiful in venture – the recent mega-funds and the imperfect data above not withstanding.
Navin Chaddha from Mayfield put it best in a reccent interview in the WSJ:
“I believe that the VC asset class will continue to attract investment, but there will be a flight to quality, with both teams as well as track record playing significant roles. There will be the haves and the have-nots. Further, in the haves category, there will be a divergence between firms that opt to raise and deploy sub-$400 million funds into classic, early-stage companies and a few firms that will raise billion dollar-plus funds to continue a multi-stage, multi-sector (IT, digital media and health care) and multi-geography strategies all in one fund. “
But will the latter strategy actually pan out?
The historical data implies that it won’t.
