Thinking About Thinking

Silicon Valley Bank came out with a report today, called Dialing Down, that puts some data around the commonly held belief that better returns come from smaller funds.  In this case – conventional wisdom is clearly true.  Their fundamental conclusion is that venture capital funds are getting smaller – and that’s a good thing because it’s the small funds that generate outsized returns.  The most compelling statistic compared the returns of large funds versus small funds (large funds being defined as above the median size for their vintage year).  The result:

• 2% of large funds returned 2.0x or better.
• 48% of small funds returned 2.0x or better.

Volition Capital is committed to a small fund model precisely for this reason.  But, why is it more likely for a small fund to succeed?  I think there are a number of reasons – some more obvious than others.

1.  The law of large numbers. Take a typical large VC firm with a $750M fund that averages 20% ownership in each portfolio company.  For that fund to return a 3x, the portfolio has to be worth over $11 billion.  And that is before accounting for fees and carry.  A good fund is lucky to have one billion dollar company, but 11 of them?  Not likely.

2.  Small fund GPs are more aligned with their LPs. It’s pretty simple really: small fund GPs make their money from carry whereas large fund GPs make their money from fees.  Large fund GPs still want to generate carry, but they don’t have to in order to create wealth.  Small fund GPs need to make great investments to generate wealth.  Who do you think is more hungry and will work harder to find and make those great investments?

3.  Small funds are more focused. When you have a small fund, you can’t make every investment under the sun.  You can’t be a late stage & early stage & PE, tech & cleantech & healthcare, US & Europe & India & China… fund.  You don’t have a lot of capital to deploy so you get razor focused and develop the culture, methodologies, domain knowledge, and accountability – around a specific type of deal.  You get good at something – and that makes better returns more likely.

4.  Small fund GPs like each other more, probably. If you could start a firm, are there 10–15 people you would be willing to call “partner”?  Someone you’re willing to bet your career on, whom you trust implicitly, whom you don’t have to ask and you know they will do the right thing?  Are there even 10–15 people that you’d want to spend 50–70 hours per week with every week making joint decisions?  Unlikely.  Since large funds have grown their partnerships – the resulting 10–15 partners are more likely to just work together rather than be true partners at the core.  Small fund partnerships don’t have the pressure to grow the partnership making it easier to preserve the “partner” in partnership.

That all being said – there are some great larger funds out there and I’m fortunate to have worked at some of them.  As the stats show, 2% of large funds did well.  It’s harder, but it can be done.  But as the stats also show, your odds are much better with a small fund.