Since 1999, iNetworks has been successfully providing needed capital, experienced management and intellectual resources to assist companies and entrepreneurs accelerate their product/service development. Our long-term success is attributed to not only investing in what we know but also comes from realizing that by maintaining a relative smaller fund size we are able to remain agile and efficient enabling us to continually deliver first quartile results.
Our rationale in offering smaller funds hinges on a simple premise, “smaller private equity funds outperform larger ones.”
We will rely on three commonly cited institutional studies to outline the advantages of small venture fund investing. The first is Investco Private Capital, who published an analysis of all their previous investments into private equity, spanning over 30 years, $4.3 billion in committed capital and nearly 50 limited partnerships. They concluded with the long-term philosophy “…smaller funds have a greater potential to result in stronger investment performance.”
The Kauffman Foundation reviewed its 20 year investment history in over 100 different venture funds and found that only 4 of its 30 venture funds with committed capital of more than $400 million delivered returns better than a small-cap index. Their study further recognized that large funds received more than two-thirds of their compensation from management fees and not performance (also known as the carry).
The last industry cited study was led by Silicon Valley Bank’s Capital Group. They analyzed not only their own historical investments but included and compared their data against data from Preqin, one of the leading venture capital data providers. In total, Silicon Valley Bank considered over 850 individual venture funds and found that “…the smaller end of the size spectrum consistently outperforms larger funds across [all] vintage years.”
We at iNetworks realize that given such anecdotal and analytical evidence, increasing our fund size would not be in our limited Partners’ best interest. Our funds have a total capital commitment of $100 million and invest in only 10 to 15 firms in sectors that we have an in-depth knowledge. This includes productivity IT, particularly in the healthcare and life sciences sectors. This allows us to apply our proprietary research techniques to identify investment opportunities while always keeping our interests aligned with our limited partners.
Where It All Began
During the 1980s, nearly all venture-type funds were $250 million or less. This smaller fund phenomenon continued through to the early-2000s. And as counterintuitive as it may sound, funds sizes did not begin to increase until well after the bursting of the internet-bubble.
The increase in fund size was primarily due to the exiting of many venture-type funds from the marketplace after the dot-com crash. For the few venture veterans who remained, they found themselves in high demand and in order to absorb the excess capital flows, they increased their fund size. Bringing into existence the mega-funds that we see today.
Over time, new funds did enter the market, but for the most part, they remained small in size creating a split venture space divided by size. This “bifurcated” market space is what we see today.
A Misalignment of Interests
As venture funds became larger, a misalignment of interests began to emerge between general partners and its limited partners.
Most venture funds are typically compensated by a 2 percent management fee on all committed capital and a 20 percent “profit-sharing” fee on excess returns, this structure is referred to as the 2 and 20 rule.
For large funds, this structure can quickly encourage general partners to shift priorities by creating disincentives for them to primarily seek out profit generating opportunities.
The 2 and 20 rule affords large funds the ability to lock in astounding levels of management fees even if they fail to produce a profitable investment or even return all of the limited partners’ committed capital. The Kauffman Foundation found through their in-house study that more than two-thirds of fees paid into venture funds came from management fees and not performance.
Academic research further supports this theory, in that when management fees become large enough, they essentially shift the long-term goal of the fund from being purely performance driven (maximizing the carry) to searching for and securing more committed capital.
Smaller Is Better: The Facts
The concept of having a misalignment in interests seems logical in theory but does it translate into the data?
Several analyses conducted by both financial institutions who invest in venture funds and academia have regularly concluded that, though other factors contribute to the “smaller is better” phenomenon, the theory holds.
Looking at the aggregated performance data for venture funds in the form of an index, Thomson Venture Economics All Venture Capital Index found, when breaking down the index components by fund size, early-stage funds with $100 to $300 million in total committed capital earned an internal rate of return of 22.3 percent. And as the ranges in fund size increased, internal rates of return began to fall significantly.
We see in Chart 1 that funds with $300 to $500 million in committed capital earned a 7.8 percent return, those with $500 million to $1 billion returned a marginal 1.1 percent and funds with more than a $1 billion gave their investors a meager 0.9 percent.
Chart 1: Smaller Venture Funds Have on Average Outperformed
The breakdown from Thomson’s index by fund size clearly illustrates the superior returns small funds have delivered over time compared to those that are larger. Comparing only the returns of the smallest range with those of the largest range, we see that the smaller range had delivered 230 percent better internal rate of return.
Like most investments, historical performance is not the sole predictor of future performance, but with such a large disparity, it seems highly probable that small funds will continue to outperform.
Additional evidence of smaller fund performance can be found in actual portfolios of venture capital funds. Two well-known investors in the venture space, the Kauffman Foundation and Silicon Valley Bank, conducted studies on their historical venture portfolio holdings and their results overlapped with Thomson’s Venture Index.
