Thinking About Thinking

The unit of measurement in the venture capital industry has long been the “fund”.  A fund is typically a discrete pool of capital that a firm raises around a particular strategy, and then deploys by investing into companies aligned with that strategy.  The fund has had longstanding significance in the venture industry because it’s how returns are calculated.  LPs calculate their returns based on multiples and IRRs of the fund.  GPs calculate their carried interest based on how the fund performs.  And research firms like Cambridge Associates have been built around comparing the relative performance of various funds.

But, the utility of the fund as the metric of measurement for the venture capital industry relies on a fundamental assumption which is slowly, but increasingly not true.  That assumption is simply this: that you can invest in that fund, and only that fund.

Let me elaborate.  There have been two parallel trends in the venture capital industry that are eroding the utility of the fund as the unit of measurement in the industry.  The first trend is that LPs increasingly are consolidating their positions around the branded venture capital firms.  More dollars are flowing to fewer firms.  Prior to and in parallel to that trend, the branded venture firms are creating a menu of different types of funds with distinct strategies with which to deploy that capital.

Ten years ago, venture capital firms were making new investments out of one fund at a time.  Now it is not uncommon for the largest firms to have their seed fund, their early stage fund, their growth fund, their China fund, their India fund, their specialty fund [mobile, data, etc.], and on and on.  Here is the key point: some of these firms will not allow LPs to select the fund that most interests them and invest in that fund on a discrete basis.  They force a broader asset allocation into multiple fund vehicles in order to invest with that firm.

The logic works in one of two ways.  Sometimes the GP will hold out the most attractive fund – the fund that every investor wants to get into – and stipulate that in order to get into that fund, the LP must invest in their other funds as well.  Other times, the GP will say that the LP isn’t investing into a “fund”, rather they are investing in a “franchise”.  This means they allocate capital to the firm, and the firm may decide the relative allocations to the various funds.  It’s another approach to the same end result.

How does this all net out?  It simply means that fund-level returns aren’t always relevant because LPs never had the opportunity to invest in that fund discretely.  If LPs had to invest in a basket of funds to invest with that firm, then the true unit of measurement of returns is the basket, not an individual fund.  But, it’s impossible to know how these baskets take shape so the individual fund persists as the unit of measurement, despite its increasing irrelevance with a number of the largest and most branded funds in the industry which may slowly but surely portend a broader trend for the overall industry as well.