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.

There are really three general asset classes in private equity: buyouts, growth equity, and venture capital.  So why is growth equity the best risk/reward among the three in my estimation? 

1.  The downside protection of leveraged buyouts is exaggerated.  The lure is that LBO firms are buying highly profitable companies with consistent cash flows, levering up the balance sheet, and ultimately trading the business while covering the debt for multiples on its equity.  The challenge with the model is that the equity of the LBO firm is not the senior security on the cap table.  Clearly, the debt is senior.  Every LBO investment is a bad quarter away, a tripped covenant away, or a bad economic cycle away from being under water from an equity perspective.  That’s the reason so many LBOs of all different sizes and shapes have been written off completely during this down cycle.  As it turns out, despite the perceived safety in leveraged buyouts, in reality, there is little room for error.  The loss ratios in LBO portfolios are higher than one might think. 

2.  The upside potential of venture capital is exaggerated.  By venture capital, I mean traditional early stage venture capital.  Firstly, the large venture funds run into the law of large numbers – no matter how good you are, turning a good multiple on a large fund is hard especially when you have modest ownership levels in your portfolio.  Secondly, traditional venture models justify their investments based on upside scenarios (i.e. swinging for the fences).  The reality is the vast preponderance of venture-backed exits are at modest outcomes so often times the investment case is divorced from the reality of where exits tend to take place.  That’s why venture capital has become more dependent on bubbles to make the math work.  Thirdly, venture-backed companies often take multiple rounds of financing thereby diluting both the ownership and governance of the early investors.  Finally, venture investments are often done at the very early stages of a business’ lifecycle where the risks are high and little is proven.  It’s a high risk asset class with moderate reward potential at the fund level. 

3.  So, why is growth equity such a great risk/reward in comparison?  Growth equity doesn’t run into the problem that LBOs have being junior on the cap table to the debt.  These are mostly non-levered equity only investments thereby making sure the investment is senior on the cap table.  Growth equity investments are traditionally done in companies that haven’t taken prior institutional investment and don’t require future institutional investment.  Therefore, the problem traditional venture firms have of diluted ownership and governance generally does not apply.  In addition, growth investments are traditionally made at a point in time when strong financial growth is proven in the business – this removes much of the early stage concept risk.  Finally, growth equity investments are, to state the obvious, growth companies.  So, they have tremendous upside potential, but the investment case is not dependent on the upside scenario happening like is often the case in venture. 

There will be winners in all three asset classes for sure.  And for full disclosure, Volition Capital is building its franchise in growth equity.  Nonetheless, I’ve seen winners and losers in my career in all three asset classes, and in my opinion, the best risk-adjusted asset class of the bunch is growth equity. 

The pressure for revenue growth has hurt a lot of young companies.  It starts with an entrepreneur representing a growth story to an investor.  Then the investor represents the growth story to his firm to gain support for the investment.  And then the investment happens.  Then the company takes the investment, invests in sales and marketing, and the company grows.  Everyone is committed to growth, gets used to growth, and expects more growth in the future.

This is all well and good – if and only if – the single unit value is there, especially in mass market companies that service consumers or small/medium size businesses.  There are two aspects to single unit value: (1) single unit satisfaction and (2) single unit economics. 

Single Unit Satisfaction

The fundamental question is if you take a single customer, do they derive sufficient value from using your product or service? 

• For a consumer social web service, maybe the key value measure is whether a user will tell two friends about it. 
• For a SAAS company, the key value measure might be renewal. 
• For a transactional company, the key value measure might be a repeat transaction rate. 

This is not intended to be rocket science.  Companies need to focus on a single customer, that is in their target market, and make sure they can deliver sufficient value to that customer to drive the right behaviors (referral, renewal, repeat usage).  It goes without saying, trying to build a great business on the backs of customers that don’t perceive sufficient value in your product or service is impossible. 

Single Unit Economics

The fundamental question now is if you now take that satisfied customer, can you make money based on your business model?  Companies need to fully burden the cost of servicing a single customer to understand single unit profitability.  This includes marketing, sales, cost of goods, capex, servicing, overhead, etc.  The question therein is whether that single satisfied customer is profitable given all that it costs to acquire and service them?

• Many online video sites excelled at single unit satisfaction, but they got hammered on the economics because they didn’t generate enough ad revenue to cover  a single cost component such as bandwidth to deliver the videos. 
• Some mass market companies that can cover sales and marketing costs, get caught up in the cost to service customers on the back-end.  The old local food delivery service, Kozmo.com had this issue. 
• Infrastructure oriented companies, like wireless service providers, that have up front capex to deploy new customers, need to be crystal clear on lifetime value of customers – to cover capex.  Otherwise growth is in fact detrimental.
• It goes without saying that if your selling your product for less than what it costs you – some of the early online retailers like MotherNature.com faced this.  You can’t make up negative gross margins with volume.

Sometimes the pressure for growth obscures the importance of single unit value.  In reality, there is no reason to invest for growth if the single unit value is not there.  It’s more prudent to wait, get customer satisfaction and economics nailed right, and then push for growth.  Pushing for growth prematurely at best will waste money unnecessarily, and at worst, will accelerate the demise of the company.  On the flip side, if the economics and value are there, rather than tiptoe forward on the growth plans, it’s prudent to invest aggressively for growth.  That’s when great companies are built, but it often requires patience in the early days.