The Kauffman Foundation analyzed their investments into 100 venture funds over a 20-year period and found that:
Only 20 of the 100 funds generated returns beating small-cap indexes by more than 3 percent per annum and half of those began investing prior to 1995.
- More than the majority of funds (62 out of 100) failed to exceed returns available from equity markets, after fees and carry were paid.
- Only 4 of 30 funds with committed capital of more than $400 million delivered returns better than those available from a small-cap index.
Silicon Valley Bank Capital Group
Silicon Valley Bank’s Capital Group (SVB) also conducted its own study on its venture portfolio but they included data from Preqin, a leading provider of venture performance data. In total, SVB’s analysis covered 850 venture funds and surmised:
- The majority (51 percent) of funds with more than $250 million fail to return all investors capital, after fees.
- Almost all (93 percent) of large funds fail to return “venture-like” returns of more than twice the invested capital, after fees.
- Small funds, under $250 million return more than 2-times invested capital 34 percent of the time, a rate that is nearly 6-times greater than the rate of return for larger funds.
Combining both, the Kauffman Foundation and Silicon Valley Bank studies, there were over 50 years of performance data analyzed in nearly 1,000 different venture funds and their conjecture is that smaller is better.
But just how much better?
Silicon Valley Bank utilized two metrics to quantify the performance between large and small funds to see just how much more likely you are to receive better returns by investing in smaller funds. The two metrics used were Total Value to Paid-in Capital (TVPI) and Distribution to Paid-in Capital (DPI).
Total Value to Paid-in Capital (TVPI)
TVPI is the ratio of the fund’s portfolio value, both distributed and undistributed, versus the original invested capital, where breakeven would be considered a ratio value of 1x. As Chart 2 shows, 66 percent of small funds in the SVB study had a TVPI greater than 1x, that is, they broke even or better. In fact, 22 percent of small funds had a TVPI of at least 3x compared to only 3 percent of larger funds.
Chart 2 — TVPI Distribution of Venture Funds
What is even more striking is that when you reduce the range of fund size to $50 to $150 million, performance improves within the small fund size group. The study found that 52 percent of funds in this reduced range had a TVPI of at least 1.5x compared to only 46 percent when the range cut off was $250 million.
Distribution to Paid-in Capital (DPI)
Similar fund performance occurs when observing the portfolio’s historical DPI. DPI measures only the realized portion of the fund that was distributed to its limited partners as a ratio of committed capital, what an investor gets back above its capital commitment. Using the original $250 million cutoff for the range of small funds, SVB found that only 30 percent of small funds had a DPI of less than 0.5x compared to 54 percent of large funds.
Further, we see that there were 21 percent of small funds with a DPI of 3x while only 4 percent of large funds met this performance level (see Chart 3).
Chart 3 — DPI Distribution of Venture Funds
Why Smaller Is Better
The rationale behind why smaller funds perform better is that they are considered to be more nimble and efficient. When you start raising more and more funds, the need for more and more investment “home runs” becomes necessary to adequately affect overall fund returns.
Let us suppose that you invest in a venture fund that has a total capital commitment of $100 million. That fund could buy a 20 percent stake in 10 to 15 start-ups and handily beat the equity markets returns by having only 1 or 2 of them produce exit values of $200 to $300 million.
During the investment process, the incentives for the general partner remain in-line with its limited partners because the annual management fees collected are only large enough to “keep the lights on” while the potential profit sharing agreement from generating returns of 2x to 3x remain as the prime motivation.
That’s why when you look at average performance levels, the larger end of the fund size range consistently underperform. SVB found that there was more funds in $100 to $200 million range that exceeded the Cambridge Associates venture fund return benchmark than any other range. The average TVPI in that range was found to be higher than any other size range.
Chat 4: Average TVPI (in millions)
As Chart 4 illustrates, all average fund ranges’ TVPIs below $200 million well outperformed those ranges between more than $200 million and larger than a $1 billion.
Why iNetwork Funds
iNetworks purposefully choose to keep its fund sizes small because we realize the necessity of keeping our institutional investors’ interest aligned with ours.
Keeping the fund size small, a total capital commitment of $100 and investing in only 10 to 15 firms, we are able to remain agile by investing in a limited number of early- to mid-stage firms that possess game changing technologies and help in fostering their development by providing necessary capital, our experienced management skills and intellectual resources to ensure a profitable exit for our institutional investors.
- “Dialing Down: Venture Capital Returns to Smaller Size Funds”, Steven Webber & Jason Liou, May 2010.
- “We Have Met the Enemy… And He is Us: Lessons from 20-Years of the Kauffmnan Foundation, May 2012.
- In Private Equity Performance, Fund Size Matters, Investco Investment Insights, January 2013.
- For VC & Buyout Funds, Smaller Means More, Pensions & Investments, Arleen Jacobius, April 1, 2013.
- Why Small Is Beautiful In Venture Capital, Venture Beat, Manu Rekhi & Rafiq Dossani, August 18, 2012.